TOPIC 3 :

EXCHANGE
RATE
DETERIMINATION
(PART 1)
Introduction
• Flexible price model and sticky price model are two different
models used to explain the behavior of prices in the economy.

• In the flexible price model, prices adjust quickly to changes in

supply and demand.

• In the sticky price model, prices do not adjust immediately to

changes in supply and demand.
Flexible Price Model
• The Flexible Price Model was proposed by Frenkel in 1976.
• The Flexible Price Model suggests that changes in exchange rates
are primarily driven by changes in supply and demand for
different currencies.
• The model assumes that prices are perfectly flexible and that
there are no barriers to trade or capital flows.
• Under the Flexible Price Model, changes in exchange rates occur
quickly and automatically, as the market responds to changes in
economic.
Flexible Price Model
• In reality, prices may not adjust perfectly and there may be trade
restrictions or capital controls that limit the ability of markets to
respond to changes in exchange rates.
• According to the model, prices in different countries adjust to
changes in exchange rates
• The currency of the country that experiences a depreciation
becomes relatively cheaper than the currency of the country
that experiences an appreciation
Sticky Price Model
• The Sticky Price Model is an exchange rate theory that assumes
prices adjust slowly to changes in economic conditions.

• Prices in the short run are "sticky" and do not adjust immediately
to changes in exchange rates or other economic factors.

• This can lead to short-term deviations from the long-term

equilibrium level of exchange rates.
Sticky Price Model
• The model assumes market participants have imperfect
information or face transaction costs, which make it difficult for
prices to adjust quickly.

• In the short run, changes in exchange rates can have significant

effects on the economy, such as changes in trade balances and
inflation rates.

• However, in the long run, prices are assumed to become more

flexible and eventually return to their long-term equilibrium levels.
Sticky Price Model
• The Sticky Price Model suggests that governments may need to
intervene in the market to stabilize exchange rates in the short term.
• This could include measures such as buying or selling currencies or
adjusting interest rates to influence the supply and demand for
currencies.
• The model also implies that the effectiveness of government
intervention may depend on the degree of market inefficiency and the
flexibility of prices.
• Overall, the Sticky Price Model highlights the importance of
understanding the short-term effects of exchange rate fluctuations and
the potential need for policy intervention to stabilize exchange rates in
the short run.
Market efficiency
• Flexible Price Model:
• Assumes that markets are perfectly efficient and rational, and that all
available information is reflected in exchange rates.
• Market participants are assumed to be well-informed and able to
make rational decisions based on economic conditions and exchange
rates.
• The model assumes that prices adjust quickly to changes in supply and
demand for currencies, without any barriers to trade or capital flows.
• In this model, government intervention in the foreign exchange market
is generally not necessary since the market will naturally adjust to
changes in economic conditions.
Market efficiency
Sticky Price Model:
• Assumes that markets are not perfectly efficient and that market
participants may have imperfect information or face transaction costs.
• Market participants may not have access to all available information
about economic conditions or exchange rates, which can lead to
inefficiencies in the market.
• Prices in this model are "sticky" and do not adjust immediately to
changes in exchange rates or other economic factors.
• In this model, government intervention in the foreign exchange market
may be necessary to stabilize exchange rates in the short run.
Short-term and Long-term effects
Flexible Price Model:
• Has both short-term and long-term effects on exchange rates.
• In the short run, changes in supply and demand for currencies can
cause fluctuations in exchange rates.
• These short-term changes in exchange rates can affect the economy
in a number of ways, such as changes in trade balances or inflation
rates.
• In the long run, exchange rates are expected to return to their
equilibrium levels as prices adjust to changes in economic conditions.
Short-term and Long-term effects
Sticky Price Model:
• Emphasizes the short-term effects of exchange rate fluctuations.
• In the short run, changes in exchange rates can have significant effects
on the economy, such as changes in trade balances and inflation
rates.
• Prices in this model are assumed to be "sticky" and do not adjust
immediately to changes in exchange rates or other economic factors,
leading to short-term deviations from the long-term equilibrium level of
exchange rates.
• Over time, prices are expected to become more flexible and
eventually return to their long-term equilibrium levels.
 Implications for Policy
• Flexible Price Model suggests that countries with flexible
exchange rates do not need to actively intervene in the market
to maintain a fixed exchange rate

• Sticky Price Model suggests that governments may need to

intervene in the market to stabilize exchange rates in the short
term
THANK YOU