Exchange Rate Determination

Question

Most introductory international economics textbooks use the Uncovered Interest Rate Parity condition for deriving bilateral exchange rates. In other words, it is solely interest rate differential brought about by monetary policy that cause exchange rates to fluctuate, as investors demand/supply more attractive currency, which then adjusts exchange rate till the return in both currencies are equalized.

The question is- how do trade in goods affect this phenomenon? For instance, say China increases money supply, effectively decreasing interest rate, and this causes flight away from China towards American dollars, causing the American dollar to appreciate. China then benefits by improving its Current Account position. However, as the Chinese exchange rate has depreciated, Chinese goods are now cheaper, so more people will demand Chinese goods. Would this not have an offsetting effect on the depcreciation as people now demand the Yuan more?

Answer 1

1st of all, regading your remark

... , it is solely interest rate differential brought about by monetary policy that cause exchange rates to fluctuate...

That's just because it these models the internet case is isolated (like the joke of economists needed to change a light bulb)

As to your question, its always a combination between interests/ exchange rates and trade:

Per your example: When China lowers rates, effectively increasing money supply, the Yuan decreases and make exports more profitable Once exports occur, dollars come back to China, and converted to Yuans, making the Yuan increase back. To keep exports more profitable to China, a constant increase of money, lower interests rates, are needed. This, in turn, can create local price surges. Essentially the local economy subsidizes exports

What China does though, is not exactly that, even if similar China holds its foreign exchange rates low, and its interest higher. That sounds a bit contradicting, but its possible, if China's government absorbs dollars. So on one hand, Chinese exports are cheap, and on the other hand, the Yuan is a strong local currency. Furthermore, due to yhe e, export accelerated growth, wages and wealth has increased...

Answer 2

There are multitude of factors affecting exchange rate determination. It is not just about interest rate differential. Introductory economics textbooks deal in Ceteris Paribus situation.

The thing I appreciate in your question is, you think beyond what is written in textbook and question it.

Remember anything can happen in any economy, since there are n-number of factors simultaneously at work.

You hypothesized that depreciated Chinese currency will boost Chinese exports, but what if there are supply side constraints and exports cannot be increased; what if, the Mundell Fleming effect does not work in the first place due to low expectations of investors regarding Chinese economy. These are just examples that things can turn out in any way.

Just get a general understanding of how system works. The best thing is to know the mechanics of changing the light bulb and then consider all the random and non-random factors that that can change the light bulb. :)