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Discuss the flexible price monetary model of exchange rate determination and its ability to explain foreign exchange movements. How realistic is the assumption that prices are fully flexible Does this model perform well when tested empirically - Essay Example

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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…
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Discuss the flexible price monetary model of exchange rate determination and its ability to explain foreign exchange movements. How realistic is the assumption that prices are fully flexible Does this model perform well when tested empirically
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Extract of sample "Discuss the flexible price monetary model of exchange rate determination and its ability to explain foreign exchange movements. How realistic is the assumption that prices are fully flexible Does this model perform well when tested empirically"

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