1 Chapter Two: Theories of Exchange Rate Determination

Outline
 The Purchasing Power Parity Theory
 The PPP theory and the Law of one price
 The absolute, relative and generalized versions of the PPP theory
 Empirical evidence on the PPP theory
 Money, Interest rate and Exchange rate
 A Brief Review of the Money Market
 The Definition of Money
 The Functions of Money
 The Supply of and the Demand for Money
 The Demand for Foreign Currency Assets
 Interest Parity Condition and Rate of Return
 Exchange rate and rate of return
 Linking Money, the Interest Rate, and the Exchange Rate
 The monetary model of exchange rate determination
06/15/2025
2 The Purchasing Power Parity Theory
Purchasing Power Parity (PPP) Theory and the Law of One Price
 Purchasing Power Parity (PPP) and Law of One Price (LOP)
are fundamental concepts in international economics that help
explain how exchange rates and price levels adjust across
countries.
 LOP serves as the foundation for PPP and states that identical
goods should sell for the same price in two different countries
when prices are expressed in a common currency.
 PPP extends the LOP to a broader basket of goods, proposing
that exchange rates adjust to equalize the price levels of these
06/15/2025 baskets across countries.
3 Cont’d…
The Law of One Price (LOP)
 The Law of One Price states that, in the absence of transportation costs,
tariffs, and other barriers to trade, identical goods should cost the same in
different countries when prices are expressed in a common currency.

Mathematical Representation:
 If the price of a good in country A is PA​ (in currency A), and the price of
the same good in country B is PB (in currency B), then: PA = e × PB
where e is the exchange rate (units of currency A per unit of currency B).
 Example: If a book costs $10 in the U.S. and €8 in Germany, with an
exchange rate of $1.25/€, the LOP would hold if: 10=1.25×8
06/15/2025
4 Cont’d…
Assumptions:

 No transportation or transaction costs.

 No trade barriers or tariffs.
 Perfectly competitive markets where arbitrage can take place
freely.
 Implications: If the LOP does not hold, arbitrage opportunities
arise where traders buy goods where they are cheaper and sell
them in markets where they are more expensive, until prices
equalize.
06/15/2025
5 Cont’d…
Purchasing Power Parity (PPP) Theory
 Purchasing Power Parity (PPP) is an economic theory that explains
the relationship between exchange rates and price levels across
countries.
 PPP posits that, over time, exchange rates should adjust to equalize
the prices of similar goods and services in different countries,
allowing for currency valuation based on purchasing power.
 The three main versions of PPP – Absolute PPP, Relative PPP, and
Generalized PPP – each offer different perspectives on how prices
and exchange rates interact over varying timeframes and contexts.
06/15/2025
6 Cont’d…
1. Absolute Purchasing Power Parity (Absolute PPP)
 Absolute PPP suggests that the exchange rate between two currencies
should reflect the ratio of their absolute price levels.
Mathematical Representation e =
where, e is the exchange rate (e.g., currency A per unit of currency B), PA​and
PB​ are the aggregate price levels of a basket of goods in countries A and B,
respectively.
 Interpretation: If Absolute PPP holds, an identical basket of goods
should cost the same amount in each country once prices are converted to
a common currency.
 Example: If a basket of goods costs $100 in the United States and €80 in
the Eurozone, the exchange rate according to Absolute PPP should be:
06/15/2025
e= = 1.25 USD per EUR
7 Cont’d…
Assumptions:
 Identical consumption baskets across countries.
 No transportation or transaction costs, tariffs, or other trade barriers.
 Perfectly competitive markets that allow for arbitrage.
 Limitations: Absolute PPP often fails in practice because price levels
across countries are influenced by local taxes, transportation costs,
tariffs, and differences in the composition of consumption baskets.
 Application: Absolute PPP provides a basis for comparing price levels
between countries, but its assumptions make it less applicable in real-
world conditions.
06/15/2025
8 Cont’d…
2. Relative Purchasing Power Parity (Relative PPP)
 Relative PPP suggests that the rate of change in the exchange rate over time is
equal to the difference in inflation rates between two countries. Mathematically:
= πA – πB

where ∆e is the percentage change in the exchange rate, π A and πB ​ represent the
inflation rates in countries A and B, respectively.
Interpretation: Relative PPP implies that if one country has a higher inflation
rate than another, its currency should depreciate to offset the inflation differential.
For example, if the inflation rate in the U.S. is 3% and in the Eurozone it is 1%,
the U.S. dollar should depreciate against the euro by approximately 2% over
time.
06/15/2025
9 Cont’d…
 Relative PPP is particularly useful in predicting long-term
exchange rate movements and is often applied in economic
models to estimate inflation-adjusted currency values.
 Relative PPP is more practical than Absolute PPP since it does
not require identical price levels, only that changes in prices
(inflation) are considered.
 Limitations: It assumes inflation rates are a major determinant
of exchange rate changes, which may not account for short-term
factors like speculation, interest rate changes, and political
events that can influence exchange rates.

06/15/2025
10 Cont’d…
3. Generalized Purchasing Power Parity (Generalized PPP)
 Generalized PPP extends the concept of PPP by considering not only inflation
differentials but also other factors that may impact exchange rates, such as
productivity differentials, interest rates, and economic growth.
 Generalized PPP incorporates the Balassa-Samuelson effect, which suggests that
countries with higher productivity growth in tradable goods sectors experience
real currency appreciation.
 Mathematical Representation: While Generalized PPP does not have a single
standard formula, it can be expressed as: e = f(πA​, πB​, gA​, gB​, iA​, iB​,…) where g
represents productivity growth, π inflation rate and i represents interest rates in
each country.
 This function accounts for multiple economic variables beyond inflation,
expanding the PPP framework to include broader economic indicators.
06/15/2025
11 Cont’d…
 Generalized PPP suggests that exchange rates adjust in response to a range
of economic factors, not just inflation differentials.
 For example, if Country A has high productivity growth in its tradable
goods sector compared to Country B, Country A’s currency might
appreciate relative to Country B’s currency, even if inflation rates are
similar.
 More realistic as it captures additional determinants of exchange rates
beyond inflation, making it a more comprehensive approach.
 Generalized PPP is complex and can be challenging to apply in practice
due to difficulties in measuring all relevant economic factors consistently.

06/15/2025
12 Cont’d…
Key Differences Between Absolute, Relative, and Generalized PPP
Aspect Absolute PPP Relative PPP Generalized PPP
Focus Absolute price level Inflation rate Broad economic indicators
comparison comparison (e.g., productivity, interest
rates)
Exchange Direct exchange rate Exchange rate Exchange rate changes
Rate determination based on changes according to based on multiple economic
Implication price levels inflation differentials factors
Assumptio Identical price levels Consistent inflation Considers a variety of
ns across countries rates as main driver macroeconomic variables
Applicabilit Long-term, cross- Medium- to long- long-term, multi-variable
y country comparisons term; inflation-driven economic analysis
Limitations Unrealistic due to trade Ignores non- Complexity in measuring all
barriers, consumption inflationary factors influencing factors
differences accurately
06/15/2025
13 Cont’d…
Applications of PPP in Economic Analysis
 Exchange Rate Targeting: PPP theories provide a framework for
assessing the alignment of actual exchange rates with economic
fundamentals, assisting policymakers in determining if a currency is
overvalued or undervalued.
 Inflation Forecasting: Relative PPP is used in inflation targeting models,
helping central banks to anticipate inflationary effects on exchange rates.
 Economic Comparisons: Absolute PPP is used to compare standards of
living across countries by organizations like the IMF and World Bank.
 Long-term Forecasting: Generalized PPP is employed in complex
econometric models that incorporate various macroeconomic indicators to
project long-term exchange rate trends.

06/15/2025
14 Cont’d…
Empirical Evidence on Purchasing Power Parity (PPP) Theory
 The empirical validity of Purchasing Power Parity (PPP) has been a major focus in
international economics, especially as economists aim to understand how well PPP
can predict exchange rate behavior over different timeframes. Studies reveal mixed
evidence, with PPP holding under certain conditions but often deviating due to
various real-world factors.
Short-Term vs. Long-Term Validity of PPP
Short-Term Evidence
o Empirical studies show that PPP often fails in the short term, with exchange rates and
price levels experiencing significant deviations.
o Short-term factors such as speculative capital flows, interest rate differentials, and
political events frequently cause exchange rates to deviate from PPP predictions.
o Studies by Rogoff (1996) indicate that short-term volatility in exchange rates and
06/15/2025
speculative forces can overshadow the stabilizing forces predicted by PPP.
15 Cont’d…
Long-Term Evidence:

o Over longer periods, PPP tends to hold more closely, especially for
major industrialized countries with stable economic conditions.
o Long-term studies, such as Frankel and Rose (1996), suggest that
although deviations from PPP can persist, exchange rates generally
revert towards levels consistent with PPP over the long term (5-10
years).
o The mean reversion of exchange rates towards PPP levels is slower
than initially expected, but PPP remains a helpful tool for assessing
long-term currency valuation trends.
06/15/2025
16 Money, Interest rate and Exchange rate
Brief Review of the Money Market
 The money market is a crucial segment of the financial system
where short-term borrowing, lending, buying, and selling of
financial instruments with high liquidity and short maturities take
place.
 It plays a key role in maintaining liquidity and facilitating the
flow of funds within an economy, providing businesses,
governments, and financial institutions with access to capital for
short-term needs.
 The money market is a market for short-term funds and
financial instruments that typically mature in one year or less.
These instruments include treasury bills, commercial paper,
certificates of deposit, and repurchase agreements, among others.
06/15/2025
17 Cont’d…
Features of Money Market Instruments
 Short-Term Maturity: Money market instruments generally mature within
one year, making them ideal for short-term financing needs.
 High Liquidity: These instruments are highly liquid, allowing for quick
conversion into cash, which is crucial for managing cash flow and meeting
immediate financial obligations.
 Low Risk: Most money market instruments are low risk due to their short-
term nature and the high credit quality of issuers like governments and
large corporations.
 Fixed Returns: Many money market instruments offer fixed returns or
interest rates, which can be attractive for investors seeking safe, predictable
06/15/2025 returns.
18 Cont’d…
Major Money Market Instruments

1. Treasury Bills (T-Bills): Issued by governments to finance short-term needs, T-

Bills are considered one of the safest investments as they are backed by the
government.
o They are typically issued at a discount to their face value and redeemed at par
upon maturity.

2. Commercial Paper: Unsecured promissory notes issued by corporations to meet

short-term funding requirements, often for working capital.
o Commercial paper typically has maturities ranging from a few days to several
months and is generally issued by companies with high credit ratings.

3. Certificates of Deposit (CDs): Time deposits issued by banks with a fixed

interest rate and maturity date, usually ranging from a few months to a year.
06/15/2025
19 Cont’d…
o CDs are low-risk and provide a slightly higher return than savings accounts
due to their fixed terms.
4. Repurchase Agreements (Repos): Short-term borrowing agreements where one
party sells a security to another with an agreement to repurchase it at a later date at
a higher price.
o Repos are widely used by financial institutions to manage liquidity.
5. Bankers’ Acceptances: A form of short-term debt guaranteed by a bank,
commonly used in international trade to facilitate payments between exporters and
importers.
6. Federal Funds: Overnight loans between banks to meet reserve requirements
set by the central bank.
o The interest rate on these loans, known as the federal funds rate in the United
States, serves as an important benchmark rate for other interest rates in the
06/15/2025
economy.
20 Cont’d…
Role of the Central Bank in the Money Market
 Setting Interest Rates: Central banks, like the Federal Reserve in the
United States or the European Central Bank in the Eurozone or National
bank in Ethiopia, influence the money market by setting policy rates.
These rates affect the cost of borrowing and are key tools for managing
inflation and economic growth.
 Open Market Operations: Central banks conduct open market
operations, buying or selling government securities in the money market to
regulate the supply of money and maintain interest rates at targeted levels.
 Lender of Last Resort: During financial crises or liquidity shortages,
central banks can inject liquidity into the money market by lending to
06/15/2025 financial institutions to stabilize the financial system.
21 Cont’d…
Importance of the Money Market in the Economy
 Liquidity Provision: The money market ensures liquidity for financial institutions
and businesses, allowing them to meet short-term obligations efficiently.
 Efficient Allocation of Capital: By facilitating the flow of funds from surplus
units (savers) to deficit units (borrowers), the money market promotes efficient
capital allocation in the economy.
 Interest Rate Stabilization: Through short-term lending and borrowing activities,
the money market plays a key role in stabilizing interest rates, which can impact
broader economic stability.
 Financial Stability and Monetary Policy Transmission: The money market is a
primary channel through which central banks’ monetary policies affect the
economy, influencing broader interest rates, credit conditions, and overall financial
06/15/2025 stability.
22 Cont’d…
Definition and Functions of Money
 Money is defined as any item or verifiable record that is generally
accepted as payment for goods and services and repayment of debts within
an economy. It is typically issued by governments or other recognized
authorities, and it serves as the backbone of economic transactions.
 In contemporary economies, money takes various forms, including
physical currency (cash), demand deposits (checking accounts), and
electronic money (digital currency).
 Money serves several critical functions that support the economy’s ability
to operate smoothly and efficiently. The three main functions are:

06/15/2025
23 Cont’d…
1. Medium of Exchange
o Money facilitates the exchange of goods and services by acting as an intermediary
in transactions. Without money, economies would rely on a barter system, which
is inefficient because it requires a double coincidence of wants (both parties
needing what the other has).
o As a medium of exchange, money simplifies trade, reduces transaction costs, and
makes it easier to conduct business, thereby enhancing economic productivity.

2. Unit of Account
o Money provides a common measure for the value of goods and services, which
simplifies price comparisons and financial record-keeping.
o As a unit of account, money allows for standardized pricing, enabling individuals
and businesses to make informed economic decisions. It provides a way to
06/15/2025 quantify and compare the relative worth of goods, services, and assets.
24 Cont’d…
o This function is essential for budgeting, accounting, and planning
purposes within an economy.

3. Store of Value:
o Money can be saved and used in the future, retaining its value over time
(assuming low inflation). This feature enables people to defer
consumption until a later date, supporting saving and investment in the
economy.
o As a store of value, money is crucial for preserving wealth and allowing
economic agents to plan for future needs.
o Inflation can erode the value of money, which can affect its function as
a store of value. When inflation is low and stable, money effectively
06/15/2025 retains purchasing power over time.
25 Cont’d…
The Supply of and Demand for Money
 In economics, understanding the supply and demand for money is crucial
to analyzing monetary policy, inflation, interest rates, and overall
economic stability. These two forces determine the equilibrium level of
interest rates and influence various economic outcomes, such as
investment, consumption, and the purchasing power of money.

The Demand for Money

 The demand for money refers to the desire of households, businesses, and
the government to hold a portion of their wealth in the form of money
(cash or checking deposits) rather than other assets. The demand for
money is influenced by several factors and serves three primary motives:
06/15/2025
26 Cont’d…
Transaction Motive

 People need money for everyday transactions, such as buying goods and
services. The transaction demand for money is directly related to the level of
income and the frequency of transactions in the economy.
 As income rises, people generally need more money for transactions,
increasing the transaction demand for money.
Precautionary Motive

 Individuals and businesses also hold money as a precaution against

unforeseen events or emergencies, such as medical expenses or sudden
financial needs.
 This demand for money depends on the uncertainty of future needs and the
06/15/2025 general stability of the economic environment.
27 Cont’d…
Speculative Motive:

 Money is held as a store of value when interest rates are low,

and alternative investments, like bonds or stocks, do not offer
attractive returns.
 When interest rates are high, people are more likely to invest
their money in interest-bearing assets rather than hold it as cash.
Therefore, the speculative demand for money is inversely
related to the interest rate.

06/15/2025
28 Cont’d…
The Money Demand Curve
 The demand for money is often represented by a downward-sloping curve
on a graph where the interest rate is on the vertical axis, and the quantity
of money demanded is on the horizontal axis:
 Inverse Relationship with Interest Rates: As interest rates rise, the
opportunity cost of holding money (rather than investing it in assets that
yield interest) increases, leading to a decrease in the quantity of money
demanded. Conversely, when interest rates are low, the opportunity cost is
lower, and people are more inclined to hold onto money.

06/15/2025
29 Cont’d…

Fig 2.1 The Money Demand Curve

06/15/2025
30 Cont’d…
Factors Influencing the Demand for Money

Several factors impact the demand for money, including:

 Income Level: As income increases, individuals and businesses engage in
more transactions, increasing the demand for money.
 Price Level: Higher price levels lead to a greater need for money for
transactions, increasing the demand for money.
 Interest Rates: Higher interest rates increase the opportunity cost of holding
money, reducing the quantity of money demanded.
 Economic Uncertainty: In times of economic uncertainty or crisis, the
precautionary demand for money often rises as people hold onto cash for
06/15/2025
security.
31 Cont’d…
The Supply of Money
 The supply of money is the total quantity of money available in an economy
at a given time. It includes both currency in circulation and deposits held in
banks and other financial institutions. The money supply is largely
determined by the central bank in conjunction with commercial banks.
 Central Bank’s Role: Central banks, such as the Federal Reserve (U.S.) or
the European Central Bank (Eurozone) or National Bank of Ethiopia control
the money supply through monetary policy tools, including open market
operations, setting reserve requirements, and adjusting interest rates.
 Commercial Banks’ Role: Commercial banks influence the money supply
through lending. When banks lend, they create money by adding to the
deposits in the banking system, effectively increasing the money supply.
06/15/2025
32 Cont’d…
Monetary Policy Tools Affecting Money Supply

Central banks control the money supply using various tools:

 Open Market Operations: The central bank buys or sells government
securities in the open market to influence the amount of money in
circulation. When the central bank buys securities, it injects money into
the economy, increasing the money supply; when it sells securities, it
reduces the money supply.
 Discount Rate: The discount rate is the interest rate at which commercial
banks can borrow from the central bank. Lowering the discount rate
encourages borrowing and increases the money supply, while raising it
discourages borrowing and decreases the money supply.
06/15/2025
33 Cont’d…
Reserve Requirements: The central bank sets reserve requirements, which
specify the minimum amount of reserves that banks must hold relative to
their deposits. Lowering reserve requirements allows banks to lend more,
increasing the money supply, while raising them reduces lending capacity,
decreasing the money supply.

Equilibrium in the Money Market

 The equilibrium in the money market is determined by the interaction of
money demand and money supply:
 Equilibrium Interest Rate: The intersection of the money demand and
money supply curves determines the equilibrium interest rate. At this rate,
the quantity of money demanded equals the quantity of money supplied.
06/15/2025
34 Cont’d…

Fig 2.2 Equilibrium in the Money Market

06/15/2025
35 Cont’d…
 Adjustment Mechanism: If the interest rate is above equilibrium,
there is an excess supply of money, leading individuals to invest their
surplus money in interest-bearing assets, which drives down interest
rates. Conversely, if the interest rate is below equilibrium, there is
excess demand for money, leading people to withdraw funds from
investments, driving up the interest rate.
The Importance of Money Supply and Demand
Understanding the supply and demand for money is crucial for several
reasons:
 Economic Stability: Managing the money supply and demand helps
central banks stabilize the economy, control inflation, and influence
economic growth.
06/15/2025
36 Cont’d…
 Interest Rate Determination: The interaction of money supply and
demand is essential in determining interest rates, which affect investment,
consumer spending, and economic activity.
 Monetary Policy Effectiveness: Effective management of the money
supply allows central banks to implement policies that address
unemployment, inflation, and overall economic stability.
The Demand for Foreign Currency Assets
 In international finance, the demand for foreign currency assets is a critical
component in determining exchange rates and capital flows between
countries. The demand for these assets is influenced by several factors,
including interest rate differentials, exchange rate expectations, and
economic conditions in different countries.

06/15/2025
37 Cont’d…
 Foreign Currency Assets are financial assets denominated in a
currency other than the domestic currency. Examples include
foreign government bonds, corporate stocks, foreign currency
deposits, and any other investment instruments that provide
returns in a foreign currency.
 Individuals, businesses, and governments hold foreign currency
assets to diversify their portfolios, hedge against currency risk,
or take advantage of potentially higher returns in foreign
markets.

06/15/2025
38 Cont’d…
Determinants of the Demand for Foreign Currency Assets
Several key factors determine the demand for foreign currency assets:
 Relative Interest Rates: The difference between domestic and
foreign interest rates (interest rate differential) is a major driver of
the demand for foreign currency assets. Investors are attracted to
foreign assets if foreign interest rates exceed domestic interest rates,
adjusting for risk.
 Expected Changes in the Exchange Rate: Investors consider both
current and expected future exchange rates. If the foreign currency
is expected to appreciate, investors will be more inclined to demand
06/15/2025
foreign assets to gain from this potential appreciation.
39 Cont’d…
 Risk and Political Stability: The political and economic stability of the
country issuing the foreign currency impacts demand. Investors favor foreign
assets from stable economies because they reduce the risks of currency
devaluation and other economic disruptions.
 Liquidity: Investors are more likely to demand foreign currency assets that
are easily tradable. Highly liquid foreign markets make it easier for investors
to buy and sell assets quickly, which is particularly important for large
institutional investors.
 Capital Controls and Regulations: Governments sometimes impose capital
controls or restrictions on the movement of funds across borders, which can
affect demand. In countries with strict controls, the demand for foreign
currency assets may be suppressed, while in more liberalized economies,
06/15/2025 demand is typically higher.
40 Cont’d…
Foreign Exchange Market Equilibrium and Demand for Foreign Currency
Assets

The demand for foreign currency assets plays a significant role in determining the
equilibrium exchange rate in the foreign exchange market:
 Supply and Demand for Currency: The demand for foreign currency assets
translates into demand for the foreign currency itself. If demand for foreign
assets increases, it leads to an increase in demand for the foreign currency,
causing the currency to appreciate relative to the domestic currency.
 Equilibrium Exchange Rate: The equilibrium exchange rate is the rate at which
the quantity of a currency demanded equals the quantity supplied. When demand
for foreign assets rises, it pushes the exchange rate up until the expected return
on foreign assets, adjusted for the exchange rate, is in equilibrium with domestic
06/15/2025
assets.
41 Cont’d…
Impact of Central Bank Policies on Foreign Currency Demand

Central banks influence the demand for foreign currency assets through
monetary policy and interventions in the foreign exchange market:
 Interest Rate Policy: When a central bank raises domestic interest rates,
domestic assets become more attractive, potentially decreasing demand for
foreign currency assets. Conversely, a cut in interest rates may lead
investors to seek higher yields in foreign assets, increasing demand for
foreign currency assets.
 Currency Intervention: Central banks may directly buy or sell foreign
currency to influence its value. Such interventions affect the supply and
demand balance, impacting the demand for foreign currency assets.
06/15/2025
42 Cont’d…
Interest Parity Condition and Rate of Return
 financial assets in different countries should be equal when measured in
the same currency. If this condition holds, investors are indifferent
between investing in domestic or foreign assets because the returns, once
adjusted for exchange rate changes, are the same.

There are two main forms of interest parity:

 Covered Interest Parity (CIP): When exchange rate risk is eliminated by
using forward contracts to lock in future exchange rates.
 Uncovered Interest Parity (UIP): When investors do not use forward
contracts to hedge against exchange rate risk, and instead base their
decisions on expected future spot rates.
06/15/2025
43 Cont’d…
Rate of Return in Interest Parity
 In the context of international investments, the rate of return on
an asset considers both interest earned and any changes in the
exchange rate. Investors aim to maximize their rate of return by
comparing the expected returns on domestic and foreign assets.
 Domestic Rate of Return: The return on an asset in the
investor’s home currency, based on the domestic interest rate.
 Foreign Rate of Return: The return on an asset in foreign
currency, which includes both the foreign interest rate and any
expected or actual change in the exchange rate.
06/15/2025
44 Cont’d…
Exchange Rate and Rate of Return
 An exchange rate is the price at which one currency can be
exchanged for another. It is typically expressed as the amount
of domestic currency needed to buy one unit of foreign
currency (direct quote) or as the amount of foreign currency
that can be bought with one unit of domestic currency (indirect
quote).
 Exchange rates can fluctuate due to factors such as interest
rates, inflation, economic stability, political risk, and market
sentiment. These fluctuations impact the effective return on
06/15/2025
foreign investments.
45 Cont’d…
 Rate of Return on Foreign Assets is the return an investor earns
from holding foreign assets, adjusted for any changes in the
exchange rate between the foreign and domestic currencies. It
includes the interest or dividends from the foreign asset and the gain
or loss from converting it back into the domestic currency.
 The rate of return on a foreign asset (when measured in domestic
terms) depends on two key components:
 Interest or Yield on the Foreign Asset: The return the asset
generates in its local currency.
 Change in the Exchange Rate: Appreciation or depreciation of
the foreign currency relative to the domestic currency.
06/15/2025
46 Cont’d…
Linking Money, the Interest Rate, and the Exchange Rate
A. Money Supply and Interest Rates
 The relationship between money supply and interest rates is
fundamental in monetary policy:
 Money Supply: The total amount of money circulating in an
economy, controlled by the central bank. This includes cash,
bank deposits, and other liquid assets.
 Interest Rates: The cost of borrowing money or the return on
saving, determined by the supply and demand for money.
06/15/2025
47 Cont’d…
Expansionary Monetary Policy
 When a central bank increases the money supply, the supply of
loanable funds rises, which tends to lower interest rates. Lower
interest rates reduce the cost of borrowing and stimulate
economic activity by encouraging investment and consumption.
Contractionary Monetary Policy
 When the central bank reduces the money supply, the supply of
loanable funds falls, driving interest rates higher. Higher
interest rates discourage borrowing and spending, which can
slow down economic growth and help control inflation.
06/15/2025
48 Cont’d…
B. Interest Rates and Exchange Rates
 Interest rates play a direct role in determining exchange rates
through their effect on foreign and domestic capital flows. This
relationship is often explained through the Interest Rate Parity
(IRP) condition.
 Interest Rate Parity (IRP): IRP suggests that the difference
between domestic and foreign interest rates should equal the
expected change in the exchange rate. If the domestic interest
rate is higher than the foreign rate, the domestic currency is
expected to depreciate; if the foreign rate is higher, the domestic
06/15/2025
currency is expected to appreciate.
49 Cont’d…
?How Interest Rates Affect Exchange Rates
 Higher Interest Rates: When a country raises its interest rates,
its financial assets become more attractive to foreign investors,
leading to an inflow of capital. This increased demand for the
domestic currency leads to an appreciation of the exchange rate.
 Lower Interest Rates: When a country lowers its interest rates,
its financial assets become less attractive to investors, leading to
capital outflows. This reduces demand for the domestic currency,
resulting in a depreciation of the exchange rate.

06/15/2025
50 Cont’d…
The Role of Exchange Rates in Money and Interest Rate Linkages
 The exchange rate influences the demand and supply of foreign currency
in the market, connecting domestic interest rates with international capital
flows and investment decisions.
 Exchange Rate as a Price Mechanism: The exchange rate reflects the
relative value of two currencies, determined by supply and demand in the
foreign exchange market. If domestic interest rates change, it shifts the
relative demand for currencies and affects the exchange rate.
 Expectations and Exchange Rates: Investors’ expectations of future
interest rates and exchange rate movements also impact the current
exchange rate. If investors expect that a country will increase its interest
06/15/2025 rates, they may demand more of that currency now, appreciating its value.
51 Cont’d…
Monetary Policy, Interest Rates, and Exchange Rate Movements
 Central banks use monetary policy to influence the money supply, interest
rates, and, indirectly, the exchange rate.
 Expansionary Monetary Policy: When the central bank expands the money
supply (e.g., through lowering interest rates or quantitative easing), it aims to
boost domestic investment and spending. However, lower interest rates may
lead to capital outflows, depreciating the domestic currency, which can make
exports more competitive.
 Contractionary Monetary Policy: By reducing the money supply and
raising interest rates, the central bank can attract foreign capital, appreciating
the currency. A stronger currency can help reduce inflationary pressures but
may hurt exports by making them more expensive in foreign markets.
06/15/2025
52 Cont’d…
Exchange Rate Policy and Economic Goals
 The relationship between money supply, interest rates, and exchange rates
also influences the effectiveness of monetary policy.
 Managing Inflation: Central banks may increase interest rates to control
inflation, knowing that a higher interest rate may also strengthen the
currency and reduce the cost of imports.
 Supporting Exports: To boost exports, a central bank might adopt an
expansionary monetary policy, lowering interest rates to depreciate the
currency, making domestic goods cheaper for foreign buyers.
 Economic Stability: Central banks aim to balance these factors to maintain
currency stability, support economic growth, and control inflation.
06/15/2025
53 The Monetary Model of Exchange Rate Determination
 The Monetary Model of Exchange Rate Determination is a framework
used to explain how exchange rates are determined by changes in the
money supply, interest rates, and the relative inflation rates between two
countries. This model is based on the assumption that exchange rates are
influenced primarily by the demand and supply of money in different
economies, and that monetary policy, especially the money supply, plays a
key role in determining the value of a country's currency.

Assumptions of the Monetary Model

 Money Demand and Supply: The demand for money is assumed to be a
function of income and interest rates, while the money supply is controlled
by the central bank.

06/15/2025
54 Cont’d…
 Price Level Adjustments: The model assumes that prices in the economy adjust
quickly to changes in the money supply, leading to inflationary pressures when
the money supply increases.
 Perfect Substitution of Assets: In the long run, assets in different countries are
perfect substitutes, so investors are indifferent between holding domestic or
foreign assets, provided they offer the same real return after adjusting for
exchange rate movements.
 Flexible Exchange Rates: The model typically assumes that exchange rates are
flexible and are determined by market forces in the foreign exchange market.
 Purchasing Power Parity (PPP): The model assumes that PPP holds, meaning
that in the long run, the exchange rate will adjust to equalize the price of a basket
of goods in different countries, after accounting for exchange rate differences

06/15/2025
55 Cont’d…
The Basic Monetary Model Framework
 The monetary model expresses the exchange rate as a function of the
relative money supplies, income levels, and interest rates between two
countries. It can be represented as:
Et =
Where Et is nominal exchange rate (domestic currency per unit of foreign
currency, is money supply in domestic economy, is money supply in the
foreign economy, Pd is domestic price level and Pf is foreign price level.

06/15/2025
56 Cont’d…
 This formula highlights the relationship between the domestic
and foreign money supplies, and how changes in the money
supply or price level can influence the exchange rate.
Monetary Model with Expectations
 In the monetary model, exchange rates are determined not only
by the current state of the economy but also by expectations
about future changes in the money supply, inflation, and interest
rates. This is particularly important for the short-run dynamics
of exchange rates, as the model assumes that investors base
their decisions on expected future prices and inflation rates.
Et+1 = Etx()

06/15/2025
57 Cont’d…
Where Et+1 is expected future exchange rate and , , Pd, and Pf are defined as
above.
 This model assumes that currency markets adjust quickly to any changes
in monetary conditions, meaning that expectations of future inflation or
money supply changes directly impact the current exchange rate.
Monetary Model and the Inflation Differential
 The monetary model emphasizes the role of inflation differentials between
two countries in determining the exchange rate. If one country has higher
inflation than another, its currency will depreciate in real terms because its
price level rises faster than the other country’s.

06/15/2025
58 Cont’d…
 If a country experiences a higher growth rate of money supply, it will see
higher inflation, which will cause the exchange rate to adjust accordingly,
leading to a depreciation of its currency relative to others.
 Relative Inflation: If country A has higher inflation than country B, the
currency of country A will depreciate relative to country B. The change in
the exchange rate will reflect the difference in inflation rates over time.
The Long-Run Effects of Monetary Policy
 In the long run, the monetary model predicts that exchange rates are
primarily driven by changes in the money supply. An increase in the
money supply in one country relative to another will lead to a depreciation
of the currency of the country with the higher money supply, due to
inflationary pressures.
06/15/2025
59 Cont’d…
For example:

 If a central bank in country A increases its money supply while

country B maintains its money supply, country A will
experience inflation, and the value of its currency will
depreciate in relation to country B.
 The PPP theory aligns with this model by suggesting that
exchange rates will adjust to reflect changes in relative price
levels due to inflation differentials.

06/15/2025
60 Cont’d…
Monetary Model and Interest Rates
 Interest rates also play a crucial role in the monetary model, particularly in the
short run. A higher interest rate in one country relative to another country will
attract capital inflows, leading to an appreciation of the currency with the higher
interest rate. However, in the monetary model, interest rates are seen as a reflection
of expected inflation rather than independent variables.
 In the long run, interest rates are linked to the money supply growth rate and
inflation expectations:
 If country A's central bank raises interest rates to control inflation, this may attract
foreign capital, leading to an appreciation of country A's currency in the short term.
However, in the long run, the monetary model predicts that if the higher interest
rate is due to higher inflation, the currency will eventually depreciate as inflation
erodes its purchasing power.
06/15/2025
61 Cont’d…
The Role of Expectations in the Monetary Model
 Expectations about future monetary policy and inflation rates are central to
the monetary model. The exchange rate is not solely determined by current
conditions but also by what investors expect to happen in the future:
 Expectations of Future Money Supply Growth: If investors expect that
one country will increase its money supply more rapidly than another, they
will anticipate a future depreciation of that country’s currency and adjust
their current exchange rate expectations accordingly.
 Forward-Looking Nature: The model suggests that exchange rates reflect
not just current monetary policy, but the market’s expectations of future
monetary conditions, particularly inflation.
06/15/2025
62 Cont’d…
Criticism and Limitations of the Monetary Model
 Simplified Assumptions: The monetary model assumes that the only
factors affecting exchange rates are money supply and inflation, ignoring
other potential determinants such as trade balances, capital flows, political
risks, and investor sentiment.
 Real-World Empirical Support: In practice, exchange rates often do not
move as predicted by the monetary model, especially in the short term,
where speculative factors and market psychology can cause significant
deviations.
 PPP Assumption: The model assumes that PPP holds, but in reality, PPP
does not always work well due to market imperfections, transport costs,
06/15/2025 and barriers to trade.
63

n d !! !
e E l l
h A
T You
nk
h a
T

06/15/2025