The Flexible Price Monetary Model



The Flexible Price Monetary Model

This complex issue has been extensively studied in economic literature and widely discussed among investors, officials, academicians, traders, and others. Still, there are no definitive answers. Views on exchange rate determination differ and have changed over time. No single approach provides a satisfactory explanation of exchange rate movements, particularly short- and medium-term movements, since the advent of widespread floating in the early 1970s.

Three aspects of exchange rate determination are discussed below. First, there is a brief description of some of the broad approaches to exchange rate determination. Second, there are some comments on the problems of exchange rate forecasting in practice. Third, central bank intervention and its effects on exchange rates are discussed.

The monetary approach to exchange rate determination is based on the proposition that exchange rates are established through the process of balancing the total supply of, and the total demand for, the national money in each nation. The premise is that the supply of money can be controlled by the nation's monetary authorities, and that the demand for money has a stable and predictable linkage to a few key variables, including an inverse relationship to the interest rate-that is, the higher the interest rate, the smaller the demand for money.

In its simplest form, the monetary approach assumes that: prices and wages are completely flexible in both the short and long run, so that PPP holds continuously, that capital is fully mobile across national borders, and that domestic and foreign assets are perfect substitutes. Starting from equilibrium in the money and foreign exchange markets, if the U.S.

money supply increased, say, 20 percent, while the Japanese money supply remained stable, the U.S. price level, in time, would rise 20 percent and the dollar would depreciate 20 percent in terms of the yen.

In this simplified version, the monetary approach combines the PPP theory with the quantity theory of money-increases or decreases in the money supply lead to proportionate increases or decreases in the price level over time, without any permanent effects on output or interest rates. More sophisticated versions relax some of the restrictive assumptions-for example, price flexibility and PPP may be assumed not to hold in the short run-but maintain the focus on the role of national monetary policies.

Empirical tests of the monetary approach- simple or sophisticated-have failed to provide an adequate explanation of exchange rate movements during the floating rate period. The approach offers only a partial view of the forces influencing exchange rates-it assumes away the role of nonmonetary assets such as bonds, and it takes no explicit account of supply and demand conditions in goods and services markets.

Despite its limitations, the monetary approach offers very useful insights. It highlights the importance of monetary policy in influencing exchange rates, and correctly warns that excessive monetary expansion leads to currency depreciation.

The monetary approach also provides a basis for explaining exchange rate overshooting-a situation often observed in exchange markets in which a policy move can lead to an initial exchange rate move ...