The Flexible Price Monetary Model of Exchange Rate Determination - Essay Example

The Flexible Price Monetary Model of Exchange Rate Determination According to Block & Hirt (2008), exchange rate refers to the price at which one unit of the currency of a country is bought in terms of the currency of another country. Exchange rates will continue changing constantly in response to various economic events and the expectations from the market in general. The forces of demand and supply bring about depreciation and appreciation of a currency. Depreciation of domestic currency refers to decline in exchange rate brought about by the forces of the market in the price of domestic currency in terms of a foreign currency (Brigham and Houston, 2009). On the other hand, appreciation of the domestic currency refers to increase in exchange rate brought about by forces of the market in the price of domestic currency in terms of a foreign currency. The need for foreign country’s currency in order to buy goods denominated in a foreign currency is reflected by demand for the foreign currency. In most cases, the selling country denominates its goods and services in terms of domestic currency hence importers from other countries will feel the need for the foreign currency in order to conduct the financial transaction. Foreign currency is supplied into the country when foreign currency is sold in order to carry out financial transactions that are denominated in home currency. It is the demand for and supply of a currency which yields an equilibrium position in the foreign exchange market. The equilibrium point being the point where there is an intersection between the upward sloping supply curve and the downward sloping demand curve (Koller, Goedhart and Wessels, 2010). A low value of foreign currency makes the demand for foreign currency on the foreign exchange market to increase whereas the demand for foreign goods increase due to its relatively cheaper price than domestic goods. On the other hand, a high value of foreign currency makes the demand for foreign currency on the foreign exchange market to decrease whereas the demand for foreign goods increase due to its relatively higher price than domestic goods (Needles, Powers and Crosson, 2010). Therefore, the question that arises is the cause of exchange rate revaluation and whether the depreciation or appreciation of an exchange rate can be predicted. This paper will rightly answer this questions by using a thorough discussion on the determination of exchange rate using the flexible price monetary model. The discussion will further explore the ability or inability of the model to explain the observed movements in foreign exchange. In addition, the discussion will include the reality of the price flexibility assumption and the performance of the model when tested empirically. There are very many factors that cause changes in exchange rates as outlined below: Differences in inflation rate between countries Differences in interest rate between countries Differences in income between countries Government policy changes Changes in foreign exchange rate expectations As noted in Kothari and Barone (2006), the basic premise about exchange rate is that rise in demand results in currency appreciation while increase in supply will lead to currency depreciation. Higher interest rates usually lead to an increased demand by investors whereas lower interest rates lead to decreased demand by investors. When the rates of inflation is high in the home country, the demand for domestic currency will decrease and the residents of the country will sell of local currency in order to buy cheaper goods from other countries where there is low inflation (Lewis and Pendrill, 2004). When the exchange rate of a country changes, it affects the prices of goods and services which are imported and exported by that country. The transaction prices are also affected by the existing differences in rates of inflation between the trading countries in addition to the exchange rate. The flexible price monetary model uses the asset approach to determine the exchange rate. In its simplistic explanation the equilibrium exchange rate is set by the demand and supply of money when the purchasing power parity holds. There are various assumptions which are taken to hold under the flexible price monetary model as will be discussed here below: All prices including wages are assumed to be fully flexible and the equilibrium position is restored through changes in prices. It is also presumed that economic agents are rational and will react rationally when any of the elements of the model change. Exchange rate is regarded as a means of holding wealth, that is, viewed as an asset price. Both domestic and foreign goods are assumed to be a perfect substitute of each other The purchasing power parity (PPP) is assumed to hold continuously. According to McCrary (2010), the theory of purchasing power parity asserts that in the long term exchange rates change according to price changes in between countries hence St = Pt – Pt* where St is the spot rate of exchange and Pt and Pt* are unit price of the product in domestic country and unit price of the product in foreign country respectively. Simply putting the theory of PPP is based on the law of one price which states that homogenous products sell for similar price in two different markets or countries when the prices are stated in terms of a common currency like the Dollar. The model also assume perfect mobility of capital It is also assumed that money supply is exogenous to the model and when it occurs it clears instantly. The general equation for flexible price monetary model is stated as below: St = (Mt - Mt*) – α1(yt - yt*) + α2(it - it*); where; it and it* respectively represent rate of domestic inflation and rate of foreign inflation. Mt and Mt* respectively represent supply of domestic money and supply of foreign money. Yt and Yt* respectively represent domestic level of income and income level of foreign country. The coefficients α 2 < 0, α 2 > 0, the money supply differential coefficient is 1. When domestic money supply (Mt) increases, it leads to depreciation of exchange rate. This is because the price increases when there is more money in system. For example, a 15% increase in money supply results to a corresponding 15% in prices which leads to a corresponding depreciation of exchange rate at 10% since the model assumes PPP to hold continuously. When there is an increase in domestic income, the demand for money increases and since the model assumes money supply to be exogenous, the money supply will remain fixed. In order to equate money demand and money supplied, the price will reduce thus re-establishing the equilibrium position (Pratt, 2010). Increase in the domestic rate of interest causes the domestic currency to depreciate. This is because the increase in domestic rate of interest reduces money demand which is counteracted by an increase in price in order to re-establish the equilibrium position hence the exchange rate will change because of the purchasing power parity (Merchant and Van der Stede, 2012). However, the flexible price monetary model does not fully explain movements in foreign exchange. This is because early research shows that exchange rate has high volatility compared to income and money stock. This means it does not support the expected flexible price monetary model relationship. Therefore, there must be another factor which accounts for the high volatility in exchange rate beside income and money stock that has not been accounted for in the model. Moreover, you will notice that in recent economic events money supply has been in a sharp increase in some countries but the exchange rate has always been stable. Empirical Testing of The Model The model is considered a multiple regression with three independent variables identified as money stock, M, income, Y and interest rate, i. St = β1(Mt - Mt*) – β2(yt - yt*) + β3(it - it*) According to the flexible price monetary model, we anticipate that β1 = 1, β2 < 0, β3 > 0 the empirical testing by Hodrick in 1978 showed that the coefficients in the model do not hold in all countries. He found that β3 which is in respect to interest rate was not correctly signed and that all independent variables were significant but for foreign income at the 95% significance level (Hodrick, 1978). This revelation can only be used to mean that foreign income is not a major determinant of the foreign exchange rate hence its inclusion in the flexible price monetary model is incorrect which can only mean that the model is not suitable for determining the movements in exchange rate. In 1976 Frenkel used data for the 1920s which showed favourable results in support of the model. He established that money differential coefficient was different from one though the difference was insignificant. The multiple coefficient of determination on interest differential was positive 99% which is significant. However, there was huge variation when the same test was applied on data in the 1970s (except that countries with high inflation rates were excluded from the test). In conclusion, under the flexible price monetary model, there is an assumption that PPP hold continuously hence the changes in exchange rate is induced by the price changes. Therefore, the model cannot be used to explain prolonged departures for the purchasing power parity. Reference List Block, S. B., Hirt, G. A. (2008). Foundations of financial management (12th ed.). Boston, MA: McGraw-Hill/Irwin. Brigham, E. F., Houston, J. F..(2009). Fundamentals of Financial Management. New York: Cengage Learning. Hodrick, R. J. (1978). “An Empirical Analysis of the Monetary Approach to Determination of the Exchange rate”, in Frankel, J.A. and Harry G. Johnson (eds), The Economics of Exchange Rates, Addison-Wesley. Koller, Goedhart., Wessels. (2010). Valuation: Measuring and Managing the Value of Companies. (5th Edition) Wiley Kothari, J., Barone, E. (2006). Financial Accounting – an International Approach. Harlow, England: FT Prentice Hall. Lewis, R., Pendrill, D. (2004). Advanced Financial Accounting (7th Ed.). Harlow, England: FT Prentice Hall. McCrary, S. A. (2010). Mastering Corporate Finance Essentials: The Critical Quantitative Methods and Tools in Finance. New York: John Wiley & Sons, Inc. Merchant, K. A., Van der Stede, W. A. 2012. Management Control Systems: Performance Measurement, Evaluation and Incentives. Upper Saddle River, New Jersey: Prentice Hall. Needles, B.E., Powers, M. and Crosson, S.V., 2010. Financial and Managerial Accounting. New York: Cengage Learning. Pratt, J., (2010). Financial Accounting in an Economic Context. New York: John Wiley and Sons. Read More