International Finance - Flexible Price Monetary Model - Assignment Example

Flexible Price Monetary Model Flexible Price Monetary Model Introduction The flex-price model was proposed by Frenkel in the year 1976 and suggested that prices (including wages) are flexible. This means that only the Money demand and the supply of money are the key factors that set the equilibrium in the exchange rate and the purchasing power parity (PPP) is held. Exchange rate between the two countries could be determined with the comparison of demand and supply of money of the two countries. Flexible Price Monetary Model Flexible price monetary model of exchange rate describes as a relationship between the exchange rate of the country and other monetary rudiments. There is an implied concept that general price level of the country is determined by the demand and supply f money in that country. General Price level of other countries will be same when it is expressed in the identical currency. The currency exchange rate will be compared through this model. By applying this model valuation of the country’s currency could be determined as it is undervalued or overvalued. It is important to note that value of currency changes over time. The model was important in early 1970’s when the fluctuation in the prices was low. The inflation was not too high because the general price level between the two countries were minimum and there was a positive relationship between the prices including wages of the two countries that have to determine exchange rate between them (Wang, 2009). Assumptions All prices are flexible and have a positive relationship. Flexibility of the prices means that prices of the product in both countries must be changed. It could be possible only when the wages and other prices including interest rate of the country do not match with the other country. The assumption is realistic as the price of the product available in both the countries has different prices. Economic agents behave rationally Producers and consumers react rationally that is they do not increase or decrease their export and imports and remittances from those exports and imports. It usually happens that consumers and producers acts according to the market situation and change their behaviour in the fluctuation of exchange rates of the country in comparison with other country. Exchange rate is treated as holding wealth It is a strong assumption that the prevailing exchange rate in the country must be considered as holding of wealth by the country. Availability of perfect substitute of domestic and foreign goods Substitutes are available for the goods that are available in foreign and domestic market. Some goods have no substitute but in order to determine the model it is necessary that perfect substitute are available because elimination of the assumption will give unrealistic result of the model. Purchasing power parity holds continuously The assumption must be applied because if PPP continuous working there is a possibility that the exchange rate changes periodically that will effect the determination of the model. Perfect mobility of capital There is a perfect mobility of capital that the borrowings and investments could be made in other country and there is no restriction on the movement of capital between the two countries. The assumption is unrealistic but to test the model it should be considered that there is a perfect mobility of capital and investments between the two countries (Driver et al., 2013). Determination of the Foreign Exchange Rate The determination starts with the working on the demand of money that resembles to the LM part of the IS-LM analysis. This model fits to determine the foreign exchange rate between two countries using the relative real income, demand for money and the interest rate levels. The demand functions of both the countries are analysed and linked with the Purchasing Power Parity that leads to the determination of the foreign exchange rate. When the International Fisher Effect (IFE) is incorporated within the model the dimension of inflation is added (Driver et al., 2013). The demand of money constitutes of the real income of the residents, the interest rate prevailing in the market and the price level. The definition of velocity of money is the ratio for the demand of money and the price level prevailing, it is direct function of the real income and an indirect function of the interest rate in the market. The relationship can be expressed in an equation form as: Mt / Pt = Y1 ^ α / (1 + rt) ^ β “equation: I” Where “Mt” represents the demand of money, “Pt” is the price level, “Yt” represents the real income and “rt” is the interest rate prevailing in the market. All these variables are at the time t. In the equation the alpha value for the domestic country is α > 0 and the beta value is also β > 0. The “α” and “β” are the coefficients that represent the income elasticity of the money demand. Now taking logarithm: Mt – Pt = αYt – βrt “equation: ii” The difference after taking the logarithm is that the demand of money, real income and the price level were at their original forms in “equation: i” and in the later equation represents the logarithmic values of the variables. Both the equations illustrate that there is a positive / direct relationship between the velocity of money and the real income and a negative / indirect relationship between the velocity of money and the interest rate (Yu et al., 2007). The demand of money for the foreign country can be represented as: Mt* / Pt* = Y1* ^ α / (1 + rt*) ^ β “equation: iii” And after taking the logarithm of the equation: iii: Mt* – Pt* = αYt* – βrt* “equation: iv” Where, “*” represents the foreign countries, and all the variables are demand for money of the foreign country “Mt*”, the price level “Pt*”, real income “rt*” all are at time “t”. Whereas after taking Logarithms “Mt*=Ln(Mt*), Pt*=Ln(Pt*), Yt*=Ln(Yt*). “α” and “β” are assumed to be same/ equalized in both the countries (Bilson & Marston, 2007). The velocity of the money has the same direct relationship with real income and an indirect relationship with the interest rate. This means that a unit increase in the real income will lead to an increase in the velocity of money by one unit. Whereas, the unit increase in the interest rate will cause the velocity of money to decrease by one unit (all other things constant). This represents that the demand for the money in both the countries are equal (same). If the money market shows equilibrium in both the countries, the equation can be represented as: Mt (demand) = Mt (supply) = Mt “equation: v” This represents the money demand in the domestic country. Mt* (demand) = Mt* (supply) = Mt* “equation: vi” The following equation deals with the demand of money of the foreign country. Prices are Flexible The assumption is realistic because the prices of the product may no similar in both the countries. The product prices vary from time to time and country to country. Wage rate are also different in both the countries. Prices are fixed in the long run when equilibrium is determined. Equilibrium is determined through the interaction of aggregate demand and aggregate supply. In long run, it usually happen that point of equilibrium price shifts upwards or downwards. Upward shifting of the price reflects surplus and downward shift reflects that there is a shortage in the country. The approach proved to be realistic and it could be said that the prices including wages are flexible. Wages of the country could also be not hold for a long time period because if the inflation is prevailing in the country (Cherunilam, 1988). Other assumptions of the model are also unrealistic as the PPP to hold continuously. It is impossible that PPP could be hold continuously for a long time and exchange rate of the country changes time to time. Government interferences do not allow holding PPP for a substantial time period (Cherunilam, 1988). Empirical Testing of the Model S= β1 (m-m*) + β2 (y-y*) + β3 (i –i*) + ε In the model we expect: β1=1, β2 0 Overview of Empirical Testing The model worked quite well in early 1970 because the exchange rate was free floating at that time. In free-floating exchange rate the flow of the exchange rate was changing due to the inflation and other import export values. The government was not interfering in the exchange rate of the country and the rate was determined on the free floating regarding two countries currency movements. From the observance of 1920’s it was cleared that there was free floating of exchange rate between .92, .96, and 0.99. It proved that the model was quite relevant at that time depending upon the flow of demand and supply of both the countries (Yu et al., 2007). The model was failed in 1970’s because of the extreme change in the policies of governments and other institution that free floating could not determine actual exchange rate of the country in comparison with other country. However, the model supported the countries that had inflation in their domestic trade. Inflation in the country was the factor that distracts the concept of free-floating exchange rate. Inflation resulted in excess demand over supply and that caused a great exchange rate in favour of the country that had inflation. The reason was valid and an alternate was practiced to control the system. For the purpose the government interference was necessary that putted a restriction on the extreme points of the exchange rate (Driver et al., 2013). PPP could not hold continuously because the exchange rate of the country could not be stable for a long time. It was not possible in early 1970’s that the purchasing power parity to stable for a long time. Fluctuations in the prices and exchange rate of the country did not allow PPP to hold continuously so the assumption of the model is failed in the empirical testing in the period of 1970 (Bilson & Marston, 2007). List of References Bilson, J.F. & Marston, R.C., 2007. Exchange Rate Theory and Practice. Chicago: University of Chicago. Cherunilam, 1988. International Economics 5E. Tata McGraw-Hill Education. Driver, R., Sinclair, P.J.N. & Thoenissen, C., 2013. Exchange Rates, Capital Flows and Policy. London: Routledge. Wang, P., 2009. The Economics of Foreign Exchange and Global Finance. Illustrated ed. New York: Springer Science & Business Media. Yu, L., Wang, S. & Lai, K.K., 2007. Foreign-Exchange-Rate Forecasting with Artificial Neural Networks. New York: Springer Science & Business Media. Read More