EC7075 Assignment Sample – International Money and Finance 2022

Introduction

Exchange rate helps to determine the value of a country’s currency by comparing with another country’s currency. Free-floating is the most common feature of an exchange rate and the rise or fall of a rate depends on the demand and supply of a currency in the market. In this essay three exchange rate determination models are going to be included to determine capital flow and trade dynamics.

The three models are “Monetary Model”, “Mundell-Fleming Model” and “Dornbusch Model” among which comparison is going to be drawn to provide a clear analytical idea on elements dependent on determining the exchange rate of a currency.

Discussion

Review from Literature

Monetary model is being considered as one of the oldest approaches to determine the exchange rate. This model is being used to compare with other usable models and create a yardstick. Within this model an assumption on “simple demand for money curve” and a vertical aggregate supply curve are being done by considering “purchasing power parity” is true.

The monetary model puts forward an equation that is Md=Ms in the situation of equilibrium, where Md represents “demand for money” and Ms signifies “supply for money”. Depending on the equation, the rise or fall of an exchange rate can be determined keeping the fact situation is equilibrium (Hakkio, 2017).

At a certain point, an external equilibrium has been achieved by an economy as a result there is an increase in the “supply of money” creating an appreciation for the domestic currency. In that same point, an exchange rate is inversely related with the international price level and output level.

As per the concept of monetary model within the domestic economy money supply rises up when all the parameters of an exchange rate are constant. Hence, prices of product or services remain fixed and excess money creates higher demand for each saleable item in the economy. A depreciation in the nominal exchange rate becomes clear with a push in “fixed output price”.

“Mundell-Fleming Model” (MF-model) is the most realistic model for determining the rate of exchange of currency. This model is being used in the open economy to determine exchange rate and observe the impacts on export as well as import (Itskhoki and Mukhin, 2021).

One of the primary assumptions of this model is movement of capital is free and flows into other countries where investment of that capital brings a maximum return. Under the open economy framework, two systems are being included for an exchange rate determination, those are “floating exchange rate” and “fixed exchange rate”. During “floating exchange rate”, the rate of exchange is determined through the rise or fall of price because of demand or supply of currency.

No intervention of a central bank can be seen in this scenario within the market. The rate of exchange is entirely fixed during the “fixed exchange rate” but in practical situations certain countries allow variation to a limit within an exchange rate (Bostan and Firtescu, 2018). Central banks mostly oppose this allowance and intervene into the activities of determination to keep the exchange rate at its fixed rate.

Overall, from the concept of this model it can be judged under “flexible exchange rate” a strong currency appreciated but a weaker currency depreciated. While on the other hand, under “fixed exchange rate” revaluation occurs for a strong currency and devaluation for a weaker currency.

Dornbusch Model” puts forward the concept of overshooting that explains the “exchange rate overshooting hypothesis” and provides a way to think and evaluate an idea on volatility of high level “currency exchange rate” through using the concept of “price stickiness”.

The primary ideology of this model is that prices of goods or services within an economy do not react immediately with a sudden change in the “foreign exchange rate”. Furthermore, it states that an economy can observe a domino effect where the first impact is visible at financial markets, bond market, money market and derivative market (Cheung et al. 2019).

After the spread of impact is fully being done on all the stated markets, an influence transfers to the prices of goods. As per overshooting model creator Rudiger Dornbusch believes a country’s economy always tries to reach equilibrium from any situation.  “Dornbusch model” argues that volatility is the fundamental part of an economy’s market for determining exchange rate rather than simply portraying the result of inefficiencies.

This concept of volatility has been contrasted by other economists and laid down that “volatility was purely the result of speculators” resulting in the “foreign exchange rate” inefficiencies. Temporary overreaction of “foreign exchange rate” is being clearly observed through the changes in monetary policy through compensating goods having stick prices within the economy (Beckmann and Czudaj, 2017).

This concept provides knowledge that in the short run a shift in the equilibrium market becomes clear with the financial market prices. Gradually, the prices of sticky goods become unstick and have to adjust with the actual financial prices creating an impact on “foreign exchange market”

Analysis of the theories

The nature of MF-Model is quite similar with the ISLM model but the primary difference is the operating market. ISLM model operates on the closed-economy but MF-model operates on the open-economy. The application of MF-model for determination of exchange rate is being expressed through “r=rf”, where r represents the “interest rate in the economy and rf signifies “world rate of interest”.

The domestic interest rate under the MF-model is being determined through the world’s interest rate by keeping a focus on the rate of exchange done via “national income” in the short run (Engel, 2019). Economy’s behavior creates a knowledge of whether the exchange rate is going to adopt floating or fixed rate.

While in the monetary method no such concept can be found the entire determination of an exchange rate depends on supply or demand of foreign currency. “Relative price level through purchasing power parity” is the primary monetary approach for determination of an exchange rate.

Overall, it can be said monetary approach holds relative price of a currency during exchange by determining “stock equilibrium” in the currency markets. While the concept of “Dornbusch Model”  emphasizes “foreign exchange rate” temporarily overreacts due to certain changes within monetary policies, it can be compensated by the presence of goods holding stick prices in the economy.

Determination of an exchange rate through this model can be done by the equation   “r = r* + Δse that clearly states any expected appreciation or depreciation of currency and bringing any difference in the exchange rate (Suidarma et al. 2018).

The essence of volatility is quite high during determination of an exchange rate because of overshooting and subsequent corrections. Comparing two out of three models, it can be judged, monetary approach and overshooting model have the same ideology that an ideal market will reach an equilibrium situation but the way of determination is different.

As discussed the equations of three models for determining exchange rate, the values of each rate differ due to the equation put forward by each method.

Evaluation

Among all the three model’s evaluation and analysis, the monetary model is the most used approach for determining an exchange rate. “Purchasing Power Parity” (PPP) is being used to determine the exchange rate within the “equilibrium goods market” and money market equilibrium determines the exchange rate through “monetary model”.

PPP gets stronger due to the “law of one price” that determines identical goods in one country have to be sold in another country in indenticial prices (Toth-Bozo and Szalai, 2019).  In the market there are different ways to measure an exchange rate but among all the “bilateral exchange rate” is the common one as it refers to the relative value of one currency with another one.

This exchange rate is generally being quoted against a strongest currency that can be “US dollar” as this currency is considered as strong and traded globally.

Though the monetary approach and MF-model differs from conceptual aspect, still from MF-model’s “fixed exchange rate” regimes arte being set beforehand with “pre-established peg” while comparing with another currency or set of currencies. While on the other hand, determination of “floating exchange rate” is being determined through the macro factors of demand or supply of the open market which includes the monetary approach’s money-supply concept.

The “supply of money” creates an appreciation for the domestic currency while the opposite can be observed during “demand for money”. The monetary model provides a concept why the domestic economy’s money supply rises up when all the parameters of an exchange rate are constant.

Conclusion

Analyzing all the three models it can be concluded by saying determination of exchange rate varies due to the provision of different concepts and establishing different equations. The supply and demand of money within an ideal equilibrium market is the primary concept of monetary approach.

While MF-model focuses on the floating fixed rates for estimating appreciation and depreciation of a currency rate. Lastly, the overshooting model by Dornbusch considers the volatility concept for determining an exchange rate.

Reference

Books

Hakkio, C., 2017. Expectations and the foreign exchange market. Abinghdon: Routledge.

Journals

Beckmann, J. and Czudaj, R., 2017. Exchange rate expectations since the financial crisis: Performance evaluation and the role of monetary policy and safe haven. Journal of International Money and Finance, 74(1), pp.283-300.

Bostan, I. and Firtescu, B.N., 2018. Exchange rate effects on international commercial trade competitiveness. Journal of Risk and Financial Management, 11(2), p.19.

Cheung, Y.W., Chinn, M.D., Pascual, A.G. and Zhang, Y., 2019. Exchange rate prediction redux: New models, new data, new currencies. Journal of International Money and Finance, 95(2), pp.332-362.

Egilsson, J.H., 2019. Old shocks cast long shadows over the exchange rate. Journal of Applied Economics, 22(1), pp.196-218.

Engel, C., 2019. Real exchange rate convergence: The roles of price stickiness and monetary policy. Journal of Monetary Economics, 103 (5), pp.21-32.

Hsing, Y., 2021. Are The Predictions Of The Mundell-Fleming Model Applicable To Argentina?. Applied Econometrics and International Development, 21(1), pp.37-48.

Hsing, Y., 2021. Are the Predictions of the Mundell-Fleming Model Applicable to Mexico?. The Economics and Finance Letters, 8(1), pp.53-60.

Itskhoki, O. and Mukhin, D., 2021. Exchange rate disconnect in general equilibrium. Journal of Political Economy, 129(8), pp.2183-2232.

Suidarma, I.M., Sanica, I.G., Ayu, P.C. and Darma, I.G.N., 2018. Overshooting Indonesian Rupiah’s Exchange Rate towards US Dollar: Dornbusch Model Hypotheses Test. International Journal of Economics and Financial Issues, 8(5), p.52.

Tica, J., Globan, T. and Arčabić, V., 2019. The mundell-fleming trilemma and the global financial cycle: An empirical test of competing hypotheses. Romanian Journal of Economic Forecasting, 22(3), p.62.

Toth-Bozo, B. and Szalai, L., 2019. Political Announcements and Exchange Rate Expectations. World Journal of Applied Economics, 5(2), pp.53-66.

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