Answer to Question #243013 in Macroeconomics for Zee

Question

For the theories under the determination of exchange rates;

Give a background of the theory i.e. who originated the theory, what are the conjectures of the theory etc.



Highlight how the theory best explains the determination of exchange rates.

Do you think a floating exchange rate is a better option for protecting the value of a domestic currency versus a fixed exchange rate?

Discuss the relevance of the given theory in a South African and global perspective using empirical evidence.

Answer 1

Monetary Approach to Exchange Rate

Monetary approach emerged in 1950s by Polal(1957) and advanced by Mundell, Johnson and Frenkel and thereafter by their followers. Monetary approach states that rates of exchange are determined via balancing the total demand and supply of the national currency.

The monetary approach holds that the demand for money depends on real income, price and interest rate.

Floating exchange rate is good in a situation where a country has faith in its central bank to maintain prudent monetary policy. On the other hand, fixed exchange rate can be adopted when a central bank is unable to maintain prudent monetary policy leading to low inflation rates.

The significance of the theory is that it states that excess money supply over money demand implies balance of payments deficit. The excessive money can be used to purchase foreign goods and securities.