Theoretical Model and Empirical Methodology essay

In order to determine the exchange rates in UK, the use of theoretical and empirical methodology is inventible as suggested by economists Paul and Glassman, (2007). This is because the error in arriving at conclusive results is reduced through combination of these two mechanisms. Theoretical Model In economics working out of exchange rates and considerations the basic variables are the purchasing power parity and quantity theory of money. The two variables are fundamental cornerstones in the monetary approach.

Therefore empirically economists can approximate theoretically the exchange rates using factors like spot exchange rate of pound per unit of foreign currencies (Richardson 1979). However, to approximate the theoretically identified factors to this model, there should be a combination of two components. These components are: purchasing power parity relationship to link the exchange rate with the price levels; and the money demand functions of the home countries which in this case the UK and foreign country which can be taken to be the bilateral trade partner.

These two aspects are represented by the three equations: e t =pt? pt f …………… (i) p t =m t ?? ( y t) +? (i t )………. (ii) p t f = m t f ?? f (y t f )+ ? f( i t f)……… (iii) Whereby: e; is the spot exchange rate that denote the units of domestic currency per unit of foreign currency. m and mf are exogenously given domestic and foreign money supplies, y and y f are domestic and foreign real income. i and i f are domestic and foreign short-term nominal interest rates.

When these equations are substituted from this initial stage to the seventh step exchange rate is determined precisely incorporation of such factors like: a rise in expected inflation leads bilateral trade partners to substitute domestic currency with domestic and foreign bonds that leads to depreciation of the domestic currency. Secondly, possible money gradual output adjustment market disequilibrium contributes towards deviations of the exchange rate from its long-run value and provides sources of adjustment dynamics additional to sticky prices.

In this regard, error-correction and cointegration methodology (Federal Reserve Bank of Boston, 2008) is the most appropriate technique that can be used for exchange rate modeling to represent the proposition of long-run equilibrium with an error-correction mechanism to rectify the disequilibrium in the short-run for the model application. Other components used in the theory are the exogenous domestic and foreign money supplies, pound and foreign currencies short-term nominal interest rates and domestic and foreign real income arrived at using the GDP (Gardner 2007; Huston 1969; Jonson 1999; James, 2008).

All these approximations are used in the estimable model. It should be noted that domestic interest rate has a positive influence on the exchange rate, whereas foreign interest rate has a reverse influence on the exchange rate (Nelson 2001). The reason for this is because the interest rate reflects the inflation premium in theoretical model. This comes because an expected rise in inflation results to variables to substitute pound with UK and foreign bonds, which results to depreciation of the sterling pound.