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Monetary approach to determine exchange rate

Derive and explain monetary approach in order to determine the exchange rate.

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Monetary approach is related with Chicago School of Economics.  This method is based upon the two tenets: the quantity theory of money and purchasing power parity. Joining these two theories permits stating, say, the $/£ spot exchange rate as:

S($/£) = (M$/M£)(V$/V£)(y£/y$),

Where, V the velocity of money, M denotes money supply, and y the national aggregate output. Theory holds that what matters in the exchange rate determination are:

a) Relative velocities of monies,

b) Relative money supply, and

c) Relative national outputs.

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