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The following are the effects of exchange rates on the Banking

1. Purchasing Power Theory
2. Currency Base Theory
3. The Monetary Approach
4. The Traditional Theory
5. The Portfolio Balance Model/ Theory
6. The Flexible Price Monetary Theory
7. The Asset Approach

Purchasing Power Theory

Purchasing Power Theory is the idea that in a stable market place, the
correlation between the interchange rates of various nations should be in
the same ratio as the price of a fixed goods and services. In other words,
there exists a difference between the procuring strength of currencies and
their exchange rates. There are different ways of expressing this, but most
commonly it is expressed as:

Rate of change of exchange rate = different inflation rates

In other words, these also examine or determine the appropriate equilibrium

exchange rate at which countries should regain their monetary standard.
The specific case of the law of one price assert that allowing for
transportation costs and absence of non-price barriers to trade commodity
arbitrage will ensure that the price of any goods says a particular model of
car, is equalized in domestic and foreign currency terms.

The purchasing power parity is explained in two forms; firstly absolute

form which states that the exchange rate balances the general purchasing
power of income regarding domestic and foreign prices. Secondly, there is
the reactive form which also asserts that the change in the exchange rate,
when measured from a base year, will reflect relative rates in two countries.
In practices, there are many practical difficulties in inferring equilibrium
speed of adjustment between asset markets and goods market, and the
problem of selecting the appropriate price index in calculating PPP rate.

Currency Base Theory.

It is postulated that internationalization of firm can best be explained in the
regarding the relative strength of different currencies, such as companies
from a stable country and businesses from a weak country. In a weak-
currency country, the income stream is fraught with greater exchange risk
and as a result, the revenue from a high currency firm state business is
capitalized at a higher rate, implying that such a firm is to

acquire a large segment of income generation in the weak currency country

corporate sector.

The Monetary Approach.

The theory emphasized the role of financial transaction or the capital

account of the balance of payment (BOPs) in producing exchange rate
changes. Excess demand for or supply of money is seen to give rise to
overall BOP disequilibrium, but it is a capital transaction which brings about
an adjustment through a change in the exchange rate. Thus the position
suggests that exchange rate change as a result of the firm's stock
disequilibrium the willingness of resident to hold the outstanding stock of
money rather than a company the flow of receipt and payment arising from
international trade over any given period. Hence, the exchange rate is seen
to be the price of foreign money in term of private money. The approach can
be further explained with a simple illustration.

Consider an increase in the exogenously determined money supply brought

about by a central bank purchase of government bonds in the open market
(which clearly represents an increase in the demand sources component of
the monetary base or high-powered money). The supply of foreign currency
and demand for same in the overseas country are taken and given the
domestic interest rate, output and price level. A rise in domestic nominal
interest rates will reduce the demand for real money balances and given the
nominal capital stock lead to a depreciation of the exchange rate and an
increase in the domestic price level. Thus the commercial model or
approach provides a satisfactory explanation of the break in the link
between the exchange rate and transaction flows represented in the current
account of the balance of payment (BOPs).
The Traditional Theory

This theory considers exchange rate as the price which brings into
equilibrium the supply and demand for home currency in exchange for
foreign exchange arising from the international transaction in goods,
services, and financial assets. The impact of a change in the stance of
analyzing exchange rate determination and an easy monetary policy will
tend to lead to an ex-ante BOPs deficit. An increase may worsen the current
account, while lowering interest

rates, will lead to a capital outflow. The traditional approach or theory

gives further insight into exchange rate movements.

The Portfolio Balance Model/ Theory

The portfolio balance approach stresses the role of assets market
adjustment or capital transaction in exchange rate determination. However,
unlike the monetary theory, it explains that exchange rate change reflects
the supplied of and demand for a broad range of different currency
denominated assets. In a single portfolio balance framework, individual are
assumed to allocate wealth between money and domestic and foreign
bonds. Only debt assured by the government and by non-residents is
regarded as perfect substitutes. It is due to risk (such as political risk) and as
such risk aversed investors are no longer indifferent between the mix of
domestic and foreign securities held in their portfolio. Consequently, the
current account and the stance of fiscal policy is brought to the forefront of
the analysis, as well as financial factors. The portfolio balance framework or
net financial wealth is explained as the sum of non-interest bearing money,
domestic bonds and foreign bonds expressed in the unit of local currency.
The demand for local bonds relates positively to the domestic interest rate
and negatively to the foreign interest rate. Conversely, the demand for
foreign bonds is an active function of the international interest rate and a
negative function of the domestic interest rate. The different rate is
assumed to be fixed. Stocks of national and foreign currency denominated
assets are considered to be fixed in the short run.

The Flexible Price Monetary Theory

The flexible - price monetary model or theory (FPMM), attempts to

demonstrate how changes in the supply of and demand for money both
directly and indirectly affect the exchange rate. FPMM can be further
explained under the assumption of a two-country global economy for
example, a quiet country (such as Kenya) and a foreign country (such as the
USA). If money supplied (M) in the two nations are exogenously determined
by the respective central bank; real demand for money (M-P) is determined
by the level of income (Y) and the standard of interest rate (I) and that their
respective elasticity is the same in both countries. For emphasis, and an
asterisk to denote unknown variable and parameter monetary equilibrium is
achieved when the supply of and demand for money in each country is

The Asset Approach

Modern exchange rate models emphasize financial asset markets, rather

than the traditional view of exchange rates adjusting to equilibrate
international trade in goods; the exchange rate is considered as changing to
equilibrate international trade in financial assets. Because commodities
prices change slowly about financial asset prices and financial assets are
sold each business day continuously, the shift in emphasis from goods
markets to asset markets has principal insinuations. Exchange rates will
often change as suppl

ies of and demands for financial assets of different nations change. An

impact of the asset approach is that exchange rates should be much more
variable than goods prices. The practical considerations are consistent with
the fact that exchange rates respond to changing conditions in financial
asset markets and are not just reacting to the evolution in international
goods trade. Exchange rate models emphasizing financial asset markets
typically assume perfect capital mobility.

In other words, money flows freely between nations as there are no

significant transactions costs or capital controls to serve as barriers to
investment. In such a world, covered interest arbitrage will ensure
covered interest rate parity. In the category of asset-approach models, there
are two basic groups: the monetary approach and the portfolio-balance

In the economic approach, the exchange rate between any two currencies
determined by relative money demand and money supply between the two
countries. Relative quantities of local and foreign bonds are irrelevant. The
portfolio-balance approach ensures relative bond supplies and demands as
well as related money-market conditions to determine the exchange rate.
Hence, the essential difference is that monetary-approach (MA) models
assume domestic and foreign bonds to be perfect substitutes, whereas
portfolio-balance (PB) models assume imperfect substitutability.

If domestic and foreign bonds are perfect substitutes, then demanders

are indifferent toward the currency of denomination of the bond as long as
the expected return is the same. In this case, bondholders do not require a
premium to hold foreign bondsthey would just as soon hold foreign bonds
as domestic onesso there is no risk premium, and uncovered interest rate
parity holds in MA models.