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International Finance - Essay Example

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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,…
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International Finance
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"International Finance"

Download file to see previous pages 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.
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 ...Download file to see next pagesRead More
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