Exchange Rate Determination

Solution Preview

1. Describe the monetary approach to exchange rates between a pair of countries, including description of the market involved and the equilibrium conditions that must hold. Why does this approach fail to fully explain exchange rate movements?

As per the monetary approach the foreign exchange market is in equilibrium when deposits of the two currencies offer the same expected rate of return. (This is also called the interest parity condition.)

The market involved is the foreign exchange market. The major participants are commercial banks, corporations that engage in foreign trade , nonblank financial institutions such as asset management firms and insurance companies , and central banks. The volumes are huge.
Take the example of dollars and pound.

R $= R ₤ + (E' $/₤- E $/₤)/ E $/₤

R $= Interest rate on dollar deposit
R ₤ = Interest rate on pound deposit
E' $/₤=Expected exchange rate
E $/₤= Spot rate

Exchange rate movements are driven by other factors like foreign exchange risk, liquidity in the foreign exchange market . Thus this approach fails to fully explain exchange rate movements.

2. Explain the difference between open economy and closed economy national income accounting. what is the difference between total savings under these two approaches?

For a close economy the division of GNP into consumption, investment and government purchase is exhaustive. Any final good or service that is not purchased by the household or the government must be used by firms to produce new plant equipment and inventories. The consumption goods that cannot be sold immediately to consumers or government is added by the firms to their inventories thus increasing investment.

Y= C+I+ G
Y= GNP
C= Consumption
G=Government purchases.
All the output must be consumed, invested or bought by the government.

National saving is the portion of output Y that is not devoted to household consumption C or government purchases G.
In a closed economy , national savings always equals investment. This is seen from the following:

Let S stand for ...