International Finance: the Flexible Price Model of Exchange Rate - Essay Example

International finance International finance In the flexible price monetary model, the coefficient of the given relative supplyof money is positive thus equal to one based on the neutrality of this money (Madura 2012). The rationale undertaken indicates that for a percentage increase given in the money supply, prices are likely to increase by a similar percentage. Moreover, if the PPP is held continuous, the domestic currency would depreciate by the same amount restoring the equilibrium. Thus, the flexible price model of exchange rate determination simply put entails that money demand and supply set the equilibrium rate of exchange and the PPP holds. There are various assumptions that are held regarding this model. The first one is that all prices, wages included are flexible both increasing and decreasing to restore the equilibrium after the observed shocks. The other assumption is that economical agents are rational and that exchange rate is regarded as an asset price, which is seen as a means of holding the wealth (Ghatak & Sánchez-Fung 2007). There is also an assumption that there is a perfect sustainability of foreign and domestic goods, PPP holds continuously, capital is perfectly mobile and that money supply is exogenous with an instant clearing. The assumption that PPP holds continuously can be represented as follows: St=Pt-PtFor UIP, given the sustainability of the bonds and the mobility of capital: ∆Set+1=it-it. For the domestic residents wealth constraint: Wt=Mt+ Bt+Bt .Here Wt is nominal wealth, Mt= holding of domestic money, while Bt=holding of the domestic bond. This allows the IUP to hold. Attention is often focused on the money market where bonds have no independent role in the determination of the exchange rate (Evans 2011). This could be indicated by considering the domestic and foreign money demand: MDt –pt =α1yt –α2it α1, α2 is less than 0 MtD-pt=α1yt – α2it Here: mD = in (money demand) From this, mDt -pt is the quantity of money in terms of the quantity of goods and services that it is likely to buy which is the real money balances. Thus from the equation, it is evident that: The real balances of money are positively related to the real income which is the increased transaction of demand. It also indicate that this real money balances are often negatively related to the resulting interest rate which is the incentive to utilize a much better rate. This demand function is often applicable in economics (Copeland 2008). More representation of this demand function is as follows: MDt –pt = α1yt – α2it α1 MtD =pt+ α1yt – α2it α1 y = In(real national income) i = interest rate α1 is the income elasticity of the demand for money α2 is the interest rate semi elasticity of the demand for money Thus: MDt –pt =α1yt –α2it α1, α2 is less than 0 MtD-pt=α1yt – α2it Thus, if the national income goes up, there is more demand for an individual to hold money in ones hands as one wants to spend. Moreover, if interests go up there is more incentive to save rather than hold the money (Parvin 2009). This leads into a less to hold making an individual to hold less in the long run. If the prices go up, it costs more to purchase given goods and services making an individual more content in holding money more. This makes an individual to hold more of this money (increase in pt while the mtt also increase). Considering that money supply is in this extent exogenous with instant clearing where money market is always equilibrated: then, mtD =mts≡mt, and mtD =Mts≡mt..From the equations, mt is the equilibrium level of money in a given domestic country. When the domestic and the foreign money demand are put in terms of their equilibrium levels, then the following is observed: mt – pt = α1yt - α1yt – α2it and Mt –Pt = α1Y1- α2It. Subtracting domestic equation from the foreign, the following results: Mt –Pt -mt +pt = α1Y1- α2It - α1yt + α2it pt –Pt =mt – Mt –α1 (yt –Yt) + α2 (it – It) Thus, from the PPP assumption, it gets easy to come up with a reduced form of the flex priced monetary model: St= (mt – Mt) – α1 (yt – Yt ) +α2 (it –Ii) This model reveals a lot to us. For instance, considering an increase in the domestic supply of money, this leads to an increase in s (depreciation) thus accounting to more money in the system thus increasing the price (Cuiabano & Divino 2010). An example is say a 10% increase in the money supply that can lead to a 10% increase in prices leading to a 10% depreciation of the exchange rate as the PPP has to hold. Moreover, an increase in the domestic income often leads to an increased money demand. Money supply is fixed and the equilibrium is reestablished through a reduction in price. This reduces the money demand in the end. In addition, if the domestic interest rate increases, then there is the depreciation of the overall domestic currency. This means that increase in domestic rates reduces the demand for money to enable the reestablishment and increase of equilibrium prices. This leads to the depreciation of the exchange rate by PPP. Due to this, the current determination should depend on the expectations of the future determinants. All the currently available information on the future development of macro-economics is already factored in the exchange rate today. As a result, only new information can bring changes to the exchange rate (David, Robert, & Nicole 2009). This explains the access volatility of exchange rates relative to current fundamentals. This, in turn is consistent with the notion of information efficient markets. This can be explained through the observed relatively high supply of money in the 1970s in US. There was a long fall through the 1980s despite the exchange rate going through two cycles. More recently, money supply has risen sharply though the exchange rate is not stable. Empirical testing: it worked exceptionally well in the 1970s for certain rates of exchange but performed badly in the late 1970s except in countries with high inflation. Thus, the empirical testing of this model is represented as follows: S =β1(m –M) +β2 (y –Y) +β3 (i –I) +ᵋ From the model we expect that :β1 =1 ,β2 is more than 0, and β3 is less than 0. The assumption that prices are fully flexible is realistic. The reason is that for a given increase in the percentage of money supply, prices increase by similar percentage. Thus, there would be a depreciation of the domestic currency in a similar percentage to restore the required equilibrium. This translates to that an increase in the domestic money supply leads to an increase in depreciation increasing the system’s prices, but is only applicable when the PPP holds. As a result, it translates to that an increased domestic income increases the demand for money. As a result it leads to the money supply becoming fixed and the equilibrium reestablished through a reduction in prices. This then reduces the demand for money to reach an equilibrium and the cycle continues. Moreover, if the domestic rate of interests increases, there is the depreciation of the domestic currency. Thus, the flexibility of prices would decline and reduce significantly only if all factors affecting the foreign exchange movements remain constant. This is very unlikely thus there will always be a cycle explaining this flexibility of foreign exchange movements. If this model is tested empirically, there is the observation of the short run failures of the purchasing power parity of this model. Considering that this models assumes that there are analogous goods for markets. This indicate that there are no barriers segmenting this markets of goods but also the domestic and the foreign goods are perfect substitutes in the demand functions of the consumers. This translates to that there is only one single good in the whole world. This assumption implies that the level of domestic price is equal to the foreign price level multiplied by the exchange rate. As a result, empirical testing leads to long failures of the short run in the PPP. However, this assumption can be useful in certain contexts including hyperinflation contexts. Thus, this model can only perform well when tested empirically only when the current determination depends on the expectations of the underlying determinants of the future. This is considering that co-efficient are not equal across the globe. However, with the crucial help of some data from the early 1920s, the coefficient on the differential money is insignificantly different from 1, coefficient on the interest differential significantly positive R2= .99, .92 AND .86. In conclusion in the flexible price monetary model, the coefficient of the given relative supply of money is positive thus equal to one based on the neutrality of this money. The rationale undertaken indicates that for a percentage increase given in the money supply, prices are likely to increase by a similar percentage. Moreover, if the PPP is held continuous, the domestic currency would depreciate by the same amount restoring the equilibrium (Taylor & Taylor 2005). Thus, the flexible price model of exchange rate determination simply put entails that money demand and supply set the equilibrium rate of exchange and the PPP holds. Bibliography Copeland, L. S. 2008. Exchange rates and international finance. Harlow, England: Prentice Hall. Cuiabano, S. M., & Divino, J. A. 2010. Exchange rate determination . New York: International Atlantic Economic Society. David, M., Robert, R., & Nicole, S. 2009. A classroom experiment on exchange rate determination with purchasing power parity. Journal of Economic Education , 150-165. Evans, M. D. 2011. Exchange-Rate Dynamics. Princeton: Princeton University Press. Ghatak, S., & Sánchez-Fung, J. R. 2007. Monetary economics in developing countries. Basingstoke: Palgrave Macmillan. Madura, J. 2012. International Financial Management. New York: Cengage Learning. Parvin, R. M. 2009. Interest differentials and international stock return differentials as empirical determinants of exchange rate movements. Ohio: Ohio State University. Taylor, A. M. & M. P. Taylor. 2005. The purchasing power parity debate. Journal of Economic Perspectives 18 (Fall): 135-58. Read More