One of the ways to Determine Exchange Rates in forex trading is known as the Monetary Approach. It has two transmission mechanisms:
2. Interest Rate
According to the theory, a country’s price level is a function of the quantity of money. However, according to PPP, exchange rates adjust to equalize domestic tradable goods prices between countries.
Thus, if monetary factors determine prices, they also play a part in determining exchange rates. The transmission mechanism for this would be as follows:
Change in money supply -> Change in price -> Change in exchange rate
Change in money supply -> Change in interest rate -> Change in exchange rate
For example, if money supply was rising, a forex trader assumes that it’s due to relatively loose monetary policy from the central bank. That rising money supply would in time lead to rising prices as too much money chases too few goods.
PPP suggests that under the law of one price, the price of freely tradable goods must be the same everywhere over time and that the exchange rate must adjust to achieve that. Hence, as prices rise in a country relative to prices for the same goods elsewhere, so the currency must depreciate to restore equilibrium.
Similarly, a rise in money supply should lead to a reduction in interest rates. Money supply is presumed to be known and a function of central bank activity. Money demand is somewhat more complex and is determined by interest rates, real income and prices. Increase in interest rates should logically cause an investor to increase their portfolio weighting in money/cash and decrease it in interest-bearing securities.
The basic premise behind this is that a change in money supply will eventually be offset by a similar change in money demand to restore balance. Hence, the point at which real money supply is equal to real money demand should logically equate to an “equilibrium” interest rate.
Since the Monetary Approach is focused on determining exchange rates, this point should simultaneously reflect the equilibrium exchange rate. However, this point where money supply and demand equate is rarely if ever achieved.
Like any “equilibrium” level, it is a moving target, which is why central banks can get monetary policy “wrong”, and the fact that it can change is clearly a factor in interest rate and forex market volatility.
It is all about incentive. As interest rates rise above this supposed equilibrium level at which real money supply and demand equate, money demand should fall as the incentive to hold interest rate-bearing securities should rise relative to the incentive to hold non-interest-bearing money.
Here, “money” refers to cash, which is assumed to have no interest-bearing component. Thus, reduced money demand should eventually reduce money supply.
Similarly, as interest rates fall below the equilibrium level, so the incentive to hold interest-bearing securities falls and the incentive to hold money rises. Rising money demand therefore should eventually cause rising money supply.
Within this premise however, and indeed within the Monetary Approach as a whole, is the idea that the transmission mechanism from monetary impulse through prices to the exchange rate is perfect and immediate.
In the real world of forex trading, this is simply not the case. There can be significant lags between the monetary impulse and the change in the exchange rate, not least because the prices of tradable goods do not necessarily respond immediately to changes in the dynamics that affect them. This is the idea of prices being “sticky”, which is the economists’ response to the apparent disparity between what should happen according to the standard monetary flexible price model and what actually does happen.
Thus, instead of the theoretical transmission mechanism, we get something more akin to:
Change in money supply? Delayed price change? Delayed exchange rate change
Eventually, the same transmission mechanism takes place, but the model by itself does not tell us when the exchange rate changes in response to a change in money supply or to what extent.
In an attempt to deal with these practical issues, there have been a significant number of variations on the original Monetary Approach to exchange rates, most of them involving a blizzard of formulae. Given this book’s practical emphasis, we do not go through these here.
While the results of the Monetary Approach to trying to predict exchange rates have been far from satisfactory, we cannot reject it out of hand, not least because we know that most of the building blocks of the theory are correct.
Rising supply will eventually meet rising demand of any commodity. The key lies in the transmission mechanism. We know that there are delays, but why is that so?
The usual component of the model which is blamed is PPP, which makes sense given that we know that PPP itself involves delays. However, this is not the whole story. After all, if none other than the Federal Reserve accepts that recent changes within the financial system, notably the much greater public involvement in the equity market, mean that money supply data can no longer be relied on as an inflationary indicator, then why should we suppose that changes in money supply can be used to predict exchange rates?
As with any market, an exchange rate is a function of supply and demand. In a freely floating exchange rate regime, the market sets both the prevailing and the equilibrium exchange rate levels.
In a fixed exchange rate regime, however, a central bank determines the prevailing level of the exchange rate. In committing to a fixed exchange rate regime, the central bank most likely would seek to commit to an exchange rate value which mirrors the equilibrium level at which exchange rate supply and demand meet.
However, we know that equilibrium levels themselves can and do fluctuate. Therefore, it should be safe to assume that at some point the prevailing exchange rate level and the equilibrium level will not match. Indeed, this is likely to be the case the majority of the time.
As a result, one should also assume an excess of demand or supply for the local currency to be the norm. The central bank has to offset that excess supply or demand by buying or selling its own currency. If there is excess demand for the currency within a fixed exchange rate regime, this forces forex trading market interest rates higher than they otherwise would be, obliging the central bank to “sterilize” the effect of excess money demand by injecting money supply into the system.
Equally, if there is excess supply of the local currency, the authorities must drain that excess. The ability of a central bank to achieve either of these goals is limited.