Question

Which factors affect the exchange rates of the Australian dollar with respect to US dollar in terms of the monetary theory of exchange rate.

Why the monetary theory is deficient?

Answer 1

The factors that will affect the exchange rates of Australian dollar and US dollar is the demand and supply of the currency in each of these countries.

Another factor is the rate of interest, general price level and level of real income. The demand for money is the direct function of prices and level of income and inverse to rate of interest. The supply however is taken care by the monetary authorities of the country.

Here are some of the short comings of the Monetary Theory of determining the exchange rates:

a) It fails to explain the movement of exchange rate of major countries at the time of the currency floatation. Like the one which is seen since 1973.

b) It provides more emphasis on money and very little aspect of trade is involved in determining the exchange rates.

c) According to this approach the domestic and foreign assets are perfect substitute to each other.

d) The monetary approach to the determine rate of exchange has otherwise not been empirically efficient  . The estimated parameters are found insignificant and also with wrong signs.This approach has been rejected due to failure in tests of market efficiency and also not fared well in the ability of forecasting rates.