Question

International Economics Problem

1 There are (at least) three different approaches to explaining how exchange rates are determined. Select 2 and compare and contrast them.

Answer 1

We will discuss the balance of payments approach (BOP) and purchasing power parity (PPP) approach to exchange rate determination.

According to the purchasing power parity approach the equality of the purchasing power of two in-convertible currencies determines the exchange rate. The purchasing power of the currencies is influenced and determined by the inflation levels in the countries.

According to the balance of payments approach the exchange rate is determined by the lance of payments position of the country and is independent of the money supply and price level of the country. A BOP deficit is suggestive of a greater demand for foreign currency than the supply of the foreign currency at the prevalent exchange rate and a BOP surplus is suggestive of a greater supply of foreign currency than the demand for the foreign currency at the prevalent exchange rate. The exchange rate is determined when their is neither deficit nor surplus in the BOP.

BOP approach, as opposed to the PPP approach, includes or factors in for factors other than just the merchandise trade in the determination of exchange rate. BOP considers all the factors which can affect the demand and supply of the foreign currency. BOP approach believes that disequilibrium in the BOP can be eliminated by devaluation or revaluation of the currency, whereas PPP approach eliminates disequilibrium in the BOP through policies which cause inflation or deflation.

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