Monetary Approach
According to PPP, exchange rates adjust to equalize tradable goods prices between countries. Therefore, if money supply rises, they’ll be more supply of money chasing too few goods. Thus, currency has to be depreciated to restore equilibrium. Also, as a result, there will be a reduction in interest rates as well.
To an investor, this means that there’ll be a need to decrease his/her portfolio in interest-bearing securities. Thus, the monetary approach is based on the theory that a change in money supply will eventually be offset by a change in monetary demand to restore equilibrium. However, in the real world, this is simply not the case as there are significant lags between the change in money supply and the change in exchange rate. Thus, there are models which fill this gap and I’ll show you one of them:
The Mundell-Fleming model shows how certain combinations of monetary and fiscal policy changes can cause temporary changes in the balance of payments relative to an equilibrium level. Basically, it shows how a country’s fiscal or monetary policy (loose/tight) can lead to an exchange rate appreciation or depreciation depending on the capital mobility.
For example, in an economy with high capital mobility, with weak growth conditions and benign inflation, the following normally happens:
Central bank loosens monetary policy -> Cut interest rates -> Capital Outflow via Increased Domestic Demand -> Exchange Rate Depreciation!
Conversely, in the opposite situation, the following can happen:
Central bank tightens monetary policy -> Increase interest rates -> Capital Inflow via Weaker Domestic Demand -> Exchange Rate Appreciation!
On the fiscal side, it depends on whether trade or capital flows dominate. Anyway, the following tables show a simplified result of the different monetary/fiscal policies.
This model is normally used for developed and leading emerging market economies which have deregulated and liberalized barriers to trade. However, due to the multitude of factors involved in the determination of exchange rates, we have take note that there may be a delay in the transmission mechanism and the initial exchange rate reaction may be the exact opposite of what standard models assume. Thus, the Mundell-Fleming model is more suitable for medium to long term outlooks rather than the short term.