The above factors will therefore be important in answering the discussing whether the market microstructure to exchange rate has been a radical departure from the 1960's, 1970's and 1980's international macroeconomic models. This will involve assessing ach factor against a certain model thus noting the development undergone. For example, the economic growth under the monetary model of the 1960's was slow compared to the economic growth in the recent market microstructure approach. Combining these factors with the market exchange rate expectations will give us the current change value. According to the monetary model argues that relative price levels of any given two countries will provide the determinant to exchange rate. ( Obstfeld, M. and Kenneth, R, 1996)
The real output level in a given country will also be a very important factor in assessing the models development; this is because it directly affects the price levels of certain goods and services. For instance, a rise in the United States output level with the other factors remaining constant will lead to a fall in the average prices in the US this will in return lead to the dollar appreciation. Past and future fundamental economic factors will matter a lot since the plays an important role of determining the future market expectations rate.
Some of the traditional model of exchange rate includes asset market approach, mundell Fleming model orgarch model among others. They all had a shortcoming of failing to explain exchange rate movement's ion the long run.
Mundell Fleming Model
This theory was developed by Marcus Fleming and Robert Mundell in the 1960's. It was an extension of the LM model describing a small open economy. It gives the relationship between the nominal exchange rate and output of an economy in the short run. The model assures that under fixed rate regime an increase in government expenditure will shift the cure to the right. (Hamilton, 1994)
This shift will increase the interest rate with the resultant effect being an appreciation of the exchange rate. In the fixed system framework the exchange will be controlled by the local momentary authority. The momentary authority stabilizes the exchange rate by using local currencies to purchase foreign currencies. This will in turn shift the LM curve in line with the direction of the IS shift, a thing that helps in lowering the exchange rate by increasing the supply of local currency in the market. However, a decrease in the government expenditure will shift the IS curve to the right. The shift will lead to a decline in the level of interest rate resulting to a depreciation of the exchange rate. (Hamilton, 1994)
The central bank or relevant monetary authority will vary the money supply so as to realize a constant exchange rate level. Local authority adds its foreign reserves through increased purchase of foreign currencies using the local currency. this will lead to exchange rate appreciation.Incase it wants to depreciate the exchange rate the authority will use the foreign reserves to purchase its own currency to