Explain asset market approach to Exchange rate determination.

Asset Market Approach to Exchange Rate Determination

The asset market approach is a modern theory for determining exchange rates, focusing on the role of financial assets (like stocks and bonds) and their expected returns in different currencies. This approach emphasizes that exchange rates are determined by the supply and demand for a wide variety of financial assets.

1. Role of Financial Assets

• Financial Assets as Key Influencers: The approach posits that the exchange rate is determined by the demand and supply of financial assets of different countries. Investors seek assets with the highest expected returns, adjusting for risk.

• Portfolio Balancing: Investors balance their portfolios across different assets and currencies. Changes in the perceived attractiveness of assets in a particular currency can shift demand and supply for that currency.

2. Expectations and Returns

• Expected Returns on Assets: Exchange rates are influenced by the expected returns on assets denominated in different currencies. These returns include interest rates, dividends, and capital gains.

• Influence of Interest Rates: A key factor is the interest rate differential between countries. Higher interest rates in a country increase the expected return on assets in that currency, leading to an appreciation of the currency.

3. Capital Mobility and Exchange Rates

• High Capital Mobility: In a world of high capital mobility, investors can quickly move funds across borders in response to changes in expected returns.

• Immediate Response to News: Exchange rates can change rapidly in response to new information affecting expectations about returns on assets.

4. Exchange Rate Expectations

• Future Expectations: Investors not only consider current differentials in interest rates and other factors but also expectations about how these differentials will change in the future.

• Self-Fulfilling Prophecies: Expectations about future exchange rates can become self-fulfilling, as investors buy or sell currencies based on these expectations.

5. Policy Implications

• Limited Effectiveness of Monetary Policy: In the short term, monetary policy can influence interest rates and thus exchange rates. However, in the long run, other factors like inflation expectations may counteract these effects.

• Integration with Global Financial Markets: Exchange rate movements are closely tied to global financial market dynamics, making them sensitive to international capital flows and investor sentiment.

In summary, the asset market approach views exchange rates as determined by the relative supply and demand for financial assets denominated in different currencies. This demand and supply are influenced by factors like interest rates, expected returns, investor expectations, and global capital mobility.