Flexible Price Monetary Model of Exchange Rate Determination - Case Study Example

Flexible Price Monetary Model of Exchange Rate Determination In 1973, the exchange rates system was allowed to float for many industrialized countries. As a result, the monetary approach emerged as another way of determining the foreign exchange rates. As time went by in the 1980’s the monetary models developed were found to be no better in terms of forecasting and predicting future exchange rates. Meese and Rogoff (1983, 23) presented three types of models, which include the sticky price model, flexible price model and the sticky price model, which incorporates the current account (Meese and Rogoff 1983, p. 67). The paper discusses the flexible price model as a tool for determining the exchange rates and how the model performs when tested empirically. The flexible price model is built on a definition that exchange rates are the relative prices of two monies in different economies (Frenkel 1986, p. 45). The relative prices are described in terms of the relative demand for and supply of those monies. The monetary equilibria in discrete time can be given by the formulas for domestic and foreign country. Mt = pt+kyt-rit Mt*=pt*+k*yt*-r*it* In reference to the formulas, m, y, p, and i are the logarithms of money supply, income level, price level and interest rate levels respectively. Based on the assumption that there is perfect capital mobility, the interest rate in the economy is exogenous, in the long run. Other than the concept of relative prices of monies, the flexible price model is also built on the concept of absolute purchasing power parity (PPP). PPP holds that the money and commodities market will alter the exchange rates as they try to equalize the prices in two economies (Engel 2000, p. 250). For example, if the US goods are more expensive that the Canadian goods, then the consumers in both countries will tend to buy more goods in Canada and fewer in US. As a result, the raised relative demand for Canadian goods will lead to the appreciation of the Canadian currency with respect to the US dollar. The Canadian currency will equalize the prices denominated by the dollar for goods in both countries. The flexible price model assumes that the purchasing power parity holds continuously. Therefore, St=pt-pt* where St is taken as the logarithm level of nominal exchange rate for both countries. It may also indicate the domestic price of the foreign currency. p and pt* are taken to be the domestic and foreign price levels, respectively. The equation that defines the flexible price model is as follows: St= (mt –mt*)-(kyt - k*yt*) +(rit-r*it*) The domestic money supply is a parameter that determines the level of domestic prices. Hence, the relative money supplies in two countries determine the rate of foreign exchange. In order to simplify the flexible price model, it is assumed that the interest rate and income elasticities of money demand are the same in the foreign and domestic country. Therefore the reduced model is illustrated by; St= (mt –mt*)-k(yt - yt*) +r(it-it*) Relevance of Flexible Price Model In reference to the equation illustrated above, increase in domestic supply of money to the foreign market leads to depreciation of the domestic currency with respect to the foreign currency. It may also mean that the nominal exchange rate increases, as well (Chinn and Meese 1995, p. 171). If the domestic real income is increased at ceteris paribus, the domestic money will be highly demanded. The situation will be associated with attempts to increase the money balances between the two countries. As a result, residents in the domestic country will reduce their expenditure and thus the prices will reduce until the equilibrium for the money market is finally achieved (Diebold and Mariano 1995, p. 254). Based on the concept of PPP, therefore, the decline in domestic prices, with the foreign prices of goods remaining constant, the domestic currency will depreciate in terms of the foreign currency. In other words, the value of the domestic money will rise in terms of the foreign money. Similarly, when the prices of commodities in the domestic country increase, it means that the value of the domestic currency will decline in terms of the foreign currency. Using this approach, therefore, five markets out of six are cleared; remaining with the money market. Based on Warlas’ law, the equilibrium of the nth market is implied to the equilibrium in n-1 markets in a market system containing n markets. Thus, the equilibrium in money market, in this case, would be implied to the equilibria in the other five markets of an open economy. The flexible price monetary model is, therefore, based on the assumption that the PPP continuously holds so as to determine the rates of foreign exchange in two countries. The simple, flexible price monetary model is based on assumptions that make it applicable. In an open economy, there are many markets covering, labor, foreign exchange, money, goods and the bonds markets (Mark and Sul 2001, p. 30). The bonds markets represent the non-money assets and are divided into domestic and foreign bonds. The flexible price monetary model, however, focuses on the equilibria in the money market only. This is achieved by assuming that there is perfect substitutability of foreign and domestic assets. As a result, the foreign and domestic bond markets are reduced into a single market. Then, the foreign exchange rates are considered to be the determinants that equilibrate demand and supply in the foreign exchange market. The model assumes that the prices and wages are perfectly flexible in equilibrating the demand and supply of goods and labor markets (Groen 2000, p. 307). The perfect flexibility in prices and wages enables the achievement of equilibria even in times of bubbles. In a macroeconomic perspective, demand and supply of goods in the markets in an economy would be determined by the prevailing prices. The price factor is taken as the determinant of demand and supply because it directly affects the behaviours of buyers and sellers, unlike the cartels and other collisions, which are not common in most economies. The prevailing wage rate substantially affects the demand and supply in the labor market. This is because other determinants attributed to affecting the labour market such as unemployment rates keep changing over time (Cheung, Chinn and Pasual 2002, p. 78). The flexible price monetary model has also assumed that the economic agents in the two countries under study are rational. The uncovered interest parity (UIP) is assumed to hold for the model to work. UIP requires that funds are flowing freely across the borders of countries and the investors do not fear any risk (Berkowitz and Giorgianni 2001, p. 100). The UIP states that after the adjustments/alterations of expected depreciation are made, the expected rates of return on the assets are equal. Note that the assets must be substitutable in the denominated different currencies for UIP to apply. Inclusion of the UIP would alter the model in that you will consider the rational mathematical expectations made and incorporate them into the model. The flexible price model will not hold if such assumptions are not made. The validity of the model can be tested by applying it to economies full of rational bubbles. However, the most effective way of evaluating the validity of the model is by testing it empirically (Wang 2009, p. 90). Empirical Testing The empirical testing involves an assessment of the ability of the models in forecasting the future foreign exchange rates. In 1970s, efforts were made to test the empirical fit of the models and their ability to predict the future exchange rates. Among the monetary models used is the flexible price model which is based on the assumption that capital is perfectly mobile. Meese and Rogoff conducted an empirical test in 1983 the model and concluded that it could not forecast the future. However, they presented some evidence that the flexible price model brought some prospects of future exchange rates at longer horizons, but, not, smaller ones (Meese and Rogoff 1983, p. 67). In other words, the model presented massive failure in short periods, but, showed some predictability in in long periods. Research shows that the flexible price monetary model worked quite well in 1970’s for given foreign exchange rates. In the late 1970’s, the model performed poorly due to high inflation rates. Literature reveals that the monetary model worked in most countries except those that experienced high inflation rates. The poor performance in this period was attributed to the inability of the purchasing power parity (PPP) to hold. The assumptions made by the flexible price model resulted in its failure in determining the bilateral exchange rates of countries experiencing inflation. Inflation was viewed as another equilibrium conditions that affected the demand and supply in the market. Thus, the price and wages at that time were not perfectly flexible in determining the demand and supply for the goods and labour market due to inflation (Johansen 1988, p, 243). Therefore, the model resulted in wrong rates of foreign exchange. Since the Meese and Rogoff presented strong negative results of the model in 1980’s, enormous research was carried in the subsequent years as an attempt to rescue the monetary models. However, the models were ineffective in determining the exchange rates despite those attempts. For example, economists in the late 1980’s used coefficients that considered the time changes in modifying the model, but, were eventually unsuccessful. The empirical tests of the 1970’s, 1980’s created the conventional wisdom that the monetary models including the flexible price model are cannot be used in predicting the future foreign exchange rates. References List Berkowitz J and Giorgianni L 2001, Long-Horizon Exchange Rate Predictability? Review of Economics and Statistics 83(1), 81-91. Cheung Y, Chinn M D, Pascual A 2002, Empirical Exchange Rate Models of the Nineties: Are Any Fit To Survive? Working paper, University of California, Santa Cruz 23(3), 23-34. Chinn M and Meese, R 1995, Banking on Currency Forecasts: How Predictable is Change in Money? Journal of International Economics 38, 161-178. Diebold F X and Mariano R S 1995 Comparing Predictive Accuracy.” Journal of Business and Economic Statistics 13(3), 253-63. Engel C 2000, Long-Run PPP May Not Hold After All, Journal of International Economics 51(2), 243-73. Frenkel J A 1986, Exchange Rates and International Macroeconomics, Chicago, University of Chicago Press. Groen J 2000, The Monetary Exchange Rate Model as a Long-Run Phenomenon, Journal of International Economics 52, 299-319. Johansen S 1988, Statistical Analysis of Cointegration Vectors, Journal of Economic Dynamics and Control 12(1), 231-254. Mark N and Sul D 2001, Nominal Exchange Rates and Monetary Fundamentals: Evidence from a Small Post-Bretton Woods Panel, Journal of International Economics 53(2), 29-52. Meese R A and Rogoff K 1983, Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14 (1), 3-24. Wang P 2009, The economics of foreign exchange and global finance, Berlin, Springer-Verlag. Read More