Asset-Based Thoeries Of Exchange Rates

Exchange rates are relative prices of two assets: monies.  The current value of an asset depends on what that asset is expected to be worth in the future.  For example, the more valuable a stock is expected to be worth, the more it is worth now.  Similarly, the more a currency is expected to be worth in the future, the more it is worth now.  It follows that today’s exchange rate depends on the expected future exchange rate.  In turn, the expected future exchange rate depends on what is expected to happen to all the factors mentioned so far as affecting currency demands or supplies.  The asset approach to exchange rate looks at the current spot exchange rate as a reflection of the market’s best evaluation of what is likely to happen to the exchange rate in the future.  All relevant information about the future is incorporated into the current spot rate.  Because new information is random, and could as easily be good or bad news for one currency versus the other, the time path of the exchange rate should contain a random component.  This random component, fluctuate around the expected change in exchange rate.  The expected change can reflect the implication of PPP – with more rapid inflation than elsewhere implying depreciation or any other influence on exchange rate that is reflected in asset supplies or demands or in the balance-of-payments accounts. 

The asset approaches offer an explanation for departures from PPP, because expectations about the future are relevant to the current exchange rate, there is no necessity for the spot exchange rate to ensure PPP at every moment.  For example, if a country is expected to experience rapid future inflation, poor trade performance, or something else leading to future depreciation, the current exchange rate of that country’s currency is likely to be below its PPP value.  However, because the expected future exchange rate could be based on a tendency for PPP to be restored, the asset approach is not inconsistent with the long-run implication of the monetary approach.