Flexible Price Monetary Model in Exchange Rate Determination (Essay Sample)

FLEXIBLE PRICE MONETARY MODEL IN EXCHANGE RATE DETERMINATION
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Flexible Price Monetary Model in Exchange Rate Determination
Globalization and proliferation of international trade have increased the applicability of foreign currencies. Finance and monetary policy experts have indulged in the determination of these exchange rates following the increased demand for the same (Williamson 2009, p. 123). Model exchange rate designs and the analysis of exchange volatility is gaining much consideration in international economics and finance. The flexible price monetary model is one of the models extensively applied in the determination of exchange rates (Devereux, Lane & Xu 2006, p. 478). The paper presents an evaluation of the flexible price monetary model of exchange rate determination and its capability of explaining fluctuations in foreign exchange rates. Also, the paper will show the reality of price flexibility in the application of this model.
The flexible price monetary model was proposed by Mussa (1976) and Frenkel (1976). The model insinuates that all prices are highly flexible (Coricelli & Jazbec 2004, p. 86; Devereux & Yetman 2010, p. 182). The flexible price model observes the currency conversion rate as a projection of the value of a nation’s exchange rate in expressions of another (Williamson 2009, p. 124). It argues that the two-sided exchange rate shifts can be elucidated by the variations in demand and supply for domestic currency stocks in the participating states (Williamson 2009, p. 123). The flexible-price monetary model (FPMM) tries to validate how deviations in the demand of and supply of currency in a country indirectly and directly implicate the prevailing exchange rates (Engel, Mark & West 2007, p. 5).
The model hypothesizes the comparative currency stock as the contributing factor to relative charges which regulate the exchange rate. In this case, the aggregate supply curve is perpendicular, and a change in aggregate demand does not affect the output projected (Engel, Mark & West 2007, p. 5). The output is, therefore, determined by forces on the supply side. The model assumes that the total purchasing power parity (PPT) holds continuously. According to Devereux and Engel (2003, p. 770), the PPT means that the currency conversion rate is equivalent to the prevailing price levels, showing that exchange rate is acquired by apportioning the value of the local currency against the foreign country’s price. In this case, the prices will keep on changing to bring about determination in rates (Devereux & Yetman 2010, p. 188). The applicability of the PPP is vital to exchange rate experts as it shows the association between the price of goods and the prevailing exchange rate (Williamson 2009, p. 133). When determining the amount of currency to exchange for a given amount of another, the price of a combination of goods in one country to another when expressed in the same currency (Coricelli & Jazbec 2004, p. 89; Engel, Mark & West 2007, p. 6). The flexible price monetary model proposes the consideration of two price indices for a domestic and foreign country. Therefore, the model asserts that increase or diminution in the predictable inflation level in a particular nation will elicit a proportional rise or decrease in the exchange rate in the state (Devereux, Lane & Xu 2006, p. 490; Williamson 2009, p. 123).
The model assets that an escalation in the local currency supply compared to the external currency stock prompts a devaluation of the local currency comparative to the foreign currency (Williamson 2009, p. 126). The relative cash supply has a progressive association with the long-run minimal exchange rate. It insinuates that an increases in the level of currency supply increase the nominal exchange rate (Devereux, Lane & Xu 2006, p. 486). An upsurge in real local revenue rises the transactions claim for money. According to Devereux and Yetman (2010, p. 182), the augmented demand for cash implies that if the money balances and holding the lending rates constant, the amplified demand for tangible balances only occurs through a reduction in the prices of local commodities. The fall in local prices, supposing that the foreign prices remain persistent, it proposes an increase in the local currency as compared to the foreign currency (Engel, Mark & West 2007, p. 7). The comparative real revenue projection develops a negative correlation with the long-run minimal exchange rate. According to Devereux and Engel (2003, p. 776), an intensification of the local interest rate hints to a decrease in the domestic money, mainly because an increase in the local lending rate culminates into a reduction in the demand for money and hence a depreciation of the domestic currency. According to Bilson & Marston (2007, p. 12), Coricelli and Jazbec (2004, p. 90), the interest rates are regulated by the demand and supply of currency, whether local or foreign currency. The comparative interest rate has a positive correlation with the long-run nominal exchange rates (Devereux, Lane & Xu 2006, p. 498; Coricelli & Jazbec 2004, p. 86).
The supposition about PPP suggests that the actual exchange rates are constant over time (Engel, Mark & West 2007, p. 11). Other assumptions in this model are the steady demand functions for both local and foreign currency; the capital mobility is perfect as well as the existence of uncovered lending parities. The assumptions presented in this model fail to provide support on how to determine the exchange rates explicitly. The suppositions are, therefore, unrealistic because the forces of supply and demand of money in an economy cannot remain purely flexible. There will be instances where some prices contributing to a country’s consumer price index will tend to stick, hence terming the PPT assumption impractical (Devereux, Lane & Xu 2006, p. 486). It sets out a hypothetical situation that cannot occur in real economies for the actual determination of exchange rates.
There are numerous studies carried out to evaluate the rationality of this version of the flexible price monetary model regarding the determination of exchange rate (Williamson 2009, p. 125) empirically. For instance, the traditional regression analysis has been applied in the search for the legitimacy of the flexible price monetary model in providing an explanation for the diverse movements in the exchange rates between two nations engaged in international trade (Bilson & Marston 2007, p. 12). The purchasing power parities, as well as the constant demand for money, occur at the center of the financial approach (Devereux, Lane & Xu 2006, p. 502). It is, thus, relatively astonishing, in a non-overactive inflationary background, that the financial tactic executed will not yield the desired results. The elasticity of price and the PPP will most probably hold during the long-run period. The PPP accomplishes better projections in the short-run, and an imperative cause seems to be price flexibility (Engel, Mark & West 2007, p. 9).
Empirical tests done to verify the assumptions presented in the flexible prices monetary model shows large discr...