A Review of the Monetary Approach to Exchange Rate Determination: Theory and Empirical Evidence

Abstract

The monetary approach to exchange rate determination is one of the most influential theories in international macroeconomics, explaining exchange rate movements through changes in monetary fundamentals such as money supply, income, inflation, and interest rates. This paper reviews the theoretical foundations and empirical evidence relating to the monetary approach with particular emphasis on its three principal variants: the Flexible Price Monetary Model (FPMM), the Sticky Price Model (SPM), and the Real Interest Rate Differential Model (RIDM). The review examines the assumptions underlying each model and analyses their implications for exchange rate determination. It further synthesises empirical findings from developed and developing economies to assess the explanatory performance of these models. The literature suggests that the Flexible Price Monetary Model has generally received stronger empirical support than the Sticky Price and Real Interest Rate Differential models, although empirical evidence remains mixed across countries and exchange rate regimes. Differences in monetary policy frameworks, financial market development, institutional characteristics, and external economic shocks contribute to these inconsistencies. The review also identifies important research gaps, including the need for greater evidence from emerging economies and the application of advanced econometric approaches to capture nonlinear exchange rate dynamics. Overall, the paper concludes that the monetary approach remains a valuable framework for understanding long-run exchange rate behaviour while highlighting avenues for future theoretical and empirical research.