Theories Of Exchange Rate Determination Essay

906 words - 4 pages

Before discussing the economic literature on the relationship between interest rates and exchange rates is full, it will be useful to briefly discuss some of the important theories of exchange rate determination. There are many theories such as the theory of Purchasing Power Purchase Agreement (PPP), the Flexible Price Monetary Model (FPM), Sticky Price Monetary Model (SPM), Real Interest Rate Differential Model (RIRD), and Portfolio Balance Theory (PBT) of exchange rate determination. The PPP to maintain equality between domestic and foreign prices are based on the domestic currency through commodity arbitrage. If the equilibrium is violated, the same commodity after exchange rate adjustment will be sold at different prices in different countries. As a result, commodity arbitrage or buy a commodity at the same time the lower price and sell at the higher prices will lead back to the equilibrium exchange rate.
The FPM, SPM, and RIRD known as model monetarists exchange rate determination. Demand and supply of money is a major determinant of the exchange rate. They also assume that domestic and foreign bonds are equally risky to their expected returns will be equalized which covered interest parity will prevail. Assuming wages in the labour market and commodity prices in the goods market to be perfectly flexible PPP theory continued to hold and the expected return between domestic and foreign bonds with the same risk and the same maturity, FPM argue that the relative money supply, inflation expectations, and economic growth as the primary determinant of the exchange rate in the economy. The SPM, which was first developed by Dornbusch (1976), argues that short-term prices and wages tend to be rigid, investors desire to equalize expected returns across countries is seen as a key determinant of short-term exchange rate, while the arbitrage market is seen as related items the determination of the exchange rate in the medium and long term. Frankel (1979) developed a model of the exchange rate, known as model a real interest rate differential which combines the role of inflation expectations from FPM and sticky price Dornbusch's model is the determination of the exchange rate. According to the portfolio balance model, current account, risk factors and fiscal policy are the authorities intervene in the foreign exchange market is a key determinant of exchange rates (Branson, 1976; Kouri, 1976).
Keminsky and Schumulkler (1998) studied the correlation between the time series of daily exchange rates and interest rates in Indonesia, Korea, Malaysia, Philippines, Thailand, and China using daily data during the second half of 1997. They found that the signs of this correlation are very unstable and concluded that interest rates in these countries should not be an exogenous variable.
Goldfajn and Baig (1998) studied the relationship between real interest rates and real exchange rates for the...

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