Theories of exchange rate determination

Purchasing power parity
  Purchasing power parity states that the price of a good in one
country should equal the price of the same good in another country, exchanged at the current rate—the
law of one price. There are two versions of the purchasing power parity theory: the absolute version and the
relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries'
general price levels, which is the weighted average of all goods produced in a country. However, this
version works only if it is possible to find two countries, which produce or consume the same goods.
Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In
reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and
well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution.
Finally, this version disregards the importance of brand names. For example, cars are chosen not
only based on the best price for the same type of car, but also on the basis of the name ("You are what you
drive").
Under the PPP relative version, the percentage change in the exchange rate from a given base
period must equal the difference between the percentage change in the domestic price level and the
percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it
is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as
with the absolute version, different price index weighting and the inclusion of different products in the
indexes make the comparison difficult and in the long term, countries' internal price ratios may change,
causing the exchange rate to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices.


Modern monetary theories on short-term exchange rate volatility
 The modern monetary
theories on short-term exchange rate volatility take into consideration the short-term capital markets'
role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the
divergence between the exchange rate and the purchasing power parity is due to the supply and demand
for financial assets and the international capability.
One of the modern monetary theories states that exchange rate volatility is triggered by a onetime domestic money supply increase, because this is assumed to raise expectations of higher future
monetary growth.
The purchasing power parity theory is extended to include the capital markets. If, in both countries
whose currencies are exchanged, the demand for money is determined by the level of domestic income and
domestic interest rates, then a higher income increases demand for transactions balances while a higher
interest rate increases the opportunity cost of holding money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest
rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust
more slowly than the financial markets. This version is known as the dynamic monetary approach