The monetary model of exchange rates

The monetary model says that the exchange rates of a currency are determined by the country's monetary policy. According to this model, countries whose monetary policy is stable over time generally have currencies whose value increases. Conversely, countries whose monetary policy is excessively expansionary experience a depreciation of their currency.

How is the monetary model used?

Depending on the model's perspective, several factors can influence a currency's exchange rate:

• The country's money supply.
• The level of money supply expected in the country's future.
• The ratio or growth rate of the country's money supply.

All of these factors are key to understanding and determining a monetary trend, which may then require a change in interest rates. To understand this, take the example of what happened to the Japanese economy in the past decade, a period during which the country went in and out of a recession. During this time, interest rates were close to 0% and annual budget deficits prevented the Japanese from coming out of the recession through spending, leaving Japanese authorities only one solution to solve the problem: print more money.

By purchasing stocks and bonds, the Bank of Japan increases the country's money supply, which generates inflation while forcing the currency exchange rate to change.

The monetary model itself is most effective when used in a context of ??overly expansionary monetary policies. One way that a nation can prevent its currency from undergoing a radical devaluation is to apply a strict monetary policy. This was the case, for example, with the Asian monetary crisis, when the Hong Kong dollar was attacked by speculators. This is why Hong Kong authorities had raised interest rates by 300% to prevent their currency from losing its parity with the US dollar.

This strategy worked perfectly because speculators couldn't cope with such high interest rates. The biggest downside, however, was the risk that the Hong Kong economy would enter a recession. Despite this, parity was finally maintained and the monetary model worked.

Shortcomings of the monetary model

Currently, few economists rely exclusively on the monetary model because it doesn't take into account capital flows or trade flows. For example, in 2002 the UK had higher growth rates, interest rates and inflation rates than the European Union and the United States, yet the British pound hadn't increased against the euro and the dollar.

In reality, the monetary model has experienced great difficulties since the emergence of floating currencies. According to this model, if interest rates are high, this indicates an increase in a country's inflation which is followed by a loss of currency value. However, it doesn't take into account capital inflows that would result from increased profitability due to interest or a stock market that could be booming due to a booming economy, which could increase the value of money.

Either way, the monetary model is a fundamental tool that analysts can use with other models to more confidently predict the direction in which a currency's exchange rate will move.