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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