Flexible Price Monetary Level - Essay Example

FLEXIBLE PRICE MONETARY LEVEL FLEXIBLE PRICE MONETARY LEVEL The flexible price monetary model of exchange rate establishment gives a strong link between the nominal exchange rate and the relative set down financial basics. The monetary model states that the price level in a particular country is determined by its monetary supply and demand forces with respect to other countries. The price level in all the countries used for comparison should be in the same currency rate. The use of a similar currency serves as a useful tool for establishing and understanding fluctuations in exchange rate over a given period. Several past researchers in industrial countries have found little evidence of co-integration between nominal exchange rates and monetary basics (Baille and Selover, 1987). The unavailability of practical evidence for a long-run relationship between nominal exchange rates and monetary fundamentals means that the monetary model has little practical significance. Recent economic scholars such as MacDonald and Taylor (1991) have tested for a stable long-run relationship between nominal exchange rates and monetary basics using post-Brenton woods float. These later studies have established a strong link between nominal exchange rates, money and real output through the use of panel co-integration tests. Studies on high inflation countries also indicate that monetary fundamentals are essential in the determination of exchange rates behaviour (McNown and Wallace, 1994). This academic paper shall test the flexibility of the price monetary model of exchange rate and its relative ability to explain foreign exchange movements in different countries. Flexible Price Monetary Model of Exchange Rate Determination The monetary exchange rate models the flexibility determination begins with the assumption of capital mobility. The model uses both purchasing power and interest rate parities to define equilibrium conditions. With reference to the determination of the flexibility of the price monetary model, this research paper shall focus on three different models. These three models are the flexible price monetary model, the sticky price monetary model and the sticky price monetary model that entails relative price differential (Cuaresma, Fifmuc and MacDonald, 2005). The first principle of the monetary model assumes that purchasing power consistency is continuous. This is represented by St = pt – p*t + C. With reference to this; C is the constant, S the logarithm of exchange rate. This is in local unit’s currency per foreign legal tender. P* and P are as foreign and domestic price levels. The second principle of the model assumes a stable money demand function at both domestic and international markets. The monetary market equilibrium situations for both domestic and foreign markets are considered to be dependent on the income, price level and interest rate (Baille and Selover, 1987). Monetary Equilibria in the both the domestic and foreign are as equations 1 and 2 below respectively; mt = Pt + B2yt - B3it … …………………………1 mt* = pt* + B2*yt* - B3*it* …………………2 In the above two equations, mt and mt* are the domestic and foreign monetary supply functions. B2 is the income elasticity of demand and B3 is the interest rate semi-elasticity. Should we rearrange the two equations for domestic and foreign price levels and substituting develops into a monetary price exchange model equation as follows: St = B1 (mt - mt*) - B2 ( Yt - Yt *) + B3 ( it - it* ) + C + Et . In this equation, the significant nominal level of interest rate is composed of real interest rate and the expected inflation rates (Miyakoshi, 2000). The rationale provided for a percentage increment with respect to monetary supply will result in the price increase by the same proportion. In the Flexible price monetary model, an increase in the domestic real income results in the creation of excessive demand for the domestic currency. This situation will force monetary supply and demand agents to decrease their expenditures in order to increase their income propensity that will lead to a fall in the overall prices. On the other hand, an increase in the cash supplies results in inflation. This makes agent’s switch from domestic currencies to bonds that lead to depreciation of the local currency. This thus implies that an appreciation of the local currency restores the equilibrium level (McDonald and Taylor, 1993). The Sticky price monetary model of exchange rate incorporates short run interest rates in order to capture the liquidity effects involved. This model assumes the expected depreciation of the exchange rate to be a function of the gap between current exchange rate and long-term equilibrium rate (Kia, 2006). The long-run inflation expected which is the differential between the domestic and foreign countries yield would be calculated using the following formula: In the above equation, λ is the economy’s adjustment speed to the equilibrium. This equation argues that the present exchange rate returns to its long term equilibrium position at the rate λ. In the long-run effect, St = thus the expected depreciation rate of the currency will be equal to the difference of both domestic to foreign inflation rates. The gap between the present exchange rate and its resulting long-run equilibrium exchange rate is proportional to the differentials of real interest between any two countries. This implies that if the foreign real interest rate becomes higher than the local interest rate, then there will be an outflow in capital form. This is from domestic to foreign bonds until the interest rates are equal (Johansen and Juselius, 1991). The relationship in the long run effect in sticky price monetary model can be as follows: In the long-run the interest differential should be equal to the long-run expected inflated differential; the formula can be as below These two equations when combined produce This combined equation states that the exchange rate will go beyond its long-run equilibrium rate whenever the relative nominal interest differential increases above the equilibrium levels (Frankel, 1993). Empirical results The irony of the monetary models was discovered by an economist Bilson, who had initially developed one of the original monetary models of the exchange rates. Bilson argues that the PPP does not apply in the short run while nominal interest rates are non-exogenous as previously thought. Other scholars such as the duo of Caves and Feige claimed no statistical support for the model (Caves and Feige, 1980). Similarly, Huang established that the exchange rates were far too volatile to be consistent with any of the monetary models or an efficient market. Johansen between 1988-1991 came up with a multivariate co-integration that was superior to Engle and Granger’s simple regression model. Johansen’s method was able to identify the underlying time series and data properties hence found the monetary models valid (Engle and Granger, 1987). On the contrary, McDonald and Taylor used Johansen’s approach to the analysis of three currencies from England, German and Japan. They established that one co-integrating vector indicated that the monetary model had some level of long-run effect validity (Mac Donald and Taylor, 1991). Furthermore in the year 2000, Miyakoshi used the flexible price monetary model and found one co-integrating vector that indicated the validity of the monetary model (Miyakoshi, 2000). Three other scholars Crespo Cuaresma, Fifrmuc and MacDonald in 2005 estimated the monetary exchange rate model while using panel cointegration methods. This process involved an analysis of Central and Eastern Europe countries. This model was able to account for the different relationships in the long-run exchange rate and was more effective when accompanied a Balassa-Samuelson effect. As a means of testing for the number of cointegration relationships among the different variables, Johansen and Julius (1990) provided two tests. These were to determine the number of co-integrating vectors that were namely trace and maximum eigenvalue tests. Once the number of relationships has been determined, restrictions can be imposed on coefficients to test the theory based hypothesis with respect to long-run variables value (Balassa, 1995). Despite present scholars developing overwhelming support for the monetary approach to exchange rates, there are still a number of existing limitations. Primarily the process of measuring money supply with the relative growth of term deposits, market mutual funds among other financial vehicles has become extremely difficult. Furthermore, another problem arises due to the problematic nature of purchasing power parity since it does not hold in all the cases and tends to vary from nominal exchange rates (Taylor and Sarno, 1998). The demand for money also acts as a function of the risk associated with holding domestic currency. Another economics Scholar Kia (2006) demonstrated the demand for money as a function of the majority of the domestic and foreign debts and deficits among others. These thus make the monetary models insufficient enough in determination of the exchange rate. Conclusion Up to date, the monetary approach continues to be one of the most important tools used in explaining variations in exchange rates. From the previous years to the late 1980’s, there was no available evidence to support the flexibility of the price monetary level. However, as a result of improved statistical tools and more precise specification of the model, research from the late 1980’s has established the long-term validity of the exchange rate monetary model. This academic paper has presented and expanded three different models so as create the flexibility and long-term effects of the models. The three models used include the flexible price monetary model, the sticky price monetary model and the sticky price monetary model that entails relative price differential (Bilson and Marston, 1984). Reference List Baillie, R.T., Selover, D.D., (1987). Cointegration and models of exchange rate determination. International Journal of Forecasting 3, pp.43-51. Balassa, B., (1995). The purchasing power parity doctrine: A reappraisal. Journal of Political Economy.72, pp.584-596. Bilson, J. F. O., & Marston, R. C. 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Cointegration Tests of the Monetary Exchange Rate Model for Three High Inflation Economies. Journal of Money, Credit, and Banking, 26: 396-411. Miyakoshi, T. (2000).The Monetary Approach to the Exchange Rate: Empirical Observations from Korea. Applied Economics Letters, 7: 791 -794 Taylor, M.P and Sarno, L., (1998). The behaviour of real exchange rates during the postBretton Woods period. Journal of International Economics 46, pp.281-312. Read More