Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 12 - Theories of Exchange Rate Determination

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter twelve.

Chapter Introduction

One of the key questions confronting international investors concerns what moves exchange rates? In this chapter, we look at a variety of alternative exchange rate theories. Firstly, we look at purchasing power parity (PPP) theory which has been advocated as a satisfactory model of exchange rate determination in its own right. Having looked at PPP theory, we proceed to examine how well suited this theory is to explaining actual exchange rate behaviour since the adoption of generalized floating in 1973. As we shall see, PPP theory does not provide an adequate explanation of some of the observed features of floating exchange rates. Some possible explanations for this failure are then discussed.

We then proceed to look at some more recent and sophisticated exchange rate models that have been developed in an attempt to model exchange rate behaviour more successfully. The models we examine are known as monetary models. They bring macroeconomic factors into the picture, emphasizing the important role of relative money supplies in explaining the exchange rate. A variety of monetary models have been put forward in an attempt to explain exchange rate behaviour, and we deal with three of the most important: the ‘flexible-price’ monetary model, the ‘sticky-price’ monetary model and the ‘real-interest-rate-differential’ model.

Important note
Throughout most of this chapter we shall be defining the exchange rate as domestic currency per unit of foreign currency. Taking sterling as the domestic currency and the US dollar as the foreign currency we are talking of pounds required to purchase one US dollar. Hence a depreciation of sterling is represented by a rise in the exchange rate, that is, more pounds have to be given to purchase one dollar; for example a move from ?0.50/$1 to ?0.60/$1 per dollar represents a depreciation of sterling.

Conversely, an appreciation of sterling is represented by a fall in the exchange rate.

Learning Objectives

In this chapter you will learn about:
  • ​The difference between the absolute and relative versions of purchasing power parity (PPP)
  • The empirical evidence regarding PPP
  • Expected future spots rates and the uncovered interest rate parity theory
  • What is meant by the ‘carry trade’ and whether such trades are likely to generate excess returns
  • The flexible price and sticky price monetary models
  • The Dorbusch ‘overshooting’ model and its importance
  • The Frankel real interest rate differential model

Further Reading

McDonald, R. (2007) Exchange Rate Economics: Theories and Evidence, Routledge.

Moosa, I. and Bhatti, R. (eds) (2009) Theory and Empirics of Exchange Rates, World Scientific Publishing.Pilbeam, K.S. (2006) International Finance, Palgrave Macmillan.

Rosenberg, M. (2003) Exchange Rate Determination: Models and Strategies for Exchange Rate Forecasting, McGraw-Hill.

Sarno, L. and Taylor, M.P. (2002) The Economics of Exchange Rates, Cambridge University Press.

Revision Questions

  1. A computer costs $1,500 in the USA and the same computer costs €1,800 in Europe. The spot exchange rate is $1.30/€1. What is the appropriate dollar per euro exchange rate according to absolute PPP? Is the US dollar spot rate overvalued, undervalued or correctly valued according to absolute PPP?
  2. The US inflation rate is predicted to be 9 per cent and the UK inflation rate is predicted to be 4 per cent. The current dollar–pound exchange rate is $1.70/?1. What is the expected dollar per pound rate in one year’s time according to relative PPP?
  3. The UK interest rate is 4 per cent, the US interest rate is 7 per cent and the spot exchange rate is $1.70/?1. Is the pound expected to appreciate or depreciate?
  4. What is the expected dollar per pound rate in one year’s time according to UIP?
  5. Briefly explain what happens in the flexible price monetary model if there is an increase in the domestic money supply.
  6. Briefly explain what will happen in the Dornbusch overshooting model if there is an increase in the domestic money supply.

Multiple Choice Questions

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