Flexible Price Monetary Model of Exchange Rate Determination - Essay Example

FLEXIBLE PRICE MONETARY MODEL OF EXCHANGE RATE DETERMINATION by In international trade, there exist two majortypes of trades. These are trade in goods and services and the trade in financial assets such as futures, hard currency, and interest rate swaps. In the era before the world embraced financial liberalization, governments of countries across the world placed very tight conditions and restrictions with regard to international trade, specifically, the inflows and outflows of capital. This was predominantly so because governments then thought that flows of capital in international trade was the sole determinant of exchange rates. This model assumed that countries with positive trade balances or surpluses would have a currency that appreciates whereas countries with negative trade balances will have a currency that is depreciating. However, this assumption is incorrect as there are countries, which enjoy surpluses in trade but still have their currencies depreciating. The trade in financial instruments has also surpassed that of the traditional goods and services. This is attributed to financial liberalization. This paper will thus attempt to discuss monetary models of exchange rate determination, specifically the flexible price monetary model and its ability to explain foreign exchange movements. It will also discuss the assumption that prices of commodities are fully flexible, and finally examine the effectiveness of the flexible price monetary model when it is empirically tested. The reliance on the concept that trade flows determine exchange rates did not hold. There are models today, which governments use to determine the exchange rates of currency in their respective currencies. The International Monetary Fund (IMF), the world body that monitors and advises on the economies of member states, allows member countries to have and operate any of the three exchange-rate determination models (Marston, 2011:45). These three monetary models are; the fixed exchange rate, the intermediate exchange rate, and the flexible exchange rate. It is important, before we discuss the flexible exchange rate monetary model, to examine the other two models and their roles in exchange rate determination. In the fixed exchange rate model, the authority charged with the responsibility of managing the country’s currency exchange rate, usually the central bank, fixes the domestic currency to a foreign currency. For instance, if Switzerland operates a fixed exchange rate model, it would fix its Swiss Francs to say the dollar. Since the rate has been predetermined and fixed, any changes in demand and supply will not serve to affect the exchange rate (Goldberg, 2007:34). The central bank, or the supervising authority body, usually intervenes in the event the rate deviates from the fixed one. The intermediate exchange rate model, on the other hand, is the intermediary model between the fixed and the flexible exchange rate models. It is also referred to as the managed fixed rate model. In this monetary model of exchange rate determination, the central bank of a country will both fix its currency in a bid to devalue or revalue the county’s currency (MacDonald, 2007:12). However, it can also intervene in the market for foreign exchange to influence the price of the currency relative to other currencies. This type of model thus has characteristics of the fixed and flexible models. The flexible price monetary model of exchange rate determination is a monetary system whereby the exchange rate is determined by the supply and demand of a particular currency, usually in relation to other currencies in the world. For instance, if demand for the dollar is high, its exchange rate against another currency like the Euro increases. On the other hand, if its demand reduces, its rate decreases. The flexible exchange is a popular model that has been embraced by most world governments today. This is primarily so because any changes in the foreign currency exchange rates affects the prices of goods, services, and financial instruments. These changes, especially significant ones, can therefore easily affect a country’s economic growth and development, as well as the well-being of its systems (Gagnon, 2011:34). Under the flexible price monetary model, the forces of demand and supply are left to determine the direction and value of a currency. However, the central banks of countries operating this regime still exercise the discretion of being able to intervene in the market for foreign exchange and thus able to determine the price of their currencies relative to others. So how does the flexible price monetary model of exchange rate affect foreign exchange movements? As discussed above, a high demand for a certain currency relative to another causes an appreciation of the exchange rate. For example, in net importing countries, corporate institutions and other traders seeking to import commodities or deal in financial instruments and will visit the foreign currency market to buy dollars to facilitate their transactions. This increases the demand for dollars and consequently exerts pressure on the local currency. This generates movements in the foreign exchange market (Edwards, 2007:42). Central banks, who also participate in this kind of model, also affect foreign exchange movements. This is normally through interventions in the foreign exchange market. For instance, from the example given above, the central bank may intervene by releasing dollars from its reserves into the market to stabilize the local currency thus causing movements in both the exchange rate and foreign currency (Fernando, 2008:32). The flexibility of prices is one of the three fundamental assumptions of classical economics. The other two are Say’s law and the saving-investment model (Hutchison, 2007:35). According to the classical economists, the economy of a country operates at optimum if the three assumptions are in play. This means that the economy achieves a status of full employment, that is, the economy is able to fully utilize all resources that are available and produce an aggregate output. In the theory of classical economics, prices are assumed flexible (Smith, 2011:53). This means that prices are determined by the forces of demand and supply, and the market will eventually reach equilibrium without any government intervention. The flexible prices assumption is also applied in the labor markets. Labor markets are characterized by cases of demand and supply, like in the markets for foreign currency or commodities. In situations where labor supply exceeds labour demand at the given labor price, then the price of labor or wages will fall effectively eliminating the surplus situation (Smith, 2011:42). The labor market consequently attains equilibrium status. However, this assumption is not realistic. According to Keynesian economics, prices are rigid and not flexible as suggested by the classical economists. This is because producers and manufacturers in most cases enter into contracts and agreements with their suppliers that fix prices. In the labor market, a fall in wages will not restore equilibrium. The reason is that workers seeking employment may not accept lower wages (Tibor, 2013:52). Employers also do not adjust wages to employees, as it is usually a costly exercise (Rotheim, 2013:72). Finally, employers often downsize thus reducing the number of workers, and not the wage. The assumption of flexible prices, therefore, is not realistic. The flexible price monetary model of exchange rate determination does not perform well when tested empirically. According to Baldwin, an exchange rate model performs well empirically if when tested, volatility of the exchange rate does not occur in the short term (Baldwin, 2010:28). However, under the flexible exchange rate, foreign currencies are heavily speculated on. This means that the majority of persons demanding foreign exchange are actually those speculating and seeking short-term profit maximization and not those who demand foreign exchange for purchase of goods (Sollis, 2012:49). These speculations due to uncertainties cause volatilities in the foreign exchange market. Therefore, the model does not perform well when tested empirically. In conclusion, the concept of the monetary models of exchange rate determination is an important tool in international trade, specifically in the foreign exchange market. The flexible exchange rate is one of the models that are commonly used besides the fixed exchange and intermediate exchange rate models. In this model, the forces of demand and supply are left to determine the price one currency, relative to another. However, monetary authorities of a country such as the central bank occasionally intervene in the market under this model. This is mostly to stabilize the local currency. The assumption of flexible prices is a view that is upheld by classical economists. The assumption stipulates that demand and supply forces will act to bring equilibrium in the market. In the labor market, a fall in wages will counter any disequilibrium brought about by an increase in supply of labor. However, this assumption is not realistic according to Keynesian economics. This is because laborers will not accept lower wages and employers, on the other hand, rarely revise wages, as it is usually costly. The empirical testing of the flexible exchange rate model shows that it does not perform well. A key test of good performance of any model is its ability to reduce volatility of the exchange rate in the short term. However, the flexible price monetary model allows for speculation of foreign currency, which consequently leads to volatility of the exchange rate, therefore, this model, does not perform well when tested empirically. References Baldwin, R. 2010, Empirical studies of commercial policy. Chicago: University of Chicago Press. Edwards, S 2007, Economic adjustment and exchange rates in developing countries. Chicago: University of Chicago Press. Fernando, C 2008, Accumulating foreign reserves under floating exchange rates. New York: International Monetary Fund. Gagnon, J 2011, Flexible exchange rates for a stable world economy. Washington: Peterson Institute. Goldberg, M 2007, Imperfect knowledge economics: exchange rates and risk. California: Princeton University Press. 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