Flexible Price Monetary Model of Exchange Rate Determination - Essay Example

INTERNATIONAL FINANCE Flexible Price Monetary Model of Exchange Rate Determination Exchange rate refers to the price of one currency expressed in terms of another currency. There are several different models for determining exchange rates. The monetary models of exchange rate determination assert that exchange rates are the relative prices of assets, determined in organized markets where prices can adjust instantaneously. The monetary model assumes a situation of perfect capital mobility. Another mechanism of determination of exchange rates is known as ‘flow approach’. Inflow approach, shifts in monetary policies alter the flow of trade through changes in terms of trade or relationship between domestic absorption and output. In recent years, there has been a voluminous expansion of ‘’asset-market’’ view of exchange rates (Adolfson, 2014, p. 35). Its popularity lies in the realism of its distinguishing theoretical assumption and its distinguishing empirical implication. The exchange rate must adjust instantly to equilibrate the international demand for stocks of national assets instead of adjusting to equilibrate the international demand for flows of national goods as if it was in the traditional view. That is the theoretical assumption. The empirical implication is that floating exchange rates will display high variability. The paper tries to scrutinize the flexible price monetary model as a model of determining exchange rates and the results of empirical tests and studies done on it. Development The flexible price monetary model of exchange rate determination has been developed by Frenkel, Mussa, Girton and Roper(1977), Hodrick(1978) and Bilson (1980).Since it is an example of a monetary approach, the assumption is that there no barriers (such as transaction costs or capital controls) that might segment international capital markets. The domestic and foreign bonds are also perfect substitutes in investor demand functions (Gertler, 2014, p. 25). Thus, there is only one bond in the world. In the flexible price monetary model sub-branch of the monetary approach, there is also an assumption of goods markets. That is, apart from there being no barriers that segment international goods markets, domestic and foreign goods are also perfect substitutes in consumer demand functions. In essence, only one good exists in the world. This specific assumption implies Purchasing power parity (PPP) that is the domestic price level is equal to the foreign price level multiplies by the exchange rates. According to this exchange rate, the relative price of the currency is determined by the supply and demand for money. Purchasing Power Parity holds if s’=sP*/P=1 where: P- Domestic price level P*- Foreign Price Level S - Nominal exchange rate S’- real exchange rate Hence sP*/P = 1 meaning s = P/P* (Log form s = p – p* where S: natural logarithm of nominal exchange rate p* stands for natural log of foreign price level p - stands for the natural log of domestic price level s = p – p*(equation 1) The assumption is that there exists a stable money demand function in both foreign and domestic countries. The model assumes that money market equilibrium conditions depend on the logarithm of the price level, logarithm of real income and logarithm of interest rate, I. To get the monetary equilibria in the domestic and foreign country, the following equation comes into use M=p+a2y-a3i (equation 2) M*=p8+a2y8-a3i*(equation 3) M and m* are the domestic and foreign money supply respectively; a3 is the interest Rate semi-elasticity, a2 is the income elasticity of demand for money. Rearranging equations 2 and 3 and substituting into equation one yields the flexible price monetary model of exchange rate equation of Hedrick (1978), Frankel (1978) and Bilson (1978) S=m-a2y +a3i-(m*-a2y*+a3i*) S=a1(m-m*)-a2(y-y*)+a3(i-i*) The equation can be used to explain the ability of flexible price monetary model to help determine exchange rates. There exists a positive coefficient of the relative money supply which is equal to one based on the neutrality of money (Barsky, Justiniano & Melosi, 2014, p. 39). The rationale is that, for a given increase in the supply of domestic money, prices will increase by the same percentage. Assuming that the purchasing power parity holds continuously, there would be a depreciation of the domestic currency by the same proportional amount in order to restore balance/equilibrium. A rise in domestic income or a drop in expected financial rate raises the demand for domestic money and hence causes an appreciation. The negative coefficient prediction for relative income is contrary to what the Mundell-Flemming approach predicts. In the Mundell-Flemming model, a higher real income increases imports. In the flexible monetary policy, a rise in the domestic real income creates an excess demand for the domestic currency. Consequently, agents will decrease their expenditures in order to increase their real money balances leading to a fall in money prices. Then because of purchasing power parity, an appreciation of the domestic currency will ensure that there is restoration of equilibrium. Assuming that the system is stable, and the expectations are rationale, then the expected inflation rate is equal to the rationally expected rate of growth in money. The level of exchange rate perfectly correlates with the level of relative money supply. However in the world of today, one cannot ignore the existence of secular inflation and its effect on the demand f of the flexible or money. The Level of Reality in Assuming that Prices are Flexible However, it is not realistic to consider prices flexible. Some prices can be flexible and others rigid. Though the simplicity of the flexible-price monetary is attractive, it requires too many assumptions. An open large-scale economy requires about six aggregate components: labour, money, foreign exchange, domestic bonds and foreign bonds (Abbasi, & Safdar, 2014, p. 28). However, the monetary model concentrates directly on equilibrium conditions in only one of these markets, the money market. The model achieves this by assuming perfect substitutability of domestic and foreign assets, that is, the domestic and foreign markets become a single market thereby reducing the total number of markets to five. There is free adjustment of exchange rates to equilibrate supply and demand in the foreign exchange market. Likewise perfectly flexible prices and wages equilibrate supply and demand in the goods and labour markets. This clears three of the remaining five markets. The flexible-price monetary model is market-clearing model and hence assumes a continuous PPP among national price levels that are unrealistic (Turnovsky, 1981, p. 160). Empirical Tests Empirical studies tend to support the implications of the monetary approach instead of those of the traditional flow approach. Most economists have moved away from the application of flexible price model system to determine the exchange rates due to the empirical evidence available. They have moved on to models featuring wage and price rigidities. In the flexible price monetary model, matching the short-run dynamics in the actual data available with a defensible theoretical model is challenging. Overcoming these challenges requires assumptions that are highly unpalatable the flexible monetary model does not do a good work in prediction or forecasting. One of the reasons is that the three of the building blocks of the model, money demand equations, purchasing power parity and uncovered interest parity do not work very well. Results show that money demand equations are unstable especially in The United States. This begs the question as to why PPP and UIP perform so poorly (Levine, Pearlman, & Yang, 2014, p. 35). Also, why are the floating exchange rates volatile and in no relation to prices and interest differentials? The reason may perhaps because some volatile expectations of this model depart from rationality and because its failure. Frankel argues that the flexible price monetary model of exchange rate determination detach from fundamentals by swings in expectations concerning future projected values of the exchange rate (Benes, Berg, Portillo and Vavra, 2015, p. 100). Evidence exists to suggest that expectations are the root causes of their behaviour when subjected to the empirical tests. Firstly, survey measures of exchange rate expectations make very poor forecasters, and the forecasters are not internally consistent. Secondly, some of the expectations are very irrational which mostly contributes to the failure of UIP. Thirdly, trade rules that follow trends seem to make risk-adjusted excess returns that are a violation of the efficient market hypothesis. Finally, the change from a fixed exchange rate to a floating rate (which change the way expectations are formed) alters the behaviour of real and nominal exchange rates. It also alters the ability of UIP to explain exchange rate changes (Black, 2015, p. 45). There is the general failure of the flexible price monetary model to explain movements in the exchange rates of major currencies for example during the post-1973 floating rate period. Virtually all such tests of specific models revealed substantial problems to do with parameter estimates. Also, studies of the post sample predictive ability of these models have been uniformly negative. Bilson (1979) who developed one of the original monetary models of the exchange rate suggests that the PPP condition is not applicable in the short run. He also adds that nominal interests are not as exogenous as previously thought. Another empirical evidence suggests that important variables were left out of the model. Most of the variation (in excess of 50%) in the unexpected rate of change of the spot exchange rates of major European currencies was due to ‘news’(unanticipated events e.g. oil shocks).Some statistics, however, have expressed positive results in the flexible price monetary model of exchange rate adjustments. Miyakoshi (2000) using this model, found one co-integrating vector proving the long-run validity of the monetary model (Uribe, 2014, p. 66). Overall, the flexible price monetary approach continues to be one of the important tools used to explain the variation in exchange rates. In the early 1980s, shortly after its formulation, there was no research to prove its validity. However, improved statistical tools in the 21st century combined with a more specific approach established the long-term validity of this model to exchange rate determination. However, the empirical evidence of the model is open to debate and more scrutinization (Catão and Chang, 2015, p. 52). The money-demand functions and supply mechanisms that are specific to this model are too simplified to be stable in practise. In addition, the expectation mechanisms do not appear to be well founded just like other exchange rate determination models. Some of the empirical problems associated with the flexible price monetary model may be solvable by more careful specification of the empirical relationships. The problem with PPP lies in the fact that shifts in relative goods prices may be important and deserve an explanation if there is to exist a complete theory of exchange rate adjustments (Saez and Michaillat, 2014, p. 100). However, there exists a need for more research before people can even have a fragmentary understanding of exchange rate determination. References Abbasi, M. J. and Safdar, S., 2014. What Determines the Behavior of Exchange Rate in Pakistan: Monetary Model Analysis? IOSR Journal of Humanities and Social Science, 19(2), 27-35. Adolfson, M., Laséen, S., Lindé, J. and Svensson, L. E., 2014. Monetary policy trade-offs in an estimated open-economy DSGE model. Journal of Economic Dynamics and Control, 42, 33-49. Barsky, R., Justiniano, A. and Melosi, L., 2014. The natural rate of interest and its usefulness for monetary policy. The American Economic Review, 104(5), 37-43. Benes, J., Berg, A., Portillo, R. A. and Vavra, D. (2015). Modeling sterilized interventions and balance sheet effects of monetary policy in a New-Keynesian framework. Open Economies Review, 26(1), 81-108. Black, S. W., 2015. The Portfolio Theory of Exchange Rates—Then and Now. Review of International Economics. Catão, L. A. and Chang, R., 2015. World food prices and monetary policy. Journal of Monetary Economics. Chun, X. X. and Morley, J., 2014. Responses to Commodity Price Shocks, and the Contributions of Monetary Policy and the Flexible Exchange Rate, in an Australian Sectoral SVAR model. Gertler, M., 2014. Comment on" Effective Monetary Policy Strategies in New-Keynesian Models: A Re-Examination". In NBER Macroeconomics Annual 2014, Volume 29. University of Chicago Press. Levine, P., Pearlman, J. and Yang, B., 2014. The Science and Art of DSGE Modelling: A Dynare-Based Course on Model Construction, Calibration, Estimation and Policy Analysis. Saez, E. and Michaillat, P., 2014. An Economical Business-Cycle Model. In2014 Meeting Papers (No. 105). Society for Economic Dynamics. Turnovsky, S. J. (1981). Money Policy and Foreign Price Disturbances Under Flexible Exchange Rates. Journal of Money, Credit & Banking (Ohio State University Press), 13(2), 156-176. Uribe, M., 2014. The New Keynesian Model and Excess Inflation Volatility. Read More