Exchange Rate Specification - Flexible Price Monetary Model - Literature review Example

The flexible price monetary model of exchange rate determination and its ability to explain foreign exchange movements Introduction The issue of exchange determination has become a dominant subject of the modern day economics. However, the search for the most favorable model of explaining the behavior of the changes in the exchange rates has proven elusive, owing to the fact that the empirical evidence has been defeating most of the conventional monetary theories of exchange rate determination (Groen, 2000:312). Therefore, the economists have not been able to agree on the most suitable method of testing the exchange rate, owing to the fact that the analysis of the different methods has become ambiguous and even contradictory at times (Rapach & Wohar, 2001:27). Thus, this discussion seeks to establish how the flexible price monetary model is well placed in the exchange rate determination, while also determining how well the method is suitably placed to explain the movement of the foreign exchange. Discussion The flexible price monetary model of exchange rate determination is one of the oldest models of explaining the behavior of the foreign exchange. According to this model, there is a very strong relationship between the nominal exchange rate of the foreign currency, and a set of the monetary fundamentals, such that a country’s price level is determined by the supply and demand of currency in the country (Neely & Sarno, 2002:56). Additionally, the flexible price monetary model also holds that the price levels of the foreign currency should equal in different countries, when they are expressed in similar currency. Nevertheless, previous studies that have been undertaken to establish the existing relationship between the nominal exchange rate and the monetary fundamentals have indicated that there lacks a long-run stable relationship between the two. For this reason, it can be argued that the flexible price monetary model has little relevance in determining the exchange rate of foreign exchange, as well as in explaining the movement of the foreign currencies (Civcir, 2005:3). However, despite this criticisms, a strong co-integration of the nominal rate of exchange, relative money and relative real output has been found to exist even in the long-run, thus suggesting that the nominal rates of exchange that are forecasted using the flexible price monetary model are more superior to the forecasts of other random-walk nature models (Morley, 2007:396). Most importantly, the flexible price monetary model has been found to be highly effective in determining the nominal exchange rate in the high inflation countries. For example, a study that was undertaken to establish the co-integration of the exchange rate between a high inflation country, Turkey, on the one hand and a low-inflation country, the USA, on the other hand, has indicated the existence of a consistent strong link between the nominal exchange rate and a collection of monetary fundamentals (Civcir, 2005:3). The major building blocks of the flexible price monetary model of exchange rate determination are the purchase power parity (PPP) and the Uncovered Interest Parity (UIP), with the assumption of perfect capital mobility where the bonds, both domestic and foreign, are assumed to be perfect substitutes (Tawadros, 2001:279). The other foundation rationale for the flexible price monetary model of exchange rate determination is the proposition that for every given percentage increase in the monetary supply; the prices will increase with a similar percentage (Uz & Ketenci, 2008:63). Therefore, where the PPP holds constant, then the domestic currency will decrease in the same amount in order for the equilibrium to hold. On the other hand, the rise in the domestic real income will create an increased demand for domestic currency, which will in turn cause the agents to decrease their expenditures so that they can increase their balances of real money, resulting in a price fall (Rapach & Wohar, 2001:22). Thus, by the virtue of the PPP, an appreciation of the domestic currency will serve to ensure that the equilibrium is restored. Further, according to the flexible price monetary model of exchange rate determination, an increase in the inflation rates will serve to ensures that the economic agents will switch from the domestic currency to bonds, both domestic and foreign, such that the demand for the domestic currency will decrease and thus cause a depreciation in the value of the domestic currency (Taylor, 1995:13). Therefore, according to the flexible price monetary model of exchange rate determination, if the real rate of foreign currency is higher than the real interest rate of the domestic currency, a capital outflow from the domestic bonds to the foreign bonds will occur, until at such a time when real interest rates are equalized (Civcir, 2005:7). This therefore serves to show that the monetary fundamentals, as indicated under the flexible price monetary model of exchange rate determination, affect the exchange rate of the foreign currency in the long-run. In this respect, it can be held that the flexible price monetary model of exchange rate determination is able to explain the movement of the foreign exchange rate movements, through providing a long-run benchmark for two currencies, thus making it possible to establish when a currency is overvalued or undervalued (Civcir, 2005:3). However, while the flexible price monetary model of exchange rate determination might appear to be a dominant and superior model in explaining the movement of the foreign currency, there are certain assumptions that the model makes, which makes it lose is its credulity. First, the flexible price monetary model of exchange rate determination assumes that the foreign exchange prices in the market are fully flexible, through holding the emphasis and concentrating only on the monetary market equilibrium, while ignoring the other markets that also play a role in determining the operations of the economy, and thus influences the exchange rate. The operation of an open market economy if determined by the aggregate of six markets namely the goods markets, the domestic bonds market (non-monetary markets), the labor market, the foreign exchange market, the money market and the foreign bonds markets (Neely & Sarno, 200258). Thus, by assuming the perfect substitutability of the foreign and the domestic bonds markets, the flexible price monetary model of exchange rate determination combines the two markets into the same market. In addition, the three fundamental pillars on which the flexible price monetary model of exchange rate determination is anchored are not stable and do not work very well to determine the prices of the foreign exchange rate, when the other component markets of the aggregate economy are considered. For example, one of the fundamental pillars on which the model is built, the money market demand equations, has proven to be unstable especially in the low-inflation countries such as the Unite States (Grauwe & Grimaldi, 2001:47). On the other hand, while the flexible price monetary model of exchange rate determination is purely anchored in the principle of rationality, which offers that the prices of foreign exchange will respond to the equilibrium laws of demand and supply of the domestic currency, is defeated by the principle of volatile expectations as well as departure from rationality that is characteristic of some of the economic markets and functions (Groen, 2000:302). The failure of the economic expectations to be rational is highly attributed to the Uncovered Interest Parity (UIP), as one of the pillars upon which the flexible price monetary model of exchange rate determination is founded. Further, the trend-following trading rules have appeared to make excess economic returns, which then serve to create the departure from rationality, as well as in total violation of the efficient market hypothesis (Neely & Sarno, 2002:69). In this respect, the shift from a fixed exchange rate into a floating exchange rate serves to change the way expectations are formed. This is because, the shift from the fixed rate of exchange to a floating rate of exchange transforms the behavior of the nominal exchange rate, as well as that of the real exchange rates in a way that the IUP cannot be able to explain these exchange rate changes (Neely & Sarno, 2002:67). The ability of the flexible price monetary model of exchange rate determination to effectively explain the movement of the prices of the foreign exchange rates has been defeated by the fact that countries that move from a fixed exchange rate to a floating exchange rate experiences a very dramatic change in the relationship between the prices and the exchange rates (Civcir, 2005:5). This is because, the exchange rates are more volatile in the regimes with a floating exchange rate compared to the ones with a fixed rate of exchange. Thus, expectations are not tied down to the promises of the government to regulate the rates of inflation, thus creating a departure from rationality and enhancing very volatile expectations (Wolff, 1998:49). Conclusion In conclusion, it is evident that the swings in investor expectations may cause a departure of the exchange rates from being attached to the monetary fundamentals in the short-run. Therefore, it has been seen that the flexible price monetary model of exchange rate determination performs well in the determination of the exchange rates in the long-run, as opposed to the short-run. Therefore, it can be concluded that the flexible price monetary model of exchange rate determination is neither able to predict the exchange rate better compared to any of the no-change forecasts, nor even explain the foreign exchange movements. References Civcir, I. (2005). The monetary model of the exchange rate under high inflation: Long-run relationship and misalignment of Turkish Lira. Ankara University. 1-23. Grauwe, P.D. & Grimaldi, M. (2001). “Exchange Rates, Prices and Money. A Long Run Perspective”, Oesterreichische National bank WP 46. Groen, J.J. (2000). “The Monetary Exchange Rate Model as a Long-Run Phenomenon.” Journal of International Economics, 52(2), pp. 299-319. Morley, B. (2007). “The Monetary Model of the Exchange Rate and Equities: An ARDL Bounds Testing Approach. Applied Financial Economics, 17: 391-397. Neely, C. J. & Sarno, L. (2002). How Well Do Monetary Fundamentals Forecast Exchange Rates? Rapach, D.E. & Wohar, M.E. (2001). “Testing the Monetary Model of Exchange Rate Determination: New Evidence from a Century of Data”; Forthcoming in the Journal of International Economics. Tawadros, G. B. (2001). “The Predictive Power of the Monetary Model of Exchange Rate Determination.” Applied Financial Economics, 11: 279-286. Taylor, M. P. (1995). “The Economics of Exchange Rate”, Journal of Economic Literature, 33(1), 13-47. The Federal Reserve Bank of St. Louis. 51-74. Uz, I. & Ketenci, N. (2008). “Panel Analysis of the Monetary Approach to Exchange Rates: Evidence from Ten EU Members and Turkey.” Emerging Markets Review, 9: 57-69. Wolff, C. (1998). “Exchange Rates, Innovations and Forecasting.” Journal of International Money and Finance, 7(1), 49-61. Read More