Explain asset market approach to Exchange rate determination : The asset market approach to exchange rate determination is a theoretical framework that focuses on the interaction between supply and demand in the foreign exchange market to explain how exchange rates are determined. This approach views exchange rates as the equilibrium prices at which the supply of and demand for different currencies balance in the global market for financial assets.
Key elements of the asset market approach include:
- Demand and Supply of Foreign Exchange: The approach considers the demand for and supply of foreign exchange (currencies) in the foreign exchange market. Demand for a currency arises from individuals, businesses, and governments that need that currency to engage in international transactions, investments, or speculation. Supply of a currency comes from individuals, businesses, and governments that have excess holdings of that currency and are willing to exchange it for another currency.
- Factors Influencing Demand and Supply: Factors that influence demand and supply of currencies include interest rates, expected rates of return on assets, inflation rates, economic growth prospects, political stability, and government policies. For example, higher interest rates in one country may attract foreign investors seeking higher returns, increasing the demand for that country’s currency.
- Relative Returns on Assets: According to the asset market approach, investors are motivated by the potential returns on different financial assets denominated in different currencies. Investors seek to optimize their portfolios by choosing assets that offer the best combination of risk and return. Exchange rates adjust to equalize the expected rates of return on assets denominated in different currencies.
Equilibrium Exchange Rate:
The equilibrium exchange rate is the rate at which the quantity of a currency demanded is equal to the quantity supplied. It is the rate where the demand for a currency, influenced by its relative attractiveness as an asset, matches the supply of that currency. The equilibrium exchange rate can change as economic conditions, expectations, and relative asset returns change.
- Market Expectations and Speculation: Expectations about future exchange rate movements play a crucial role in the asset market approach. Investors form expectations based on information about economic indicators, interest rate differentials, and geopolitical developments. These expectations influence their demand for and supply of currencies.
- Implications for Exchange Rate Movements: Changes in factors such as interest rates, inflation rates, economic performance, and investor sentiment can shift the demand for and supply of currencies, leading to changes in exchange rates.
The asset market approach provides insights into the complex dynamics of exchange rate determination, taking into account the behavior of investors, expectations, and the interaction between financial markets and the foreign exchange market. It emphasizes the role of relative asset returns and market expectations in shaping exchange rate movements.