Derive & explain the monetary approach to exchange rate determination.
The monetary approach is related with the Chicago School of Economics. It is depending on two tenets: purchasing power parity & the quantity theory of money. Combing these two theories let for stating, say, the $/£ spot exchange rate as following:
S($/£) = (M$/M£)(V$/V£)(y£/y$),
Where M specify the money supply, V is velocity of money, and y is national aggregate output. The theory holds that what matters in exchange rate determination are following:
1. The relative money supply,
2. The relative velocities of monies, and
3. The relative national outputs.