Page 191 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 16 : Theories of Determination of Exchange Rate (Portfolio and Balance of Payments)

For example, a likely depreciation will increase the value of exports in home currency terms Notes
(the larger the exports demand elasticity the greater the increase).
Conversely, the imports will become 'more expensive' and their value will be reduced in home
currency (the larger the imports demand elasticity the greater the decrease).
Consequently, we can argue that unless the value of exports increases less than the value of
imports, the depreciation will improve the current account. More specifically, we can finally
assess the impact of the currency's depreciation on the current account only by considering the
price sensitivity of imports and exports.
4. The Monetary Approach
In this approach attention is given to the stock of currencies in comparison to the willingness of
people to hold these stocks.
According to the monetary theory, exchange rates adjust to ensure that the quantity of money
in each currency supplied is equal to the quantity demanded (Parkin M. & King D. 1992).
Both Quantity Theory of Money (QTM) and Purchasing Power Parity (PPP) have been used in
support of the aforementioned theory.
The QTM states that there is a direct relationship between the quantity of money and the level
of prices of goods and services sold (Investopedia.com). In other words, more money equals
more inflation.
In a domestic framework, the following equation has been formulated16.
MV = PY
M: Money supply/demand
V: Velocity of circulation (the number of times money change hands)
P: Average price levels
Y: GDP
Finally, we can conclude that an increase in the money supply leads to inflation, which in turn
results in the decrease in the value of money or purchasing power.
Consequently, if we also consider this in an international context, we will appreciate the following
implications:
Firstly, a rapid increase in the money supply (in the home currency), which as stated earlier
means inflation, will put into effect the PPP resulting in the depreciation of the currency's
exchange rate.
Secondly, a higher interest rate will also result in the currency's depreciation because of the
positive relationship between interest rates and money circulation.
Finally, if the GDP grows faster than overseas GDP, the demand for money will increase.
Assuming there is a given supply of money, the exchanged rate will decrease, which is in direct
contrast to the PPP approach.
5. The Portfolio Balance Approach
The portfolio balance approach takes into consideration the diversification of investors' portfolio
assets. Diversification is a technique that attempts to reduce risk by investing both among
various financial instruments and across national borders, to mention just a few.
For example, here below we consider a combination of domestic and foreign money and domestic
and foreign bonds.
Both the M and the B lines show combinations of domestic interest rates and exchange rates. The
upward line M is in agreement with the equilibrium in the money market and the downward line B
is in agreement with the equilibrium in the bond market. Point E, which is the intersection of M with
B, represents the combination of interest rate with the exchange rate that gives equilibrium to both
the money and bond markets.

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