In this paper, the main focus will be on the forward looking monetary model of exchange rate determination and some points surrounding this topic. I will consider the purpose and make a comparative analysis between two models. The two key models I have chosen to use are the flexible price monetary model and the Dornbusch sticky-price monetarist model.

For the purpose of this essay I will be looking at the effects of the exchange rate by the domestic nominal money supply. I will also be presenting a graphical representation of the effects to help my further explanation. In conclusion, I will assess the Flexible price monetary model and how it helps towards determining the exchange rates and how reliable this model is.

Exchange rate is defined by Anne Krueger as:

“The price at which one national money can be exchanged for another”

To be more clearly defined for the essay the exchange rate will be defined more specifically as the domestic currency units required for a foreign currency unit. There have been many developments of sophisticated models that illustrate the exchange rate behaviour. However, this discussion will be about the flexi price monetary model. This model was developed by Frenkel, Bilson and Mussa.

It is said to be that the model is defined as

“is an extension of the purchasing power parity … essentially it appends a theory of the determination of the price level to a PPP equation in order to explain the exchange rate”

This means that the model can forecast the change in exchange rates and price levels in relation to current and expected future values of variables for example the money supply, income level and the interest rate.

The main assumptions in this model are that the Power Purchasing Parity (PPP) holds continuously. PPP can be defined as

“Aneconomic theory that estimatesthe amount of adjustment neededon the exchange rate between countries in orderfor the exchange to be equivalent to each currency’spurchasing power.”

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This means that the model will adjust to shocks, to ensure the goods and stocks prices in one country will be the same price in another country. This links with another assumption that the prices are assumed to be flexible,

“This implies that movements in the exchange rate must be directly proportional to movements in prices not only in the long run but continuously.”

Another assumption is that the Uncovered Interest rate Parity holds as well. This can be referred to as the

“Equality of expected returns on otherwise comparable financial assets denominated in two currencies, without any cover against exchange risk.”

This implies that the model assumes that

“The expected rate of return on domestic and foreign bonds are equal”

This defines them as being perfect substitutes. Another assumption is that the

“The money supply is assumed to be exogenously determined by the monetary authorities and money markets are continuously equilibrated”

This means demand for money will always equal supply for money

The model has given many functions for the model, which are the explanations of the flexible price monetary model on the basis of the assumptions. The domestic money demand has is shown as

mt – pt = ayt – bit

m is the log of domestic nominal money supply

p is the log of domestic price level

y is the log of domestic real income

i is the log of nominal domestic interest rate

This equation simply states that the

“The demand to hold real money balances is positively related to real domestic income due to increased transactions in demand and inversely related to the domestic interest rate.”

The foreign money demand function is specified as

Where m* is the log of foreign nominal money supply

p* is the log of foreign price level

y* is the log of foreign real income

i* is the log of foreign interest rate

We can rearrange these two equations to make p and p* the subject:

[1]The PPP that holds continuously is expressed as

st = pt – pt*

Where s is the log of domestic currency price for foreign currency.

We can then extend this equation with (2) and (3) equations to derive

st = (mt – mt*) – a (yt – yt*) + b (it – it*)

This is known as the reduced form exchange rate equation and is explained by Keith Pilbeam as

“The spot exchange rate (dependent variable) on the left hand side is determined by the variables (explanatory variables) listed on the right hand side equations”

So far, the model has been explained as a general concept. However the model can be interpreted as a forward looking monetary model which helps look at the future action of the exchange rate.

“According to UIRP (uncovered interest rate parity)… the expected change in the spot exchange rate during a certain period of time is equal to the effective interest rate differential in the same time period between two countries”

It can be said that

it – it*= Et (st+1) – st

Where t is today. We can further expand the equation to make the model forward looking;

st = (mt – mt*) – a (yt – yt*) + b( set+1 – st)