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4.4.3 The monetary approach to exchange rate determination

The monetary approach to exchange rate determination is a direct application

of the monetary approach to the balance of payments to the case of flexible

exchange rates (see Frenkel and Johnson, 1978). Under a system of perfectly

flexible exchange rates, the exchange rate adjusts to clear the foreign exchange

market so that the balance of payments is always zero. In the absence

of balance of payments deficits/surpluses there are no international reserves

changes, so that domestic credit expansion is the only source of monetary

expansion. In contrast to a regime of fixed exchange rates where, ceteris

paribus, an increase in domestic credit leads to a balance of payments deficit

and a loss of international reserves, under flexible exchange rates it leads to a

depreciation in the nominal exchange rate and an increase in the domestic

price level. In the flexible exchange rate case of the monetary approach, ‘the

proximate determinants of exchange rates … are the demand for and supply

of various national monies’ (Mussa, 1976).

The monetary approach to exchange rate determination can be illustrated

using the simple monetary model first introduced in section 4.4.1. Assuming

the system is initially in equilibrium, we again examine the consequence of a

once-and-for-all increase in the domestic money supply (that is, domestic

credit) by the authorities which disturbs the initial money market equilibrium.

Reference to equation (4.10) reveals that, with real income fixed at its

full employment or natural level, and the domestic rate of interest pegged to

the world rate, the excess supply of money can only be eliminated by an

increase in the domestic price level. The discrepancy between actual and

desired money balances results in an increased demand for foreign goods and

securities and a corresponding excess supply of domestic currency on the

foreign exchange market, which causes the domestic currency to depreciate.

The depreciation in the domestic currency results in an increase in the domestic

price level, which in turn leads to an increased demand for money

balances, and money market equilibrium is restored when actual and desired

money balances are again in balance. In this simple monetary model, the

nominal exchange rate depreciates in proportion to the increase in the money

supply. In other words the exchange rate is determined by relative money

supplies. For example, in a two-country world, ceteris paribus there would be

no change in the (real) exchange rate if both countries increased their money

supplies together by the same amount.

The analysis can also be conducted in dynamic terms using slightly more

complicated monetary models which allow for differential real income growth

and differential inflation experience (due to different rates of monetary expansion).

These models predict that the rate of change of the exchange rate

depends on relative rates of monetary expansion and real income growth.

Two examples will suffice. First, ceteris paribus, if domestic real income

growth is lower than in the rest of the world, the exchange rate will depreciate,

and vice versa. Second, ceteris paribus, if the domestic rate of monetary

expansion is greater than in the rest of the world, the exchange rate will

depreciate, and vice versa. In other words the monetary approach predicts

that, ceteris paribus, a slowly growing country or a rapidly inflating country

will experience a depreciating exchange rate, and vice versa. The important

policy implication that derives from this approach is that exchange rate

flexibility is a necessary, but not a sufficient, condition for the control of the

domestic rate of inflation via control of the domestic rate of monetary expansion.

In the case of perfectly flexible exchange rates, the domestic rate of

inflation is held to be determined by the domestic rate of monetary expansion

relative to the domestic growth of real income.