4. THE MONETARY APPROACH
The Monetary Approach focuses on the monetary policies of two countries to determine their currency exchange rate. The Monetary Approach uses two dynamics to determine an exchange rate, the price dynamics and the interest rate dynamics.
A change in the domestic money supply leads to a change in the level of prices and a change in the level of prices leads to a change in the exchange rate.
Monetary Approach Assumptions
The monetary model assumes:
(i) A freely-floating exchange rate regime (not a fixed exchange rate regime)
(ii) Minimal interventions by central banks
(iii) The aggregate supply curve is vertical
(iv) The prices of tradable goods are immediately adjusted to any change in the dynamics that affect them
(v) The transmission mechanism through prices to the exchange rate is immediate
The Monetary Policies
In general, the monetary policy focuses on the money supply of an economy. The available money supply is determined by:
(a) the amount of money in circulation, and
(b) the level of interest rates.
Countries that apply expansionary monetary policies to increase the amount of money in circulation will face inflationary pressures. This usually leads to a devaluation of the currency exchange rate. On the contrary, countries that apply tight monetary policies decrease the amount of money in circulation and see their currencies appreciate.
Money Supply & Money Demand
■ The money supply is generally determined according to the central bank's objectives. This is happening by:
(a) adjusting the level of interest rates, and
(b) controlling the amount of printed money in the circular.
■ Money demand is a more complex variable determined by:
(a) the available income
(b) the level of interest rates
(c) the level of prices, and
(d) future income and price expectations
The Mundell–Fleming Model
The Mundell–Fleming model focuses on the short-run relationship between the exchange rate, the interest rate, and the economic output. According to the Mundell–Fleming Model, certain combinations of fiscal and monetary policies may lead to some changes in the balance of payments relative to a new equilibrium level. Therefore, the exchange rate becomes a transmission mechanism by which the equilibrium can be fully restored.
Comparing Theory and Practice on Empirical Evidence
The Monetary Approach is neither an easy predictor nor an accurate predictor of exchange rates. In reality, the transmission mechanism between the price and the exchange rates is delayed.
The Monetary Approach is unable to make accurate short-term exchange rate forecasts, it is more reliable in the long term. Depending on the market expectations, the reaction of investors to a change in the level of interest rates can be unpredictable by a static economic model. Furthermore, the monetary approach holds better when applied in emerging economies than in developed economies.
■ THE MONETARY APPROACH
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