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Answer
Approach
State the theories of exchange rate determination- all the theories
Exchange rate determination in Zambia
Read about the Zambian economy

The following are the basic theories of exchange rate determination

1. The Purchasing Power Parity Theory (PPP)
2. Balance of Payments Approach (BOPA)
3. Monetary and Portfolio Approaches

Introduction
Exchange rate is merely the price of a currency. It reflects the purchasing
power of one currency in terms of the other. It tells us for instance, how
many dollars the Zimbabweans are willing to pay to purchase an South
African Rand and vice versa. The general trend the world over has been one
of declining purchasing power of currencies due to inflationary pressures,
and the inflationary pressures differ among countries due to growth policies,
labour costs.

Inflation is exported through trade and given the varying

purchasing powers of currencies, international traders tend to identify

advantageous deals where their currencies will obtain greater value. When a
country experiences inflation, the purchasing power of the domestic currency
is affected, and this triggers the movement of the currency against other
currencies. Because of such hazardous and unstabilising movements in the
exchange rates, systems were developed to counter these effects in order to
maintain stability in the international transactions. The two main systems

that pre-dominated the period between 1960 and 1980 and the fixed
exchange rates and the floating exchange rates. In the former the
government agreed to trade on fixed parities and change came at rare
intervals, in the later currencies would fluctuate in response to political or
speculative pressures.
The Purchasing Power Parity Theory (PPP)
The first theory of exchange rate adjustment was formulated by Gustav
Cassel in the 1920`s under the name of PPP. In the modern interpretation the
theory states that purchasing power parity is determined by the balance of
supply and demand for currency.

Type equation h ere .

According to Hasan

(2006) the PPP doctrine hypothesises that prices of comparable goods and
services are similar across countries after exchange rates adjustments. This
theory, is also coined as the Law of One Price (LOP), therefore predicts a
proportional relationship between exchange rates and relative prices of
comparable goods and services between trading nations over long periods of
time. The PPP doctrine is a basic tenet of the monetary approach of
exchange rate determination and it constitutes a theoretical cornerstone of
the open economy quantity theory as proposed by Lucas (1982).

The absolute version of the PPP doctrine states that the exchange rate is
equal to the ratio of prices of the two countries in the long-run: This is
expressed as follows;
St=

Pt
Pt

Where St is the nominal exchange rate defined in local currency units per
unit of foreign currency units such as the Zimbabwean dollar per pound
sterling:

Pt and

Pt

are the domestic and foreign price levels. Zimbabwe

is regarded as the domestic country while Britain is regarded as a foreign

country. The importance of the PPP hypothesis has spawned considerable

research at both the theoretical and empirical levels that spans almost four
decades.
Johnson (1990) investigated the PPP hypothesis using the bilateral exchange
rates and price indices of Canada and the USA within the framework of Engle
and Granger's (1987) residual based approach of cointegration methodology.
Johnson (1990) reported that the PPP relationship is maintained during both
fixed and flexible exchange rate regimes.
The advent of the generalized floating exchange rates in the early 1970s has
spurred a growing interest in the formularization and the testing of models of
exchange rate determination. Much of this work has centered around models
that treat exchange rates as asset prices; chief among these models is he
monetary approach to exchange rates (MAER), which arose as an outgrowth
of research on monetary determinants of the balance of payments.

References
Mohammad, S, H. 2006. A century of Purchasing Power Parity: evidence from
Canada and Australia Applied Financial Economics, 16,145156.
Johnson, DR. (1990) Co-integration, error correction, and purchasing power
parity between Canada and the United States, Canadian Journal of
Economics, 23, 83955.