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

Finance and accounting Flexible price monetary model as d by Frenkel (1979) works with assumption that prices are all flexible. The supply curve is always vertical and a shift in demand has no effect on the output. Output level cannot be adjusted up or down because it is determined by side factors of supply. Effects on foreign exchange are determined using the monetary model (Riad 2008).the government suggests the use of monetary policy and fiscal to ensure stability of exchange rate and price.

Monetary model assumes equilibrium. The flexible model of price monetary assumes that the capital is mobile that is foreign and domestic bonds are considered perfect substitutes. In this regard there are negligible transaction costs, markets are very competitive and all investors hold expectations of exchange rate with a lot of certainty (Friedman & Woodford 2010). In the monetary model, all the prices including the wages are considered to be flexible. The economic agents are also rational. In this model capital is mobile, PPP will hold continuously and supply of money is normally exogenous.

The attention is given to the money market because there is no independent role by bonds in exchange rate determination. An increase in the domestic income will automatically lead to increase in demand for money whereas an increase in domestic interest leads to depreciation of domestic currency. The monetary assumes a stable foreign and domestic demand functions for money and excellent capital mobility (Craigwell 2009). Flexible model assumes the parity of purchasing power will always hold. The exchange rate is therefore considered to be constant.

This model assumes that an increase in the output of a given country will result in depreciation of the currency. This is because real income growth increases money demand in order to finance bigger value of all transactions. According to the flexible model, increase in domestic interest will cause a decrease in the demand for the domestic money hence causing depreciation of the currency. This means that if the increase rate is caused by tightness in monetary, it will lead to home currency appreciation or if caused by inflation the result will be depreciation of home currency.

Naturally monetary model states that exchange rate is always determined by three variables which are relative interest rate, money supply and a relative national output (Zhang 2007). An example of exchange rates is using two different countries that produce the same kind of goods. Wealth constraint for all domestic residents: W=M+V where M stands for the money stock and B represents bonds. The bonds are assumed to be perfect substitutes. Equilibrium in money market suggests equilibrium also in bond markets.

An exchange rate is a price or prices. An exchange rate between any two currencies, according to flexible model is the ratio of the currency’s value determined by money supply basis and demand positions for money of the two given countries. An increase in the rates that are prevailing in the market will lead to a rise in foreign exchange prices. In the flexible model prices are considered to be flexible because they normally adjust very fast in all money markets. In this model domestic money is only demanded by domestic people while foreign money by foreign residents only.

The exchange rate will adjust so that the level of price equilibrates supply and demand for money hence the equilibrium of money market. Demand for the money will depend positively on the income and depend negatively on nominal interest rate level. According to the parity of purchasing power, exchanged rate is a s a result of dividing home country price level with the one from foreign country. That is P=eP*, where P represents level of domestic price and P* the level of foreign price whereas e is the exchange rate (Watch 2010).

The equation of money demand is shown as Md=kPy and here k is usually constant and y represents level of real income. Flexible exchange rates always protect nations from the unexpected foreign economic changes. For example they may protect a country from high foreign inflation rates. In the flexible approach, increase in money leads to higher levels of price and hence domestic currency depreciation. When the money supply is less than the domestic output there will be a lot of demand for money balances which will result to domestic currency appreciation.

When there is interest rate rise, there will be less demand for the money and therefore the domestic currency will depreciate. Any increase in the supply of money will raise the level of domestic price. Dornbusch (1976) feels that the assumption of flexible price that PPP continuously holds and that real rate of exchange doesn’t change is very unrealistic (SHARAN 2012). In real life, the exchange rate has changed in the short run at some point in time. However nominal exchange rate variability has been greater.

Whenever there is an increase in real domestic income, the agents are likely to reduce their expenditure on services and goods so as to increase money balances (Zhang S 2005). Equilibrium will then be restored through the parity purchasing power and appreciation of domestic currency. A decline in real domestic income will cause the opposite process of equilibrium. The assumption that prices are flexible is somewhat not realistic. This is because when exchange rates are flexible they will influence a nation to determine monetary policies on their own (Marthinsen 2014).

The presence of price flexibility cannot alter any standard prescriptions for money policy in an open economy. It implies that the optimal rate of exchange rule in a price flexibility environment acts to minimize degree of flexibility of price (DOR 2012). The reason is price flexibility is expensive. In addition flexible model assumes that foreign and domestic goods are great substitutes and hence no barriers international trading of goods. For this reason assumption of flexibility of prices for the goods is tantamount to the conclusion that PPP holds all the time (Butgereit 2013) The model has been put into empirical testing.

However, the results received have greatly been disappointing. During high inflation periods the models works well because the supply of money changes tend to influence prices and exchange rates (Apte 2008). The parity of purchasing power is an important aspect in the model and as noted it doesn’t hold well empirically mostly in the short run. The model has poorly performed when tested empirically. Flexible model can also be tested in the short as well as long run. One of the tests for flexible model was done by Frenkel over the high inflation rate in Germany.

In all monetary models coefficients are said to be insignificant or that there are wrong signs. An example of the poor performance is if there could have been omitted variables while testing. Boughton (1987) also states that the variables explain a small portion of the changes in exchange rate which means that the rate movements can be responses to disturbances that are unforeseen. Rogoff and Meese used the empirical method of parameters of the exchange rate models. They used “random walk” model assuming the exchange rates are always driven by random shocks that are unpredictable, this is so that a guess about exchange rate tomorrow is only today’s rate of exchange.

They found that the exchange rate would not outperform the random walk (Nakaruma 2013). An empirical test was used in Taiwan to show the validity of PPP on Taiwan and other industrial countries. The data used was bilateral exchange rates in Taiwan relative to US, France and other countries and the price index of consumers in each of these countries. There is difficulty in choosing which index to use for PPP calculations. Therefore this leads to poor performance of the model. The monetary model has performed very poorly on sample forecasts and also on estimation.

In the flexible model the money supply coefficient is always positive and also equal to one on money neutrality. When the sample period for empirical testing was extended from 1978 onwards, the regressions produced disappointing results. The results by Frankel (1984), Dornbusch (1980) and Taylor (1992) yielded wrongly and hence the regressions produced poor performance on the samples (Cao, Ying 2011). It is therefore easier to conclude that the flexible model does not perform well when it is tested empirically.

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