1. Exchange Rate Determination
Lecture 4
Exchange Rate Determination

2. Chapter 15 exchange rate determination
15.1 Introduction
15.2 Purchasing-Power Parity Theory
15.3 Monetary Approach to the Balance of Payments and Exchange Rates
15.4 Asset Market Model and Exchange Rates
15.5 Exchange Rate Dynamics

3. 15.1 Introduction Traditional exchange rate Modern exchange rate
-Based on trade flows
-Explain exchange rate in the long run
Modern exchange rate
-Based on international financial flows
-Seek to explain the short-run volatility

4. 15.2 Purchasing-Power Parity Theory
15.2a Absolute Purchasing-Power Parity Theory
15.2b Relative Purchasing-Power Parity Theory
15.2c Empirical Tests of Purchasing-Power Parity

5. 15.2a Absolute Purchasing-Power Parity Theory
Postulates that the equilibrium exchange rate between two currencies is equal to the ratio of the price levels in the two nations.
R=P/P*
Law of one price

6. 15.2b Relative Purchasing-Power Parity Theory
Postulates that the change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the two nations over the same time period.

8. 15.2c Empirical Tests of Purchasing-Power Parity
Why do deviations from PPP die out so slowly?

9. 15.3 Monetary Approach to the Balance of Payments and Exchange Rates
15.3a Monetary Approach Under Fixed Exchange Rates
15.3b Monetary Approach Under Flexible Exchange Rates
15.3c Monetary Approach to Exchange Rate Determination
15.3d Expectations, Interest Differentials, and Exchange Rates

10. 15.3a Monetary Approach Under Fixed Exchange Rates
Demand for money
Supply of money

11. 15.3b Monetary Approach Under Flexible Exchange Rates
Under a managed floating exchange rate system

12. FIGURE 15-2 Relative Money Supplies and Exchange Rates.

13. 15.3c Monetary Approach to Exchange Rate Determination