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Please write out and explain what are the connections between the short-run (asset) approach to exchange...

Please write out and explain what are the connections between the short-run (asset) approach to exchange rate determination and the long run
monetary approach to exchange-rate determination. If you prefer, you may also use graphs.

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Answer #1

Asset Approach to Exchange Rate Determination. The interest parity condition can be used to develop a model of exchange rate determination. That is, investor behavior in asset markets which generates interest parity can also explain why the exchange rate may rise and fall in response to market changes.

Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run.

♦ It assumes absolute version of PPP.

♦ It assumes prices adjust immediately to their long run levels.

♦ In particular, price levels adjust to equate real (aggregate) money supply with real (aggregate) money demand.

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