Models of Exchange Rate Determination

Models Of Exchange Rate Determination

Exchange rates refer to the rates at which local currencies are exchanged for foreign currencies in international transactions. The study of how exchange rates are determined is necessitated by the fact that international trade is an important component of the economy. Exports and imports play an important role in the building of economies hence the need to understand possible behaviors of exchange rates and their influence on international trade. This paper assesses the key economic models applied in the determination of exchange rates.

It is true that any imbalance in the normal market is corrected by an adjustment in the price or quantities as guided by the laws of demand and supply. Imbalances in the form of excess supply are corrected by a drop in the level of price in order to achieve a level of equilibrium. Also, disturbances in the form of excess demand are corrected in the market through price increases. The same play out of variables applies in the case of market currencies. Excess demand or supply exerts pressure on the exchange rate forcing it to adjust in a bid to restore equilibrium.

Balance of Payment (bop) approach

Generally, the balance of payments gives a continued indication of the movement of funds across national boundaries in a given period of time. Movement of finances may be triggered by the act of trade through imports or exports or through international investments. An import involves the purchase of a good or service from another country hence a financial outflow while exports represent financial inflows. Similarly, when foreign investors bring in funds for investments, the transaction is a financial inflow while an outflow occurs in cases where local investors opt to invest locally held funds elsewhere. Conventionally all inflows are treated as credit to the balance of payments while outflows are treated as debits. The balance of payment is thus a cash balance of the international financial flows facing a country in relation to the rest of the world. The cash balance should always be zero just like demand must equal supply in the demand and supply model (Theory of Exchange Rate Determination, 2009, Par4).

In this model the price of foreign currency in the domestic market is determined through the normal forces of demand and supply for each foreign currency. The model hence uses the demand and supply forces for foreign currency which are determined by the flow of the currency as a result of international transactions such as imports and exports. Demand and supply of currency result the flows created by trade in goods and services, direct investment as well as portfolio investment.

The equilibrium level of exchange rate is determined when the BOP is in a state of equilibrium. Any imbalance in the BOP triggers the appreciation or depreciation of the exchange rate up to the point where the bop achieves a new equilibrium. This is akin to the movement in prices when the demand and supply are not in balance. The price moves up or down to the level where the demand and supply levels achieve a new equilibrium.

The BOP is divided into several categories: The current a/c (CA), the capital and financial account (KA) and the official reserve account. This is represented as


The CA is the balance of trade between countries. It is the balance of income received or paid on investments, the goods and services and unrequited transfers. Both imports and income paid out to other countries are debits to the balance while exports and incomes got from other countries are credits to the balance.

KA comprises all capital transactions, both long-term and short-term. They are direct as well as portfolio investments and any other flows. In a case of higher inflow than outflows in investments, the value of KA is positive and vice versa. Bigger inflows mean that the foreign currency is in excess supply making hence appreciating the exchange rate of the domestic currency in relation to the foreign currency.

The OR on the other hand is used to record transactions made by the central bank on the official reserve account. In a case where the central bank sells foreign reserves, it receives domestic currency. This act increases the supply of domestic currency while reducing the supply of foreign currency. The net effect of such action is to depreciate the exchange rate of the local currency against the foreign currency.

As has been explained above, adjustments in the CA, KA or OR can result in a BOP of a value greater than or less than zero. It is this movement of the value of BOP which causes the appreciation or depreciation of the exchange rate to the level where the equilibrium point equivalent to a zero BOP.

Monetarist Model

The financial flows approach discussed above was most approved in the 1960’s. The 1970’s saw economists challenge the assertion that exchange rates are influenced by financial flows in international trade. There was increased belief that currencies are assets like any other. Therefore, exchange rates connote the price of assets which adjust to ensure equilibrium in the trade of the assets in international markets.

In view of this, exchange rates represent the relative price of the local currency against foreign currencies. As such, the prices are determined by the desire of residents to hold both the local as well as foreign assets a factor which defines the level of demand for the assets. The desire to hold any asset is generally defined by the future expectations and not the present occurrences in the flows of the assets as argued by the BOP approach (Daniel, 2009, Par4).

The model feigns a great level of capital movement between assets denominated in different currencies. The difficult part of this approach is to specify the domestic and foreign assets to be included in the portfolio of a domestic resident. Since exchange rates are relative prices between two currencies, a simple model is to consider domestic money and foreign money (Monetary Model of Exchange Rate Determination, n. d, Par5).

A simple model can be used to illustrate the monetary approach in the determination of exchange rate. Traditionally, the model is based on the Quantity theory of money as well as the purchasing power parity. Hence


Ms is money supply, V is the speed or velocity of money, P is the price and Y the real output. In equilibrium, the supply for money equates to the demand for money.

The assumption is that prices are fully flexible hence any changes in the money supply will automatically change the price.

The spot rate which is the price of the assets (currency) as delivered on the settlement date can be defined as below (Spot rate definition finance, 2009, Par3)

St = (Vd/Vf) x (Yf/Yd) x (MSd/MSf)

d and f represent domestic and foreign

Assuming that V is constant in the short run, then

St+T = Yf,T – Yd,T + Msd,T – Msf,T

The model shows spot rate behaves like other speculative asset prices which change with the release of certain information. For this model information relating to domestic and foreign currency markets as well as changes in domestic and foreign outputs have the potential to alter the spot rate. Therefore expectations of the future play a major role in the in determining exchange rates (The Naira-Dollar Exchange Rate Determination: A Monetary Perspective, n. d, Par5).

In conclusion, the determination of exchange rate can be explained using various models of economic theory. In the balance of payment theory, the Keynesian theory reigns. The play out of demand and supply as a result of the inflows and outflow of funds in the different currencies and the need to maintain a balance of payments define the value of domestic currency in relation to foreign currency. Under the monetary approach the idea of speculative holding of assets comes in.

Despite the glaring differences the to models not only have striking similarities but also seem to complement each other in explaining hat causes the exchange rates to either appreciate or depreciate. Indeed the BOP model is credible as the normal forces of demand apply on the currency. This brings a similarity with the monetarist approach as it currency as a commodity while an asset is also a commodity (Carlo & Paul, 2006, p4). The monetarist approach cannot also be dismissed as the expectation element is important in the trade of volatile assets.

Reference List

Carlo A., & Paul, G., 2006. Forecasting And Combining Competing Models Of Exchange Rate Determination. Monetary Policy And International Finance.

Daniel, G., 2009. How Does the Monetary Model of Exchange Rate Determination. Web.

Monetary Model of Exchange Rate Determination, n. d. Web.

Spot rate definition finance, 2009. Web.

Theory of Exchange Rate Determination, 2009. Economy watch. Web.

The Naira-Dollar Exchange Rate Determination: A Monetary Perspective, n. d. International Research Journal of Finance and Economics. Web.

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