Different Models of Exchange Rate Determination

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Outline

The rate of exchange can be explained as a price. It is the worth or price of an individual currency in exchange for another currency. It can be said that it is a comparative price of the two currencies. Like any other price, it is influenced by the forces of demand and supply. So, money can be explained as the media of exchange. In international trade, the value of one product or commodity is quoted in two or more currencies. It is the ratio of the one currency units needed to buy or to obtain from selling, the product in one region or country to the units of other currencies needed to obtain or purchase from selling, the analog’s commodity in the other nation or region.

This is known as purchasing power parity or PPP which is a significant theory and benchmark of studies in international finance. This research essay attempts to throw more light on the different models of determination of the rate of exchange and also deliberate on the empirical studies on the subject in detail.

Analysis

Over the last 25 years, exchange–rate determination has magnetized a glut of empirical studies on the subject. Since the floating exchange rate system was reintroduced in the early 1970s, it is probably one of the most researched areas by eminent scholars. It is open true that exchange rates impact investments, the flow of goods, relative prices, and money between countries. Moreover, the flexible exchange–rate system has been introduced as a new element of transaction risk among individuals and nations in comparison to the fixed exchange–rate system. Hence, many empirical studies have been made to assess which model captures almost exactly the demeanor of exchange-rate fluctuations and, which is the best exchange-rate forecasting model. (Arize: 218)

Models of Nominal Exchange Rate Determination

It is crucial to determine the nominal exchange rate since it impacts real variables. According to Krugman (1993), “the proof on the real impacts of nominal exchange rate changes is, at first reading, irresistible for industrial nations, particularly since 1980, nominal exchange rates have been mirrored in nearly one-for-one changes in the relative prices of labor and goods. The $US is the most apparent model: from 1980 to 1985 as its trade-weighted nominal exchange rate jumped to a logarithmic forty-nine per cent, its real rate by forty-four per cent and then, from 1985 to 1990, the nominal rate declined forty-seven per cent, and the real rate declined forty-three percent. Thus, these nominal exchange rate changes seemed to have a very nearly one-for-one effect on real exchange rates.”

A lot of deliberations have been made on the determination of exchange rate, but it is arduous to discover an ideal exemplar that is superior both in hypothesis and demonstrated empirically also. Krugman in his empirical study made in 1993 also concurred with the identical notion: “I believe that international monetary economists have discarded, at least for now, on the suggestion of seeking to formulate models of the exchange rate that are both theoretically interesting and empirically defensible.

Quantitative policy analysts must have adequate proof to determine exchange rates in their empirical models, so they either have an exchange rate equation that roughly adapts to the data or simply imposes some mechanism, but they make a little simulation that they have figured out the surreptitious of exchange rates. Theorists apply some models in which the exchange rate is ascertained by some underlying fundamentals, but there is a little effort to confront these models with corroboration.”

Despite experimental or empirical researches to mirror some suspicions, there have been two major overtures in the nominal exchange rate determination:

4Purchasing Power Parity Model

Even though PPP is not a theory of the rate of exchange determination, it is a significant building block and equilibrium condition for many international financial models.

In traditional slopes of the demand and supply curves, there is no assurance that the foreign currency supply curve will have the customary upward slope. Thus PPP is the earliest theory of exchange rate determination.

The PPP theory of exchange rate determination was first used in 1916 and initially forwarded as a tool for making sure that exchange rates within a fixed exchange rate regime were kept at a sustainable level.

Purchase power parity theory expresses that the exchange rate will fine-tune such that a given broad market basket of goods and services will cost alike in all nations. For instance, if a market basket costs $ 1000 in the US and 10000 yen in Japan, then the exchange rate will be determined as 1$ = ¥ 10. (i.e1000/10000 ). Alternatively, if the exchange rate is 1$ = ¥ 11, we can anticipate the dollar to depreciate and the yen to appreciate so that the exchange rate attains the purchasing power parity rate of 1$ = ¥ 10.

Likewise, if the exchange rate is 1$ = ¥ 9, we can anticipate that dollar to appreciate and the yen to depreciate.

As a substitute for employing a market basket of goods and services, The Economic magazine has explained in a lucid style what is meant by PPP through the Big Mac index. Magazine used the exchange rates of 100 nations to change the domestic currency price of a Big Mac into US dollar prices. If such converted dollar price exceeds another country’s currency say British pounds, which exceeds the dollar price in the USA, the magazine finishes that the British pound is overvalued relative to the US dollar.

Conversely, if the adjusted dollar price of a Big Mac in Britain is lower than the dollar price in the USA, then the pound is said to be undervalued about the US dollar.

The Economist discovers a wide difference in the actual dollar price across the world and thus finds a little backup for the PPP theory. Economist Robert Cumby investigated the Big Mac index for fourteen nations for a decade. The chief findings are as follows:

According to the Big Mac standard, there is a ten percent undervaluation in one year clubbed with a 3.5 % increase of that currency immediately in the succeeding year.
If in a country, when the U.S. dollar price is high, the relative local currency price of a Big Mac in that nation normally declines in the succeeding year. (McConnell et al 2004:473).

PPP theory can be explained as an addition to the theory of arbitrage and least cost dealing with commodity markets. If the price of a commodity is dissimilar in two countries then arbitrage can be anticipated to benefit from the differential by purchasing products in the inexpensive market and then transporting and selling them in the costlier market. As the result, the price will be pushed up in the low-cost nation and will be forced down in the high-cost nation.

This arbitrage will eventually dissuade any profitable chances that present. The prices will be different to the extent of external factors and may differ due to a difference in shipping costs or tariffs. Equalization of prices will be achieved due to least-cost dealing. Irrespective of location, buyers will select the product assuming the lowest priced seller.

For instance, if the price of butter is relatively cheap in the USA than that of the UK due to the spot exchange rate being lower than the ratio of prices, then demand USD buy this butter in the US will increase, and also the demand for the product itself in the USA. This will have a simultaneous effect as they will exert upward pressure on both the spot rate and the US price. Concurrently, there will be an effort to sell US butter in the UK where the current price of butter is quoting higher. This will exert pressure on the spot rate and also push the price of butter to fall in the UK.

For policymakers “real exchange rate” is the main concept, when applying exchange rate policy. About the real exchange rates, there are a few diverse approaches:

Law of One Price

This overture expresses that if the transportation costs, non-tariff barriers, and tariffs are nil, and in that situation, trade should match the monetary values of similar products across nations. This is demonstrated by the undermentioned mathematical formula:

Pi = sPi* (Frankel, 1996)

Here, s is the nominal exchange rate, Pi is the price of goods and * denotes a foreign country. (Krugman 2004:400).

Absolute PPP

LOOP must hold good for similar baskets of goods,

P = sP*.

The statement that P = sP* (where s is the nominal exchange rate, P* is the foreign price index and P is the domestic price index) is cited as a complete or absolute PPP. Complete or an absolute PPP connotes that the modification in the rate of exchange must match the divergence among foreign and domestic price increases. In such a scenario, shifts in rates of exchange should be moderately little, as variances in the rate of price increase throughout nations are typically little. As this is not the expected outcome, a large number of economic experts have contended that efforts shall have to be initiated to decrease the rate of exchange unevenness, and a few have proposed a comeback to rates of fixed exchange. (Krugman 2004:400).

Comparative or Relative PPP

Modifications in the ordinary rate of exchange should mirror the derivative of the changes in price between the two nations; i.e.

%ΔP = %Δs + %ΔP* (Krugman 2004:401).

Summers and Heston, (1991) found major variances in price levels between underprivileged nations and affluent nations as a cluster. The research study made by Frenkel in 1981 established that the PPP model was proving to be an unsuccessful model for developed nations throughout the 1970s. The majority of the practical studies reveal that the PPP model has not been successful. To be precise, changes in price in various nations may not mirror the transformations in ordinary rates of exchange and there has been some change in the real exchange rate. (Krugman 2004:401).

There are many disadvantages associated with the PPP doctrine, and they are as follows:

There will be a difference in the basket of goods used in different nations.
All around the world, consumption patterns, and tastes will differ.
Law of one price may hold good for one product but may not be applicable in the case of a basket of goods.
Tariffs may not be uniform in different countries for such a basket of goods.

Attempts have been made to dissuade these differences by looking into changes in price levels and rates of inflation. This new formula is known as relative PPP. Under relative PPP, even though absolute PPP may not be true since different consumption patterns and tariffs, transformation in price levels and spot rates must shift consistently if arbitrage chances are to be secluded. This model can accommodate different tax and duty structures across nations and transaction costs.

Empirical evidence on PPP is mixed. Further, the evidence may be sensitive to the nations, price indexes, periods that one chooses. Over long periods and during periods influenced by monetary troubles like hyperinflation, PPP offers a good explanation of exchange rate behavior. However, over a short period, say 3 to 12 months, it is common to observe major exchange rate changes say about ten to twenty percent, which is unrelated to commodity price changes.

Some research studies expose that employing more modern econometric tools that relative PPP hold in the long run, even though there may be departures in the short run. Further, if there is any economic turmoil, then it will take nearly five to six years for relative PPP to be reinstated although about three-fourths of any deviation can be reinstated within 24 months. (Thygesen 1978).

Balance of Payments Approach

Under the PPP model, more emphasis is given to the trading of goods, which is the key factor in the determination of rates of exchange. The demand and supply curves for a nation’s currency are also influenced by the balance of payments account of a nation as it records the flow of receipts and expenditure between citizens of a nation and with that of the rest of the world. It is to be noted that it is not just exports and exports that constitute the balance of international payments of a nation. Other than that there are many other factors like the flow of services, the inflow of FDI, capital account transactions, and a nation’s central bank transactions also form part of components of the balance of payments of a nation.

The capital account of the balance of payments (BOP) also signifies the international capital flows which also trigger the movement in the supply and demand for that currency. Foreign invests whether it is either portfolio, direct, or incremental to bank deposits, therefore, moves the supply curve of foreign currency to the right. Similarly, the investment made abroad by domestic residents symbolizes a demand for foreign currency and moves the demand curve to the right. Therefore, net FDI inflows will be likely to decrease the foreign exchange rate.

A current account surplus is said to occur when the economic worth of exports exceeds the economic worth of imports. A current account deficit is said to occur when the value of exports is less than the value of imports. Moreover, it is recommended that the exchange rate will adjust or can be fine-tuned to bring the value of imports and exports back to balance.

MacDonald and Taylor (1992) and John Malindretos (1988) lucidly depict exhaustively the theoretical schemes of these two, opposing balance-of-payments and exchange-rate theories. The theoretical significance of Monetary and Portfolio Balance which is a traditional method has been exhaustively reviewed by Malindretos. He also carried out a major empirical analysis for the case of Germany.

He employed a fundamental equation representing the Monetary and Traditional approaches to exchange rate determination and the impact of exchange rate on the trade balance to study the strength of the models. Malindretos concluded that ‘in terms of indicators of restrictions test, it seems that both theories have merit. He commented that the two theories are not substituted for each other, but they are complementing each other. None of these theories can be considered to be superior over the other and there is merit for both in demonstrating the movements of securities, goods, and money across nations. (Malindretos 1986: 87-88).

Asset Exemplars

Economic Overture to the Rate Of Exchange With elastic Prices-Authoritative Exemplar: It presumes resilient prices at many periods and that PPP has been established as a reliable model. Because of the postulation of resilient prices, this is a long-run or medium rate of exchange fixation exemplar. This exemplar deems the rate of exchange as the comparative price of two diverse legal tenders and it exemplars the rate of exchange to mirror the counterbalance circumstances in the home currency markets in two nations. This so-called rate of exchange is shaped by the following mathematical formula:

s = M L*(Y*,R*)

M* L(Y,R)

(Frankel 1976)

Monetary Approach With Sticky Prices (Dornbusch 1976)

This is an over aiming exemplar, which offers a narration of the unpredictability of real and nominal rates of exchange, mainly due to sticky prices. Because of the prevalence of sticky prices in the short period, enduring transformations in the supply of money pave to transformations in the nominal interest rate and the real money supply. Since traders in the exchange rate market are well aware that, in the long term, an enduring transformation in the supply of money will push to an increase in prices of all products, including the symbolic rate of exchange, they amend their anticipations of the long term rate of exchange, and they make the rate of exchange to overshoot its long term worth in the short term. Due to the efflux of time, the rate of exchange reverts to its new long-term stage.

The Authentic Interest Disparity Model or the Real Interest Differential exemplar

“Since the classical monetary approach to the exchange rate has the assumption of price flexibility, transformations in the symbolic rate of interest mirror transformations in the anticipated rate of inflation. Hence, from the UIP stipulation, a high home symbolic rate of interest connotes that there are anticipations for the devaluation of the home currency. On the contrary, the overshooting exemplar presumes sticky prices and in this scenario, a higher symbolic interest rate mirrors a more stringent monetary policy, which draws in foreign capital and paves to an increase in the value of the home currency. There exist certain differences among these two exemplars in terms of the association between the symbolic interest rate and the symbolic rate of exchange. Thus, the real interest rate differential replica can resolve these divergences. (Frankel 1979):

Moreover, the monetary approach with elastic prices is a pragmatic explanation of the performance of symbolic exchange rates when the disparity in the inflation discrepancies is outsized, as witnessed in the case of hyperinflations, and that is due to the postulation of elastic prices. The overshooting replica that presumes sticky prices is a constructive hypothesis when the difference in the inflation disparity is little, as was the case with advanced economies in the 1950s.

However, Frankel comments that we also require a hypothesis that would clarify the demeanor of symbolic rates of exchange when the difference in the inflation disparity is modest, as what happened in the 1970s. The Real Interest Differential Model originated by Frankel in1979 is an account of monetary approach, but it coalesces into the above two replicas in one exemplar. In other words, it coalesces into the overshooting exemplar’s hypothesis of sticky prices with the elastic price postulation that interrelates the inflation rate to the nominal interest rate.

Empirical Researches on Exchange Rate Determination

There exist various empirical researches on the subject. Monetary models had some magnitude of success in the 1970s and Frankel’s research done in 1979 can be cited for this. 1980 witnessed empirical support for those models crumbled. Thus, the empirical study made by Isard in 1986 exposed that empirical models illustrate not much of the observed variability in exchange rates and that they struggle to match the estimated performance of simple random-walk conditions. ( Radaelli 2002:56).

Empirical evidence on portfolio-balance models demonstrated to be less successful in comparison to monetary ones, both through exchange-rate reduced forms. This is corroborated in the empirical evidence carried out by Branson in 1977 and by Halttunen and Masson in 1979. The same line of reasoning is also established by Rogoff in his empirical study made in 1984, which dealt with inverted bond demand, or risk–premium equations. ( Radaelli 2002:56).

Initiatives at harmonizing the portfolio-balance and monetary approach resulted in mixed results as evidenced in empirical research made by Hooper and Morton in 1982 and by Frankel in 1983 and 1984. ( Radaelli 2002:56).

Later research did not generate more hopeful outcomes. Especially discouraging is the incapability to devise a cohesive theory of exchange rate determination. In simple words, whenever researchers “espouse’ an empirical model, this does not fit more than one exchange rate. ( Radaelli 2002:56).

MacDonald and Taylor (1992) wrap up their research review expressing that “asset-approach models have functioned perfectly good for certain periods, for instance, in the interwar period, and, to some magnitude, for the period between 1973 and 1978; however, they have demonstrated largely insufficient elucidations for the demeanor of the major exchange rates for the remaining part of the float.” ( Radaelli 2002:56).

The reasons for the recent failures are being cited that the investors in the foreign exchange market rely on primary analysis as contrasted to economic models like time series / Chartism, mainly for longer-run forecasts. As a result, it could be successful in sculpting long-term determinants of exchange rates, perhaps by employing lower-frequency data. (Radaelli 2002:56).

Conclusion

Thus, to sum up, exchange rate spotlights on analysis of the effects of various exchange-rate arrangements on variables of interest. An exchange rate theory, by contrast, summarises how specific classes of arrangements like flexible rate and fixed exchange rates influence the economic system in general and in particular the international economy.

List of References

Frankel, J. A. (1996) ‘Real Exchange rate Experience and Proposal for Reform.’ American Economic Review volume 86.

Frankel, J. A. (1976) ‘A monetary approach to the exchange rate: Doctrinal aspects and empirical evidence.’ Scandinavian Journal of Economics Vol. 78.

Frankel, J. A. (1999) ‘No Single Currency Regime is Right for All Countries or At All Times.’ Web.

Frenkel, J. A., (1981) ‘Flexible exchange rates, prices and the role of ‘news’: Lessons from the 1970s.’ Journal of Political Economy vol.89.

Krugman, Paul R. (2004). International Economics: Theory and Policy. Tsinghua : Tsinghua University Press.

McConnell Campbell R, Brue, Stanley L, Campbell R.R. (2004) Microeconomics: Principles, Problems, and Policies. New York: McGraw –Hill Professional.

Radaelli, Giorgio. (2002) Exchange Rate Determination and Control. New York: Routledge.

University of Leicester. (2007) International Finance. London: Learning Resources / Cheltenham Tutorial College.

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