According to the modern theories that elaborate on short-term exchange rate volatility, the international capability and the supply and demand of financial assets determine the divergence between the purchasing power parity and the exchange rate. Those theories consider two factors:
- The short-term role of the capital markets
- The long-term influence of the commodity markets
Since the expectations for a higher future monetary increase are raised when the domestic money supply rises, then the latter is the major driver of exchange rate volatility.
What happens if in two countries whose currencies are exchanged, the domestic income level and the domestic interest rate are the factors that determine the demand for money? One modern monetary theory elaborates on these conditions and states that the demand for transactions balances is increased with a higher income. On the other hand, if interest rates are high, then the opportunity cost of keeping the money is increased, which leads to a fall in the demand for money.
In order to maintain the purchasing power parity over the long term, another modern monetary theory (the dynamic monetary approach) states that the exchange rate makes an automatic and immediate adjustment, which is needed for the maintenance of consistent interest rate parity. Since financial markets and commodity markets adjust at differing rate volatility occurs.
As you have probably already found out there are different theories, whose stipulations and conditions of a more rigorous character have been adjusted into synthesis of modern and traditional theories so that they are better fitted to the realities of the market.
In order to maintain the balance of payments in equilibrium when the monetary shock creates a capital outflow, a change in the exchange rate is required. Exchange rate volatility is caused by the following factors:
- Disturbances on the commodity markets
- Speculative activities
- Short-term capital mobility
The consumers’ elasticity of demand is one of the factors which determine the degree of change in exchange rates. Since the commodity markets adjust at a slower rate than financial markets the exchange rate is affected by changes in the commodities over the long-term. On the other hand, exchange rates are influenced by the capital market movements in the short-term.