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This model aims to provide an explanation for the dynamic adjustment process that occurs as exchange rate moves towards a new equilibrium by considering monetary fundamentals such as money supply, income levels, or other variables.
The concept behind it is that an increase in money supply leads to high interest rates as a result of a growing inflation. This is then followed by a depreciating currency as a means of correction towards a new equilibrium.
Followers of this model therefore see the growth of a nation's money supply in relation with inflation and inflation expectations. They sustain that a currency increases in value if there is a stable monetary policy and decreases if the monetary policy is erratic or unstable.
In a later section, we shall see the relationship between money supply, inflation and interest rates.
The problem with this model is that it doesn't take into account the variables of the balance of payments described in the above model, specially the capital inflows that would take place as a result of higher interest rates in the domestic currency or a booming equity market. In any case its theoretical approach can be used to complement the big picture.
