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International Trade and Finance

Notes countries. This assumption is unrealistic because the barter terms of trade constantly change
due to changes in the demand for foreign goods, in the volume of external loans, in the supply
of exported goods, in transport Costs etc.
9. The theory is based on the assumption of free trade and laisser faire policy. But governments
do not follow these policies these days. Rather, they impose a number of restrictions on the
movement of goods between countries. Such trade restrictions are tariff, import quotas, customs
duties and various exchange control devices which tend to reduce the volume of imports. These,
in turn, cause wide deviations between the actual exchange rate and the exchange rate set by
the purchasing Power Parity.
10. The equilibrium exchange rate may not be determined by the purchasing power parity between
the two Countries. Rath, a sudden increase in the demand for goods of one country may raise
the demand for its currency on the part of the other country. This will lead to a rise in the
exchange rate.
11. Ragner Nurkse points out that the theory is one sided in that it is based exclusively on change
in relative prices and neglects all factors that influence the demand for foreign exchange. The
theory treats demand as a function of price but neglects the influence of aggregate income and
expenditure on the volume and value of foreign trade, these are important factors which affect
the exchange rate of a country.

According to keynes, one of the serious defects of this theory is that it fails to consider the
elasticities of reciprocal demand. In fact, the exchange rate is determined not only by
changes in relative prices, but also by the elasticities of recipocal demand between the
two trading countries.

15.2 Monetary Models of Exchange Rate Determination

Since an exchange rate is the relative price of one nation’s money in terms of the money of another
nation, it is natural of think of an exchange rate as determined, at least proximately, by the outstanding
stocks of these monies and by the demands to hold these stocks. This simple proposition is the starting-
off point for two related but distinct classes of monetary models of exchange rate determination. The
first class of monetary models, which have been widely applied in empirical studies of exchange rate
behavior, expresses the current exchange rate as a function of the current stocks of domestic and
foreign money and the current determinants of the demands for these monies, including domestic
and foreign income and interest rates. The second class of monetary models, which has been more
widely used in the-oretical work, focuses on the influence on the current exchange rate of the expected
future path of money supplies and of factors affecting money demands. The distinguishing features
of these two classes of models requires that they should be given separate attention.
The essential content of the first class of monetary models may be summarized in an equation of the
form
e = m – m* – (l[y, i, k] – l* [y*, i*, k*]), (1)
where e is the logarithm of the price of foreign money in terms of domestic money, m is the logarithm
of the domestic money supply, l is the logarithm of demand for domestic money (a function of domestic
income, y, the domestic interest rate, i, and other factors k), and an asterisk (*) indicates variables for
the foreign country. In some presentations, equation (15.1) is derived from the following assumptions:
(1) The logarithm of the domestic price level, P, is determined by domestic money market equilibrium
to be P = m – l (y, i, k). (2) The logarithm of the foreign price level, P*, is determined by the foreign
money market equilibrium condition to be P* = m* – l* (y*, i*, k*). (3) The equilibrium exchange rate is
determined by the requirement of purchasing power parity to be e = P – P* = m – m* – (l [y, i, k] – l* [y*,
i*, k*).

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