The Flexible Price Monetary Model - Literature review Example

THE FLEXIBLE PRICE MONETARY MODEL By and Monetary models for determining the rate of exchange are based on the assumption that capital is perfectly mobile. The models use the theorems of Purchase Power Parity (PPP) and the Interest Rate Parity in defining the equilibrium conditions (Koller, Goedhart and Wessels, 2010). The models also assume that both domestic and foreign bonds are perfect substitute of each other. This paper will focus on the flexible price monetary model for determining the exchange rate. Under this monetary model, it is assumed that the logarithm of money demand is dependent on logarithms of real income, Y, price level, p and the nominal interest rate level, r. It can further be assumed that there exist an identical money demand from foreign country, whose variables will be denoted by asterisks in this paper. This is shown by the monetary equilibrium equations below for both the domestic and the foreign country. Mt = Pt + φyt – λrt …………………i) Mt* = Pt* + φyt* - λrt* …………..ii) Where domestic supply of money and foreign supply of money are respectively represented by Mt and Mt*. In addition, PPP is assumed to hold continuously which is expressed as St = Pt – Pt* ( S is log of rate of exchange which in this case is defined as the number of domestic currency units for each unit of foreign currency). According to this model, the uncovered interest parity is ensured that it holds by the assumption of perfect substitution of domestic and foreign bonds. Hence, ESt = rt - rt* (ESt is the anticipated depreciation rate of domestic currency). Equations i) and ii) above are substituted into this equation in addition to incorporating the two components of the nominal interest rate (expected rate of inflation and the real rate of interest) to arrive at the reduced form of flexible price monetary model equation which is stated below: St = (Mt - Mt*) - φ(yt - yt*) + λ(Πte - Πte*) Πte and Πte* respectively represent anticipated rate of domestic inflation and anticipated rate of foreign inflation. Because of money neutrality, there is a positive one coefficient of the relative money supply in the first part of the right hand side of the equation. This is based on the rationale that prices will rise by the same percentage as rise in the supply of money (Lewis & Pendrill, 2004). Therefore, in order to regain the equilibrium condition, the domestic currency will depreciate by the same amount since the PPP is assumed to hold continuously. Note that unlike in the Mundell-Fleming approach, flexible price monetary model has a negative coefficient for relative income as can be seen in the second part of the equation on the right hand side. This is because in the FLPM model an increase in the real income (domestic) results to an increase in demand for domestic currency. This process will trigger other reactions whereby households will reduce their expenditures in order to cause an increase in their real money balances. Kothari, J. & Barone (2006) observed that this causes a price decline. The PPP assumption will come into play leading to home currency appreciation which ensures that the equilibrium condition is regained. Moreover, when anticipated long run inflation rate increases, it results to agents switching to bonds from domestic currency (for both foreign and domestic). This move leads to a fall in demand for domestic currency, causing domestic currency depreciation hence an increase in St and which explains why the relative anticipated inflation rate coefficient is positive. According to Brigham and Houston (2009), movement in foreign exchange is a complex process determined by several factors which cannot be summarized in a simple model like flexible price monetary model. Generally, there are two exchange rate regimes that dictates the movement in foreign exchange rate: the floating exchange rate regime and the fixed exchange rate regime. Under the flexible exchange rate system, currency exchange rates are determined purely by the forces of the market of demand and supply. Demand for a foreign currency is increased by demand for imports since the residents of a country will have to pay using the foreign currency (Needles, Powers and Crosson, 2010). On the other hand, supply of a foreign currency is increased by demand for exports from the country by foreigners since foreigners will have to pay using the home currency of the exporting country. This creates a money market where currencies are traded based on the demand and supply of the respective currency. In this case, it is assumed there is no or just minimal government intervention to facilitate trade. The FLPM model cannot adequately explain what causes the rise in demand of a certain currency and supply of another country. It has not precisely identified demand and supply of goods and services as the prime factor influencing demand and supply of a certain currency, hence setting the process of determining the movement in foreign exchange rate. The other exchange rate regime is the fixed exchange rate regime in which the central bank of a country puts measures in place to ensure that the exchange rate of its currency is put in control. Under this case, the regime does not respect the forces of the market and in its place decides the exchange rate to prevail and then sets in place to maintain that rate. When such an exchange rate regime is in practice in a particular country the FLPM model will be inadequate to explain the movement in foreign exchange. The assumption that prices are fully flexible in flexible price monetary model is guided by the theory of purchasing power parity, PPP. Pratt (2010) notes that the PPP theory of determining exchange rate states that the rate of exchange between 2 currencies is determined by the change in the level of price in the two countries. Therefore, the PPP theory sees the price levels as the sole determinant of exchange rate. This assumption is not realistic for various reasons that will be discussed hereunder. Practically, a country will impose restrictions on trade and capital movements or transfer pricing. This has the effect of disrupting the existing relationship between foreign and home price levels (Merchant & Van der Stede, 2012). When there is trade restriction on goods from country A, the goods from country A will be relatively expensive to residents in country B because of prohibitive tax systems that is put in place to deter its citizens from importing from country A. this means that the price of the same good will not be the same in the two countries when measured using a common currency. In addition, a company that has subsidiaries operating in a foreign country will generally exchange products between the different branches at a transfer price. Based on the policy of the company in relation to transfer pricing, the same product from the same group of companies will cost different in the different countries which strengthens the argument that the assumption that prices are fully flexible under the FLPM model is unrealistic. Another argument for unrealistic assumption of fully flexible price is the speculative activities and government intervention which creates PPP disparity between any two countries. Investors in the producing countries may anticipate future rise in prices for the product and decide to produce at such a future date. Therefore, they will avoid exporting at the low price in anticipation of a higher export price later (Block & Hirt, 2008). Therefore, the product becomes scarce in the importing country and due to forces of supply and demand in the importing country; the product will sell at a relatively higher price compared to the producing country. The prices in the two countries will not respond to similar economic factors which mean that the price will not be fully flexible. Sometimes the national government of a country feels the need to provide a basic commodity to its citizens. Measures are taken to ensure that all citizens can get access and afford the commodity. Some of the measures may include subsidizing the commodity to a level that its citizens can easily afford to buy. This means that the price of the commodity between the two countries will be materially different hence the assumption of fully flexibility in price fails to hold. Productivity bias will also nullify the assumption of fully flexibility in price. According to McCrary (2010), bias in productivity arises where there is relatively slower growing productivity in non-tradable sector than in the tradable sector which causes systematic divergence of prices internally. If one country deals mainly in tradable sector goods while its counterpart deals mainly in non-tradable sector, the price levels in the two countries will show disparity. This is because of imbalance in tradable goods, the exporting country will transact its goods at a premium hence failing to meet the assumption that prices are fully flexible. In conclusion, this assumption is supported by the concept that arbitrage forces will equalize the international price of goods if they are measured using similar currency like the US dollar. Empirical evidence carried out by Frankel for data relating to years before 1978 showed immense support for FLPM model. The model has also drawn supportive empirical evidence from Bilson (1978) and Hodrick (1978). The coefficients that were estimated were in line with the expectations of the model and the regression had reasonable coefficient of multiple regression. However, the same position is not maintained when the analysis period is extended to cover data for years beyond 1978. This puts the ability of the FLPM model to explain the observed movements in exchange rate into question. The results obtained yields insignificant coefficients and the sample statistic are also poor. Reference List Block, S. B., & Hirt, G. A. 2008. Foundations of financial management (12th ed.). Boston, MA: McGraw-Hill/Irwin. Brigham, E. F., and Houston, J. F., 2009. Fundamentals of Financial Management. New York: Cengage Learning. Hodrick, Robert 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 and 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