Exchange Rate Determination

Purchasing power parity states that the price of a good in one country should equal the price of
the same good in another country, exchanged at the current rate—the law of one price. There are
two versions of the purchasing power parity theory: the absolute version and the relative version.
Under the absolute version, the exchange rate simply equals the ratio of the two countries' general
price levels, which is the weighted average of all goods produced in a country. However, this
version works only if it is possible to find two countries, which produce or consume the same
goods. Moreover, the absolute version assumes that transportation costs and trade barriers are
insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade
barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence
costs and goods distribution. Finally, this version disregards the importance of brand names. For
example, cars are chosen not only based on the best price for the same type of car, but also on the
basis of the name ("You are what you drive").
Under the PPP relative version, the percentage change in the exchange rate from a given base
period must equal the difference between the percentage change in the domestic price level and
the percentage change in the foreign price level. The relative version of the PPP is also not free of
problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and
thorny issue, just as with the absolute version, different price index weighting and the inclusion of
different products in the indexes make the comparison difficult and in the long term, countries'
internal price ratios may change, causing the exchange rate to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative domestic and foreign
prices. In the short run, the exchange rate is influenced by financial and not by commodity market
conditions.
Theory of elasticities holds that the exchange rate is simply the price of foreign exchange that
maintains the balance of payments in equilibrium. In other words, the degree to which the
exchange rate responds to a change in the trade balance depends entirely on the elasticity of
demand to a change in price. For instance, if the imports of country A are strong, then the trade
balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's
exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign
income. Whereas a rise in the domestic income (in country A) will trigger an increase in the
domestic consumption of both domestic and foreign goods and, therefore, more demand for
foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the
domestic consumption of both country B's domestic and foreign goods, and therefore less demand
for its own currency. The elasticities approach is not problem-free because in the short term the
exchange rate is more inelastic than it is in the long term and additional exchange rate variables
arise continuously, changing the rules of the game.
Modern monetary theories on short-term exchange rate volatility take into consideration the
short-term capital markets' role and the long-term impact of the commodity markets on foreign
exchange. These theories hold that the divergence between the exchange rate and the purchasing
power parity is due to the supply and demand for financial assets and the international capability.
One of the modern monetary theories states that exchange rate volatility is triggered by a onetime
domestic money supply increase, because this is assumed to raise expectations of higher future
monetary growth. The purchasing power parity theory is extended to include the capital markets.
If, in both countries whose currencies are exchanged, the demand for money is determined by the
level of domestic income and domestic interest rates, then a higher income increases demand for
transactions balances while a higher interest rate increases the opportunity cost of holding
money, reducing the demand for money. Under a second approach, the exchange rate adjusts
instantaneously to maintain continuous interest rate parity, but only in the long run to
maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the
financial markets. This version is known as the dynamic monetary approach.
Synthesis of traditional and modern monetary views. In order to better suit the previous theories
to the realities of the market, some of the more stringent conditions were adjusted into a synthesis
of traditional and modern monetary theories. A short-term capital outflow induced by a monetary
shock creates a payments imbalance that requires an exchange rate change to maintain balance of
payments equilibrium. Speculative forces, commodity markets disturbances, and the existence of
short-term capital mobility trigger the exchange rate volatility. The degree of change in the
exchange rate is a function of consumers' elasticity of demand. Because the financial markets
adjust faster than the commodities markets, the exchange rate tends to be affected in the short
term by capital market changes and in the long term by commodities changes.

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