International Finance - The Flexible Price Financial Technique - Assignment Example

INTERNATIONAL FINANCE Table of Contents Table of Contents 2 Introduction 3 The Flexible PriceFinancial Technique 3 Empirical Evidence of the Flexible Price Monetary Model 6 Conclusion 7 References 8 Introduction Financial techniques have for a long time provided insights on the functionality of exchange rate (Wilson 2009, p. 83). Thus, financial techniques have greatly prevailed in regard to providing a thorough understanding of rates of exchange function. According to Civcir (n.d., p. 2), the monetary model of determining the exchange rate suggest a substantial nexus between a set of monetary fundamentals and the nominal exchange rate. This model implies that a countrys price level is determined by its supply as well as demand for money. In addition, the price levels in different economies are expected to be similar if expressed in the same currency. Civcir (n.d., p. 2), further states that this implication makes monetary model an attractive theoretical tool for comprehending the fluctuations in exchange rates over time. In addition, it offers a long-term benchmark for the nominal exchange rates between any two currencies, serving as a clear criterion for establishing whether a currency has been significantly undervalued or overvalued (Economy Watch 2010; Shylajan et al. 2011, p. 92). The Flexible Price Financial Technique According to Civcir (n.d., p. 4) and Shylajan et al. (2011, p. 92), the Flexible Price Monetary Model is used by class1mists to justify their argument that prices are flexible. Thus, markets have the capability of adjusting quickly and efficiently to the equilibrium. According to Amos WEB LLC (2015), this assumption does not however imply that each market in an economy is in equilibrium always as it faces imbalance in terms of surpluses or shortages but which are short-lived. The market forces of demand and supply aid in automatically accomplishing the adjustment to the equilibrium without the need for government intervention. Improvements were made in the flexible price approach by Frenkel in 1976, whereby he incorporated the concepts of the financial technique illustrated by equation (1) in this approach; e = (m –m*) b(y –y*) + c(π – π*) (1) The Flexible Price Monetary Model differs from the Mundell-Fleming model as it is based on the assumptions that prices are flexible (Wang 2009, p. 167; Siddaiah 2010, p. 117). In this regard, it is justifiable to argue that it is the ability of prices to adjust instantly to the prevailing market trends that make them flexible. From Wilson (2009, p. 86)’s research analysis, the crucial assumptions used by economists in the financial markets include; domestic capital and foreign capital can be used as alternative of one another, and the Fisher equation, n (i = r + π), is applicable and the same in all countries. From this equation, the r denotes the real interest rate while π indicates the expected inflation rate (Wilson 2009, p. 86). According to Civcir (n.d., p. 4), there is the assumption that the purchasing power parity holds continuously under this monetary approach. The purchasing power parity theory posits that, when expressed in a single currency, national price levels should be equal implying that nominal exchange rates between the two currencies is equal to the aggregate price levels ratio between the two countries. The purchasing power parity theorys concept is grounded on the law of one price whose proposition is that identical goods in different markets should cost the same price in absence of official trade barriers and transaction costs when expressed in the same currency (James 2012). The theory suggests that people in one country should purchase goods and services at the same price that persons in another country buy similar products and services. Realism of the assumption that prices are fully flexible The contemporary world has become a small village due to the aspect of globalization, which has roots from the robust technology. Thus, access to any part of the world including the market sectors has become possible. The international market has become so competitive such that customers are presented with a broad gamut of goods at their best prices (Machiraju 2007, p. 79), hence integrating countries economically. As such, prices are equal when expressed in the same currency and at market exchange rates. The international goods arbitrage has made purchasing power parity theory to apply. Absolute purchasing power parity model can be given by equation (2); PBt,t = StPAt,t. (2) For a product (i) traded in America (A) and Britain (B). then (i) = PAt,t denotes the price in US dollars of product (i) in America at time t and PBt,t is the price in Canadian dollar in Britain at the same time, while St denotes the nominal exchange rate. Relative purchasing power parity is used to factor in the price level changes and is given by equation (3); [(St+1 PAt,t+1)/(P Bt,t+1)] = [St PAt,t / P Bt,t]. (3) The purchasing power parity is applicable where the deviation is constant (Asian Development Bank Institute 2015). Price indices using the weighted average of individual commodity price are also used to establish purchasing power parity’s applicability as shown in equation (4) (Machiraju 2007, p. 80) such that; PB,t = t=1N∑ α1 PBt,t = t=1N∑ α1(St PAt,t) = St t =1N∑ α1(PAt,t) = St PA,t , (4) where αt is the weight of product (i), t=1N∑ α1 PBt,t is Britain’s price index, t=1N∑ α1(St PAt,t) is the absolute purchasing power parity for individual products, St t =1N∑ α1(PAt,t) is the typical exchange rate while St PA,t is America’s price index (Snaith 2015, pp. 6-7). When expressed in logarithmic terms, such that pA,t=In(PA,t), st =In (St), and so on, absolute purchasing power parity becomes; st = pB,t - pA,t (5) Relative purchasing power parity is given when the time difference is factored in as shown in equation (6); (st+1-st)= (pB,t +1- pB,t ) – ( pA,t +1- pA,t ) (6) As such, it denotes an empirical short-term relationship between exchange rates and price indices (Machiraju 2007, p. 80). The bilateral effective exchange rate is illustrated in equation (7) qt= st - (pB,t – pA,t) (7) qt denotes the difference between price indices and nominal effective exchange rates between America and Britain. The real exchange rate is used to establish the deviation from purchasing power parity. Empirical Evidence of the Flexible Price Monetary Model Testing this model can be achieved by referring to the purchasing power parity theory that is presented by equation (8) below St =pt –pt* + c (8) Whereby, s is the exchange rate logarithm expressed in domestic currency per the foreign currency; c is a constant, and p and p*denote the domestic and foreign price levels respectively. As such, whenever, c is zero, then the absolute version of the purchasing power parity theory holds but when c is not equal to zero, the relative purchasing power parity theory holds (Siddaiah 2010, pp. 117-118). The assumption of stable money demand in domestic and foreign countries is made. Civcir (n.d., p. 5) states that, the money market equilibrium for both the home and foreign countries are taken to depend on the logarithm of price level, p, and the real income (y)s logarithm and the nominal interest rate2. An identical relationship is also assumed for the foreign country where its variables are denoted by asterisks in the equations (9) and (10). Mt=pt +β2yt- β3it (9) Mt*=pt* +β2*yt*- β3*it* (10) Where the home and foreign money supply are denoted by Mt and Mt* respectively, β2 denotes income elasticity of demand for money while β3 represents the interest rate semi-elasticity (Frenkel & Goldstein 1996, p. 357). When equations (9) and (10) are rearranged for home and foreign price levels and then substituting into equation (8), a flexible price monetary model of the exchange rate as given by Frankel (1978) is established as follows: st= β1(mt-mt*)- β2(yt - yt*) + β3(it - it*) + c+Ԑt (11) βs represents the parameters; c is an arbitrary constant while Ԑt is a disturbance term. Under equation (11), the equilibrium exchange rate is assumed to be driven by relative excess money supplies. Given that the nominal interest rate has the expected inflation rate and the real interest rate, then, it = rt + πte (12) it* = rt* + πte* (13) Where rt and rt* are the home and foreign real interest rates while πte and πte * are the anticipated inflation rates for domestic and foreign country respectively. Further assumption is made that the real interest rates for the two countries are equal to give it - it* = πte - πte* (14) Substituting equation (v14) in equation (11), the following equation is established: st= β1(mt-mt*)- β2(yt - yt*) + β3(πte - πte*)+ c+Ԑt (15) Finally, equation (15) gives the Flexible Price Monetary Model. The relative money supplys coefficient is positive and equal to one, based on the neutrality of money such that for a given percentage change in the supply of money, prices will change by the same proportion (Civcir n.d., p. 6). Conclusion The financial approaches have been adopted and used to determine the exchange rates due to the significant interconnection between economic fundamentals and nominal exchange rates. One of these models, precisely the flexible price financial technique has been analysed in this paper. From examining this approach, it turns out explicitly that it operates behind the rationale that easy adjustability of prices to the money market behaviours makes them flexible. In this regard, this paper managed to establish the viability of this approach with a supporting and concluding argument that this technique employs the provisions of purchasing power parity theory, making it applicable to the determination of exchange rates on the money market. References AmosWEB LLC, 2000-2015. Assumptions, Classical Economics, AmosWEB Encyclonomic WEB*pedia. 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