Answer to Question #222079 in Economics for Oheneba Jose

Question

Discuss the extent to which the traditional approach is an adequate model of exchange rate determination.

Answer 1

The monetary model is based on the idea that the exchange rate is a monetary phenomenon: money from one country is exchanged for money from another country. Consequently, the exchange rate is primarily related to the volume of money supply in both countries, which is regulated by the state. The demand for nominal money is proportional to the price level and also depends on the nominal interest rate and the level of real income. In the long term, the level of the exchange rate depends on the supply and demand of the national currency in each of the countries under consideration. According to this model, the determining factor of the exchange rate is monetary policy. If the Central Bank conducts a stable monetary policy, the national currency becomes more stable, reliable, and therefore expensive. The main drawbacks of the monetary model, which should be immediately mentioned, include the fact that it does not take into account trade flows and capital flows, i.e. the state of the balance of payments is not taken into account.