The Monetary Approach to Exchange Rates

The Monetary Approach to the Exchange Rate remedies the fixed exchange rate limitation of MABOP.  Instead of monetary disequilibrium being adjusted by international money flows, as in a world with fixed exchange rates like exist under a gold standard, the MAER has flexible exchange rates leading to monetary equilibrium, as money demand and money supply, controlled by central banks, is equilibrated through exchange rate changes.  A country with a managed float requires for its analysis both MABOP and MAER.

Unlike the MABOP approach, where exchange rate changes equal zero, the MAER assumes currency reserve flows are zero (with no central bank intervention) and exchange rates move instead.  The relationship can be written

E’ = D’ – P'(foreign) – Y’,

which means that the change in the exchange rate equals the change in domestic credit minus the change in the foreign price level minus the change in domestic income.  An increase in domestic credit by the central bank, with constant demand for money, will lead to a higher exchange rate with domestic currency in terms of foreign currency.  In other words, the domestic currency is losing value relative to the foreign currency.  An increase in domestic income will lead to a stronger domestic currency and a lower exchange rate, which is why Y’ and E’ are of opposite sign.  An increase in the foreign price level leads to fewer imports and a stronger currency.

The Portfolio Balance Approach to Exchange Rates

The MAER assumes that domestic and foreign bonds are perfect substitutes, meaning that investors are indifferent to the currency that a bond is denominated in and care only about the return.  In other words, uncovered interest rate parity holds between bonds in different currencies.

The Portfolio Balance Approach allows for imperfect substitutability, where investors do perceive currency risk and balance their portfolios accordingly.  PB models contain a risk premium in forward exchange rates, and uncovered interest rate parity does not hold.  As a country’s supply of bonds on the market increases, the currency’s risk premium increases, and the domestic currency depreciates.  The equation describing the MAER above is modified to be

E’ = D’ + (B’ – B'(foreign)) – P'(foreign) – Y’

The additional term added to the MAER equation above, (B’ – B'(foreign)), shows that an increase in domestic bond supplies greater than a corresponding increase in foreign bond supplies will lead to a weaker domestic currency and a higher exchange rate.

Sterilization

The central bank, in a fixed exchange rate system, can attempt to maintain a money supply greater or less than money demand, which would lead to money flows out of or into the country, through increasing or decreasing the supply of domestic credit.  If the central bank wants to increase the supply of money, but demand for money also increases, causing an inflow of reserves, then the central bank can sterilize the reserve inflow by increasing the supply of domestic credit by the amount of the inflow.

Under flexible exchange rates, a central bank can buy foreign bonds and sell domestic bonds, which would lead to higher exchange rates, or a depreciated domestic currency.

Source:  Husted and Melvin, International Economics