INTERNATIONAL ECONOMICS 2 PRESENTATION

The Monetary Approach and

the Asset Market Approach to
Exchange Rate Determination

GROUP 4
Exchange rate determination – Group 4 – Class IEs AEP 60A
 MEMBERS
1. Nguyễn Minh Trang
2. Nguyễn Khánh Linh
3. Nguyễn Hà Phương
4. Nguyễn Thị Linh Chi
5. Lê Thuý Quỳnh
6. Nguyễn Thị Trang Nhung
7. Bùi Thị Ngọc Thuỷ
8. Vũ Thuỳ Linh

Exchange rate determination – Group 4 – Class IEs AEP 60A

 TABLE
I. Definition
OF CONTENTS
II. Monetary Approach & Asset Market
Approach to Exchange Rate

III. Exchange rate overshooting in Forex

Market

IV. Q&A

Exchange rate determination – Group 4 – Class IEs AEP 60A

 I. DEFINITION
01
Monetary Analyzing exchange rates in the long run, focus on the
Approach supply and demand of money in different countries.
02
Asset Explaining exchange   rates in the short run, focus on 
Market the process of balancing the total demand and supply
Approach of financial assets of which money is only one.
03
Exchange
Rate
Refers to the factors that determine or decide
Determination exchange rates.
Exchange rate determination – Group 4 – Class IEs AEP 60A
 II Monetary Approach and Asset
Market Approach to Exchange
Rate Determination

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Monetary approach
Fundamental equation: PPP theory

R=
Where: R is the exchange rate
(domestic price of foreign currency)
  P is the index of prices in
the home nation.
P* is the index of foreign
nation’ prices.  

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Monetary approach

The nation’s supply of money: The nation’s demand of money:

        = m(D + F)   = kPY
Where: Where:
the nation’s total money supply : quantity demanded of nominal
m: money multiplier money balances
D: domestic credit by nation’s k: desired ratio of nominal money
monetary authorities balances to nominal national
F: international reserves of the income
nation P: domestic price level
Y: real output
Exchange rate determination – Group 4 – Class IEs AEP 60A
 • = kPY, = k*P*Y*
In equilibrium:
= , =
=> =

• Dividing both sides by and

=> R =

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Several things need to be noted with
respect to Equation:

Depends on the Derived from the The exchange rate

Purchasing demand for adjusts to clear
Power Parity nominal money money markets in
theory and the balances which each country
law of one does not include without any flow or
price.   the interest rate.   change in reserves.

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Monetary Approach to Balance of Payment

Under Fixed Exchange Rates

The nation must equalize the money demand and
supply in order not to price levels change which
affects to the exchange rate while being under
fixed exchange rate system.

↑ the demand for money → by ↑ the nation’s domestic

monetary base (D) or by an inflow of international
reserves, or balance-of-payments surplus

↑ the nation’s domestic monetary base (D) and

money supply (Ms) while unchanged money demand
(Md) → outflow of international reserves, deficit in
the balance of payments

Exchange rate determination – Group 4 – Class IEs AEP 60A

 1. A surplus in the nation’s balance of
payments results from an excess in the stock
of money demanded.

2. A deficit in the nation’s balance of

Summarize payments results from an excess in the stock
of money supplied.

3. The nation’s balance of payments surplus

or deficit is temporary and self-correcting in
the long run.
Exchange rate determination – Group 4 – Class IEs AEP 60A
 Monetary Approach
Flexible Exchange Rates
A balance of payments
disequilibrium is:
Corrected by an automatic change in
exchange rates without any
international flow of money or
reserves.

Excess Md → R↓ Excess Md → R↓
(to Md ↓) (to Md ↓)

Exchange rate determination – Group 4 – Class IEs AEP 60A

 2. Asset Market Approach
Fundamental equation: UIP theory
The exchange rate is determined by interest rates and
expected changes. 
Domestic and foreign bonds are assumed to be perfect
substitutes:
 (i-i*) = EA
Where EA is the expected appreciation of the foreign
currency ()

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Portfolio Balance Approach (Asset Approach)

Exchange rates are determined in the process of

equilibrating the stock or total demand and supply of
financial assets.

Demand for bonds: 

• Yield and market rate of interest.
• Opportunity cost.
• Nature of investor (risk averse/lowers).

Exchange rate determination – Group 4 – Class IEs AEP 60A

 Domestic Rate ↑ Foreign Rate ↑

Under Flexible
Exchange Rates

1. Demand for domestic

bond
2. Demand for domestic
money
3. Investors Sell foreign bonds Sell domestic bond

R R
Exchange Rate (Appreciate the (Depreciate the
domestic currency) domestic currency)
Exchange rate determination – Group 4 – Class IEs AEP 60A
 Extended Portfolio Balance Model

◼ 𝑀 = 𝑓( 𝑖, 𝑖 ∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊) (money

demand by domestic residents)

◼ 𝐷 = 𝑓 (𝑖, 𝑖 ∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊) (domestic

bond demand)

◼ F = 𝑓 ( 𝑖, 𝑖 ∗, 𝐸𝐴, 𝑅𝑃, 𝑌, 𝑃, 𝑊) (foreign

bond demand)

where Y is income, P is the price level,

and W is wealth.
Exchange rate determination – Group 4 – Class IEs AEP 60A
 III Exchange Rate
Overshooting in
Forex Market

Exchange rate determination – Group 4 – Class IEs AEP 60A

 How monetary approach explain overshooting
exchange rate?
• According to Fisher effect, raise in financial transactions
and cash flows of future income cause an increase in stock
prices in opposition to interest rate effect.

• Domestic money demand goes up as a result of wealth

increase and consequently exchange rate will appreciate.

• Relative power of income and interest rate effect is the

main determinant of the sign of the relation between stock
prices and exchange rates.
Exchange rate determination – Group 4 – Class IEs AEP 60A
 What is overshooting exchange rate?

The tendency of exchange rate to immediately

depreciate or appreciate by more than required
(exogenous change) as they move toward long-
run equilibrium in the short run.

It happens because of “difference of speed of

adjustment across markets”: price is sticky in goods
market, but price adjusts quickly in financial
markets
Exchange rate determination – Group 4 – Class IEs AEP 60A
 How asset market approach explain
overshooting exchange rate?
• An increase in a nation’s money supply leads to an
immediate decline in the interest rate and shift from
domestic to foreign bonds.
• Over time, this leads to a trade surplus and an
appreciation of the domestic currency, which neutralizes
part of its original depreciation.

Exchange rate determination – Group 4 – Class IEs AEP 60A

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Exchange rate determination – Group 4 – Class IEs AEP 60A