The
exchangerate determination (Flexible Prices) namely the Monetary model
is the earliest approach to explain theexchange rate variations.It represents an obvious benchmark when it compares toother approaches to model exchange rate such as Mundel-Flemming model andDornbusch Model which grew out of the monetary model.The monetary Model wasfirsly started as an approach to the balance of payment which could be datedback as far as the work of David Hume in 1741.It will be seen
to consist of two basic building blocks:thepurchasing power parity relationship and the demand for money.However themonetary model appears inadequate in explaining movements seen in recentyears,but it still provides some useful insights for capurting long-trends.
The monetary model is validated based on three assumptions:avertical aggregate supply curve,a stable demand for money and purchasing powerparity(PPP).I shall examine these assumptions in that order.
.Assumption 1:The aggregate supply curve is vertical
This does not imply that output is constant it can only varyif the productivity of the economy either increases or decreases such astechnical progress,the accumulation of capital,growth in the labour force orits educational level and so on.In an addition the vertical supply curve impliesthat prices are perfectly flexible in all markets.
Assumption2:The demand for real money balances is a stablefunction of only a few domestic macroeconomic variables.
The supply of money is equal to the total of the domesticcredit created by the central bank in its lending to the government and thecommercial banks by their advances to the public plus the country’s reserve ofgold and foreign exchange rate.The demand for money is to be construed as thedemand to hold a stock of purchasing power in the form of monetary assets.It istherefore a demand for real balances.It is based on the Cambridge quantityequation:real money balances depend only on real income.The quantity theory ofmoney states MV=PT
M\, is the total amount of money in circulation on averagein an economy during the period, say a year.

V_T\, is the transactions' velocity of money,
PT is the price level associated with transactions for theeconomy during the period

Tis an index of the real value of aggregate transactions.

Proof:MV=PT=Py M/P=1/v*y
Therefore M/P=ky (k=1/v)
Where M/P is real money demand,y is real income,Y=Py isnominal income and k is a parameter.
In equilibrium the money demand is equal to demand moneysupply which implies Ms =Md.For a given money stock Ms0(along the LM curve),wehave:Ms0=Md=kY.So that nominal income Y must be constant along the aggregatedemand curve.The real money supply is proportional to real income.
Assumption3:Purchasing power parity(PPP)obtains at alltimes.
Domestic and foreign price levels should be identical:eP*=Pwhen they are expressed in a common currency.Where P(P*)denotes the domestic(foreign)price level(of a consumption basket)and e is the nominal exchangerate(domestic price of foreign currency).
The vertical axis plots the domestic price level and thehorizontal plots the nominal exchange rate .The PPP line is the line drawn outfrom the origin that involves all combinations of e and P that satisfiesequation eP*=P.Points above and to the left of the lines are ones where domesticprice is too high and is undercompetitive whereas the points below and to theright of the lines are ones where domestic price are too low andovercompetitive.In terms of the real exchange rate,above the PPP line is a realdepreciation is required to restore equilibrium and vice versa.Deviations fromPPP,will normally be associated with changes in a country’s relativecompetitiveness.For that reason,it is often useful to look at the real exchangerate,which is the nomial exchange rate corrected for changes in relativeprices.

In equilibrium the closedeconomy,the intersection between aggregate demand and aggregate supplydetermines the equilibrium
pricelevels:Ms0=Md=kPy
P=Ms0/ky.Then in the openeconomy,PPP has to hold:P=eP*=Mso/ky and e=Ms0/kP*y.So the exchange rate in ourvery simple model is the ratio of the money stock to the demand,measured at theforeign price level.Whatever cause the ratio to rise due to increase thenumerator or decrease the denominator will cause the price of foreign exchange torise(the domestic currency to depreciate).

There are two types of exchange rate regimes namely purefloat and fixed exchange rates.Under a pure float,the exchange rate isdetermined by demand and supply,therefore the endogenous fluctuations in supplyor demand are reflected in variation in the exchange rate.Under fixed exchangerates,the central government are commited to preventing any variation incurrency values.Without the cotrols on transactions in foreign exchange,theycan only achieve this by direct intervention in the market,to buy up excesssupplies of pounds with dollars,when necessary.Conversely,to supply additionalsterling when there is an excess supply of dollars.Different types ofdisturbance such as a monetary expansion and a rise in real income respetivelyin the domestic economy and an increase in the world price level will haveeffect on this equilibrium for both floating and fixed exchange rates.In thisessay I will only be considering how output increase will
affect the equilibrium of the monetarymodel which is essentially the same as income increase under fixed exchangerates.Under a fixed exchange rate regime,the central bank buys and sellsdomestic currency in order to keep the exchange rate fixed.The money supply isnow given by:Ms=FX+DC.where DC is domestic credit and is controlled by thecentral bank,and FX are foreign currency reserves held by the centralbank.Increases in the money supply can arise from policy decisions to permitincreased domestic credit or from growth in the reserves.The latter are theresult of maintaining a fixed exchange rate under conditions of balance ofpayment surplus.Under the fixed exchange rate
regime the exchange rate is not allowed to move.The analysisis slightly more complicated so it will be helpful if we start by clarifyingwhich variables are being taken as exongenous and which endogenous.Real incomey is assumed to be given by factors outside the scope of our model,the foreignprice level P* is determined by foreign money supply,income and so on which is exogenousvariable.Under a fixed exchange rate regime,the money supply is not anexogenous variable,instead the policy variable is domestic credit.Therefore theforeign currency reserves FX is in charge of the adjustment to changes in theexogenous variables.The only remaining exogenous variable is the exchange rateitself,which is fixed by the decision of the central government at somelevel,e.The increase in output that is induced by increase in income under thefixed exchange rate is similar to the results from the floating case.The priceis determined by the monetary model but a rise in output which is an exogenousvariable which is not determined by the model.With the price level unchanged,anincrease in real income will cause the demand for real money balances that isonly depends on real income to increase.This will shift the aggregate supplycurve to the right from AS0 to AS1.We start from the equilibrium
at price P0 where aggregate supplyequal aggregate demand with real income y0.The point A is on the PPP curvewhich indicates the purchasing power parity holds. The impact will causedomestic residents to spend less,so as to raise their balances to a levelcommensurate with their new higher volume of tranactions,because given pricesand money supply doesnot change, whenyour real income goes up it means giveneverything else is constant, you can spendless and still get the same amount ofgood (lets say), so to get same amount ofgoods you spend less as your realincome has gone up.This will force down the price from P0 to P1,which with afixed exchange rate makes the home country’s output overcompetitive on worldmarkets.
Domesticprice is lower than the rest of world,because the price is cheaper everyonewants to buy domestic goods and services so there is excess demand for cash andthe value of the domestic currency will rise and lead to appreciation.Theresult of a rise in the domestic country’s real income will be to cause anincrease in the reserves as a result of temporary balance payment surplus,otherthings being equal.This process will come to an end only when the domesticmoney stock has grown sufficiently to match the new,larger demand.Under thefixed exchange rate regime the money stock which is the money supply that isconsists of domestic credit and foreign ,in our case the domestic creditremains the same whereas the increase in reserve from FX0 to FX1 will haverisen the domestic money stock.Therfore in the new equilibrium ,the domesticmoney stock will have risen from point K to point J and the home price levelwill have returned to its PPP level.
Overall,The monetary model combines the quantity theoryof
the demand for money withpurchasing power parity to generate clear conclusions regarding the effects ofchanges in exogenous variables on exchange rate or on balance of payment.It isstill very important if you can benchmark the monetary model with other modelssuch as Mundel flemming and Dornbusch model which were built upon the monetarymodel.Unfortunately,the monetary model could only be used in the long rumotherwise it would be inadequate which is resulting the failure of PPP.