Page 186 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes changes in the actual or expected behavior of money demands. The tautological view of the monetary
model of exchange rate determination can be justified on the grounds that the money market
equilibrium condition represented by equation (2) is a reduced form that incorporates all of the
conditions of goods and asset market equilibrium. However, this tautological view of the monetary
model still does not provide an explanation of many exchange rate movements, other than ascribing
them to “shifts in money demands” arising from unknown sources. Moreover, while it is possible to
view all economic forces affecting the exchange rate as operating through money demand or money
supply, this may lead to a rather convoluted and unnatural view of the mechanisms through which
some economic forces affect the exchange rate. In such circumstances, it is not sensible to insist on an
exclusively monetary interpretation of the determination of exchange rates.
Self-Assessment

1. Choose the correct options:
(i) The (uncovered) interest parity condition:
(a) Takes into account the liquidity of the assets.
(b) Involves forward exchange rate and spot exchange rate.
(c) Describes the equilibrium in the foreign exchange market.
(d) Takes into account the risk differential between the assets.
(ii) If the interest rate on a deposit in Euros is 6% per year, and the Euro is expected to depreciate
against the U.S. dollar by 1%, what does the interest parity condition imply about the interest
rate on the deposit in U.S. dollars?
(a)7%
(b)5%
(c)6%
(d) There is not enough information to find out.
(iii) The interest parity condition involves four variables. Which one adjusts to ensure equilibrium?
(a) Domestic interest rate
(b) Foreign interest rate
(c) Expected future exchange rate
(d) Current exchange rate
(iv) The U.S. dollar will appreciate if:
(a) The Euro interest rate rises.
(b) The U.S. interest rate falls.
(c) The U.S. dollar is expected to depreciate.
(d) The U.S. dollar is expected to appreciate
15.3 Summary

• The purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920 to determine
the exchange rate between countries on inconvertible paper currencies. The theory states that
equilibrium exchange rate between two inconvertible paper currencies is determined by the
equality of their purchasing power. In other words, the rate of exchange between two countries
is determined by their relative price levels. The theory can be explained with the help of an
example.
• The purchasing power parity theory is illustrated in Figure 1 where DD is the demand curve
for foreign currency (pound in our example) and SS is the supply curve of currency. OR is the
rate to exchange of rupees per £ , which is determined by their intersection at point E so that
the demand for the supply of foreign exchange equals OQ quantity. Suppose the price level

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