International finance - Essay Example

It is suggested that an increase in domestic money supply causes depreciation. Again an increase in domestic money demand for example results from domestic income increase or decrease in the expected inflation causes appreciation (Barnett & Chauvet, 2011). The model assumes that the purchasing power parity usually holds. The changes in price influence the changes in exchange rates. The flexible model assumes that parity of purchasing power (PPP) holds continuously. PPP implies that only traded goods exist, the modified model permits the distinction between non-traded and traded goods.

The flexible model relies on the continuous PPP and existence of the stable money demand functions for both domestic as well as foreign economies. Recent experience has shown that the real rates of exchange have fluctuated over the years therefore causing shifts in the international competitiveness (Barnett & Chauvet, 2011). Flexible model can be termed as a market- clearing equilibrium model where purchasing power parity between different countries’ price levels is assumed. An increase in the domestic interest will cause a decrease in the demand for domestic money hence causing depreciation in the currency.

Once Friedman (1953) stated that the stability of flexible exchange rate was determined by the stabilization of the speculators’ behaviors. Flexible model suggests that the prices including wages and goods prices, adjust instantaneously to their levels of equilibrium. In order to determine the exchange rate, it is clear that a rapid increase in home money supply than the foreign money supply will increase the rates of exchange one on one therefore leading to depreciation of home currency. The exchange rate which normally is the price of foreign currency increases with the stock of money (Kouretas & Papadopoulos, 2014).

On the other hand, an