The Monetary Model

According to the monetary model, the exchange rates are determined by a nation's monetary policy.

Accordingly, countries with stable monetary policy should experience their currency appreciate while the countries with erratic or excessively expansionist policies should experience it's currencies depreciate.

Under this theory, several factors can influence exchange rates viz:

• Money supply,


• Expected future levels of a nation's money supply, and


• The growth rate of a nation's money supply.

Model Case Study

In 2007, the Federal Reserve in the US - and other central banks around the world - pumped money into the global credit markets to subdue an ongoing sub-prime mortgage crisis - a financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with significant dire consequences for financial institutions and financial markets around the globe.

Monetary Model Flowchart

By pumping more money into the US financial systems, the Fed increases the nation's money supply, which produces inflation, which forces a change in the exchange rate as illustrated in the figure above.

So in this scenario we could implement monetary model for forecasting that dollar will likely depreciate.

Limitations of The Model

This model does not take into account trade flows and capital flows. So according to the model, high interest rates signal growing inflation thus a country's currency must depreciate. However, reverse may be true.

Higher interest rate attracts more investment capital to harvest higher yields or of an equity market that may be thriving in a booming economy. This causes the currency to appreciate due to higher demand for it.