ECONOMIC ANALYSIS

Assumptions and prediction of monetary model and UIRP model



Assumptions and prediction of monetary model and UIRP model

Introduction

Exchange rates of the country are formulated by analyzing the monetary demand and supply of the country for the current and future fiscal year. Exchange rate is of diverse importance for the economy of country as it is consider as the distinct price of the economy since it formulate the system of international balance of payment of the country. Economist for a long period has not able to concentrate on significant theory of exchange rate determination (Alquist et al, 2008; Lily & Kogid, 2011).

However, Eiteman et al (2001) segregate the prospective determinants of exchange rates into five common elements that include infrastructure of economic system, foreign direct investment of across the country and investment made on small or large portfolios, prevailing political risk of the country, prevailing speculation of the country regarding diverse aspects, and parity conditions. Despite of these elements no economic model has been able to predict the behavior of exchange rate for short-term period. However, economist after discussion was able to identify some common factor that affects the foreign exchange rate movement of the country.

Factors

Affect

Increase in national income

Increase in demand for currency

Increase in real interest rate of the country

Increase in demand for currency

Increase in inflation rate

Increase in demand for currency

Increase in national wealth of the country

Increase in demand for currency

Increased in preferred currency mix

Increase in demand for currency

Decrease in financial and political risk

Increase in demand for currency

Over the years economics were able to develop several models to determine the exchange rate and its effect for instance, monetary model of exchange rate that is further divided into sub parts, cover and undercover interest rate parity model, assets approach model, portfolio balance approach and others. However, next section will describe the assumption of monetary model and UIRP model and prediction regarding the decrease in the money supply (Bergin, 2006).

Discussion

Assumptions of monetary model of exchange rate

Monetary models of exchange rate initiate by assuming the ideal picture of mobility of the capital of the economy and for that, this model has aimed to use theorems of interest rate parity and PPP to identify sound equilibrium positions of the economy. Economist using this model has described the Bonds as the ideal substitutes that could be considered in order to bring equilibrium in the economy. Assumptions of monetary policy could be clearly understood through understanding the assumptions of “flexible price monetary model and real interest differentiation model” (Cheung et al, 2005; Neely & Sarno, 2002).

The most important assumptions of flexible price monetary model are based on the flexibility of prices of goods and sustainability of purchase power parity. The assumption on purchase power parity describes that real exchange rate of the economy will remain constant for long period. on the other hand, assumptions made by sticky prices monetary model is that prices of goods manufactured or sold in the country are sticky for only in short term, whereas, purchase power parity remains constant on the longer ...