The essay discusses one of the models that have been framed to determine the exchange relation relationship between the two currencies. The essay briefly discusses the flexible price monetary model of exchange rate determination and its ability to explain foreign exchange movements. Further discussion has been conducted on the validity of the results and the importance of assumptions that is made.
The monetary model of exchange rate has been one of the dominant models in the exchange rate as it explains relative price of two currencies wherein the relative value is modelled based on the supply and demand of the currencies.
One of the building blocks of this model is the absolute purchasing power parity. According to this, the arbitrage will move the exchange rate in order to make the price of the goods in the two countries equal. The supply of money in one country will impact the domestic price level and in this way the exchange rate is determined based on the relative supplies of the money. This is the other key constituent of the monetary approach to flexible exchange rate is the classical model of price determination.
The Validity of the Monetary Model
It is argued that the validity of the model can be ascertained on the basis of the purpose. The above discussion clearly shows that there are mixed reactions and findings of this model in estimating the exchange rate. However it is important to understand that the validity of the monetary model can be said to simplifying the reality i.e. reliability may be little but certainly can be considered as the basis for establishing realistic hypothesis. Thus it may be difficult but not impossible to forecast exchange rate but efficiency may be questioned.