Flexible model of exchange rate determination, its application and empirical testing

Flexible model of exchange rate determination, its application and empirical testing

Introduction

Adoption of the flexible exchange rate model is crucial as the global economies get closer ties to the international financial markets (Duttagupta et al., 2005). However, there have been various debates by scholars through empirical tests on the applicability of the model.  The concept of a flexible model for exchange rates prices has the assumption that there is flexibility in the prices of goods, but the purchasing power parity remains the same (Frenkel, 1976). In this, the real exchange rate is depicted to always remain constant. There is also the assumption that the foreign money demand function remains stable, the existence of uncovered interest parity and the presence of perfect capital mobility (Bilson, 1978). The model was introduced in 1976 and has since faced further development, and the various scholars have texted the applicability of the model. The analysis provides a description of the flexible model of exchange rate determination, its ability to explain the foreign exchange movements and its performance based on the various empirical tests conducted.

A flexible model of exchange rate determination

The aspect of the monetary model that adopts flexible prices was a concept introduced by Frenkel and Musa in 1976 (Smith and Wickens, 1986). It depicts that goods assume flexible prices but what remains constant is the purchasing power parity (PPP). PPP is a theory that depicts that the exchange rates of various currencies will be at equilibrium when there is the same purchasing power among two or more different countries. Hence, their real exchange rates tend to remain constant over a period of time (Diamandis et al., 1996). The flexible model of exchange rate determination shows the existing relationship between the aspects of prices, the real incomes, the currency exchange rates and the interest rates. However, for the model to function, various assumptions have been made, and they include; perfect mobility of capital, stability in the demand functions for domestic and foreign currencies and the aspect of uncovered interest parity.

There is the assumption that the demand for money logarithm depends on the real income logarithm labelled, y (Yong & Ling, 1995, p. 138). Also, the price level logarithm labelled, p is dependent on the prevailing rate of the nominal interest labelled, r. Also, there exists a similar demand for money for the foreign markets that are denoted using asterisks (Yong & Ling, 1995).  Moreover, the nominal interest rate is a factor of the real interest rate (i) and the inflation rate (Π).

Based on Yong and Lin, 1995, the flexible monetary model equation is represented below:

s_t = (mt – mt * ) – φ(yt – yt * ) + λ(Πt e – Πt e*)

The explanation of foreign exchange movement

The flexible exchange rate model is well recognised for volatility, and hence the movement associated with it can be likened to the aspect of the random walk. Hence, it has the ability to explain the aspect of volatility (Smith & Wickens, 1986). Based on the reduced equation for the flexible price monetary model, there is a positive coefficient of the relative money supply. It depicts that an increase in the supply of money leads to an increase in prices at the same rate. When the domestic real income faces an increase, there is the creation of excess demand on the currency. Hence, there will be a decrease in the expenditures that will result in the real money balances facing an increase that subsequently results in a price decrease. This shows the application of PPP that increases in the value of the domestic currency lead to the achievement of equilibrium.

Moreover, when there are expectations that inflation will face an increase in the long run, there is a tendency for the preference of domestic and foreign bonds over the domestic currency. In this, there will be a reduced demand for the domestic currency, and this leads to a reduction in value (depreciation) of the currency due to a positive coefficient of the expected rate of inflation (Frankel, 1982, p. 518). It is a depiction that the exchange rate is a factor of the aspect pf money supply and the relative interest.

Empirical tests

There are various empirical tests that have been conducted by the researchers in the past. Some have found some applicability of the flexible model in the determination of the exchange rates, while others concluded that there was no significant relationship. In their empirical test on the of the flexible-price monetary mode for the exchange of the UK Sterling Pound and the US Dollar, MacDonald and Taylor (1994), argued that the monetary model would behave better when it is treated well. The period tested was between 1976 and 1990, and the researchers found a series to assume the first integration order. They were able to make an estimation of the model correction error that was better than the basic monetary model (MacDonald and Taylor, 1994). Hence, the consideration of the long term equilibrium that gives room for short-term dynamics could lead to significant improvement of the monetary model. In their conclusion, they depicted that careful interpretation of the monetary exchange model to include the complex short term dynamics could lead to better use but argued the need for researching on the issue further (MacDonald andTaylor, 1994, p. 288).

Another research to that empirically tested the flexible price monetary model in the case of Lithuania made the conclusion that the model is applicable in the periods where there are high rates of inflation (Rudgalvis, 1996).  In the research, Rudgalvis used the flexible model to signify the relationship between the money held in foreign currency and relative to that of the domestic currency. In this, there was a text on the exchange rates in relation to the Lithuanian and USD for a four year period between 1192 and 1995 wherein 1993, Lithuania also brought new currency (Rudgalvis, 1996).

The empirical study by Boyko (2002) affirmed the conclusions made by Rudgalvis (1996) to conclude that the flexible model is applicable in the case of countries that experience high rates of inflation. The conclusion was made as a result of the existence of a positive relationship between the interest rates recorded domestically and the error correction model (Boyko, 2002, p. 33). Hence, there was a correlation between the interest rates and the exchange rates that is crucial in predicting inflation. The research used data from September 1996 to September 2001, where data was analysed on a monthly basis.

However, in a previous empirical test by Frankel (1982) depicts that the monetary model needs a variation. He depicted that the stock and income should be the variables in the money demand function that should be factored in both flexible and sticky-price models. Moreover, he argues that the difference between the interest rates in domestic and foreign currency should be regarded as the expected inflation (Frankel, 1982). In his conclusion, there is a need to include stocks in the monetary method and exclude real income.

A recent empirical test by Afat, et al., (2015) depicted that the various monetary models, including the flexible price model, tend not to provide the results that are expected. The research was based on the Johansen cointegration technique based on the various nations that are part of the OECD. The technique is crucial for near-integrated processes that tend to give room for small deviations in the units used in the assumption (Hjalmarsson & Österholm, 2007). It is based on its various shortcomings, and there is a need to ensure that there is a revised model. They argued that the various deviations from PPP did not lead to non-functional monetary methods; rather, it was caused by the inapplicability of the money demand function (Afat et al., 2015).

Conclusion

The flexible exchange rate model has faced great popularity based on the aspects of globalisation. Hence it has widely been used in explaining the aspect of the analysis of the changes in the currency exchange rates. It assumes that the prices tend to be flexible while the PPP tends to remain a constant aspect. Empirical test supporting the model has been weak and only shows the conditional applicability of the model because it needs to be applied correctly and works efficiently in instances of high inflation. However, research that rejects it shows that there are many shortcomings and there is need for variations.