Okyay Ucan and Nizamettin Basaran

Additional information is available at the end of the chapter Okyay Ucan and Nizamettin Basaran

http://dx.doi.org/10.5772/intechopen.71752 Additional information is available at the end of the chapter

#### Abstract

This chapter is to clarify macro issues and suggest main policy tools for emerging countries. Furthermore, financial markets, capital mobility and monetary policy are theoretically discussed. The exchange rate management (that is contractionary devaluation and real exchange rate rules) via exchange rate regimes is the purposed subject of this chapter, that is, consideration of open macroeconomic development policies for emerging markets. We take up three issues related to exchange rates in emerging countries for discussion. The first one is the concept and measurement of real exchange rates as well as exchange rate misalignment and its impact upon economic growth. The second topic taken up is the factors that are important in deciding upon the exchange rate regime and the exchange rate determination for emerging markets. Finally the dilemma problem of policy, in the face of sustained capital inflows, is discussed. A key economic feature that differentiates developed and developing countries is the structure of their financial systems.

Keywords: open economies, exchange rates, international finance, macroeconomics, international policies

### 1. Introduction

In this chapter, we mainly examine the macroeconomic problems of emerging countries. To be a developed country means not only being a mirror image of an emerging country's future but also having more economic qualifications than the emerging ones. For both developed and emerging countries, foreign exchange market is the oldest and intense one among the financial markets because of the financial integration and exchange rate crisis after the 1960s. The foreign exchange market is the center of attention not only for the firms but also for the people on the street. Exchange rate that is the principal of foreign exchange market is the key source of this attention. Here, the important problem is the determination of the real exchange rate.

© 2018 The Author(s). Licensee InTech. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/3.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

© The Author(s). Licensee InTech. This chapter is distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/3.0), which permits unrestricted use, distribution, and eproduction in any medium, provided the original work is properly cited.

There are various points of view made by authors in the economics literature. Up to middle of the 1980s, international goods and service flow, individuals' portfolio choices, interest rate, inflation, economic growth and money supply have been widely used in the exchange rate determination models. With these variables, seven types of exchange rate determination models were introduced. They are purchasing power parity (PPP), Mundell-Fleming approach (MFA), sticky price monetary model (SPMM), flexible price monetary model (FPMM), hybrid model (HM) or real interest differential model (RIDM), portfolio balance model (PBM) and currency substitution model (CSM) [1–4].

The purchasing power parity is the oldest approach among the exchange rate determination models. In most general terms, nominal exchange rate between two currencies and price level differentials is defined as purchasing power parity. Gustav Cassel, during the World War I, wrote [6]:

"At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity 'the purchasing power parity'."

After Cassel, the term was widely used in the economics literature. PPP theory has two main variants. They are absolute PPP and relative PPP. The concept that is told about in the previous paragraph is often termed as the "absolute PPP." The relative PPP hypothesis states that percentage changes in exchange rate are equal to the difference between the percentage changes of the prices of two countries.

Mundell-Fleming approach has been developed in the early 1960s. MF model has had a huge impact on the theory of determination of exchange rates. Original model assumed static expectations and fixed prices. Furthermore, regressive expectations or rational expectations are relatively easier. Mundell-Fleming approach totally analyses the effects of the exchange rate differences under various types of exchange rate regimes [7, 8].

Sticky price monetary model, which is also known as the Dornbusch model, was first introduced by Rudiger Dornbusch in 1976. The model fits into the Keynesian tradition, i.e. stickiness of prices in labor and product markets. Dornbusch's observation is that financial markets seem to adjust more rapidly while product market adjusts slowly. According to Dornbusch, this point makes the base for SPMM [9, 10].

Flexible price monetary model, also known as the Frenkel model, was first introduced by Jacob Aharon Frenkel in 1976. A simple assumption for FPMM is that all prices are flexible. That is to say, aggregate supply curve is vertical, and a shift in aggregate demand has no effect on output. The model also assumes that PPP holds continuously. That is, IS part of IS-LM analysis is irrelevant here. Therefore only a slight shift in aggregate supply results in a change in output [11, 12].

In Ref. [13] Frankel indicates that sticky price monetary model is effective and applicable for the countries with low and stable inflation. On the other hand, flexible price monetary model is effective and applicable for the countries with high inflation. Besides these two extremities, Frenkel asserts that neither SPMM nor FPMM is applicable for the economies with moderate inflation. Then, he introduces hybrid model or the so-called real-interest differential model that accommodates the flexible price and sticky price monetary models as special cases [4, 13, 14].

There are various points of view made by authors in the economics literature. Up to middle of the 1980s, international goods and service flow, individuals' portfolio choices, interest rate, inflation, economic growth and money supply have been widely used in the exchange rate determination models. With these variables, seven types of exchange rate determination models were introduced. They are purchasing power parity (PPP), Mundell-Fleming approach (MFA), sticky price monetary model (SPMM), flexible price monetary model (FPMM), hybrid model (HM) or real interest differential model (RIDM), portfolio balance model (PBM) and

The purchasing power parity is the oldest approach among the exchange rate determination models. In most general terms, nominal exchange rate between two currencies and price level differentials is defined as purchasing power parity. Gustav Cassel, during the World War I,

"At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity

After Cassel, the term was widely used in the economics literature. PPP theory has two main variants. They are absolute PPP and relative PPP. The concept that is told about in the previous paragraph is often termed as the "absolute PPP." The relative PPP hypothesis states that percentage changes in exchange rate are equal to the difference between the percentage changes of

Mundell-Fleming approach has been developed in the early 1960s. MF model has had a huge impact on the theory of determination of exchange rates. Original model assumed static expectations and fixed prices. Furthermore, regressive expectations or rational expectations are relatively easier. Mundell-Fleming approach totally analyses the effects of the exchange rate

Sticky price monetary model, which is also known as the Dornbusch model, was first introduced by Rudiger Dornbusch in 1976. The model fits into the Keynesian tradition, i.e. stickiness of prices in labor and product markets. Dornbusch's observation is that financial markets seem to adjust more rapidly while product market adjusts slowly. According to Dornbusch,

Flexible price monetary model, also known as the Frenkel model, was first introduced by Jacob Aharon Frenkel in 1976. A simple assumption for FPMM is that all prices are flexible. That is to say, aggregate supply curve is vertical, and a shift in aggregate demand has no effect on output. The model also assumes that PPP holds continuously. That is, IS part of IS-LM analysis is irrelevant here. Therefore only a slight shift in aggregate supply results in a change in output

In Ref. [13] Frankel indicates that sticky price monetary model is effective and applicable for the countries with low and stable inflation. On the other hand, flexible price monetary model is effective and applicable for the countries with high inflation. Besides these two extremities, Frenkel asserts that neither SPMM nor FPMM is applicable for the economies with moderate

differences under various types of exchange rate regimes [7, 8].

this point makes the base for SPMM [9, 10].

currency substitution model (CSM) [1–4].

252 Financial Management from an Emerging Market Perspective

'the purchasing power parity'."

the prices of two countries.

wrote [6]:

[11, 12].

The important difference of portfolio balance model among the exchange rate determination models is the assumption of perfect substitution between the domestic and foreign assets. In this model, there is a long-run and a short-run differentiate. So, the exchange rate is evaluated in this concept. In the short run, exchange rate is determined by supply and demand of financial assets. However, in the long run, real factors are added to financial assets. Portfolio balance model is far more complex among the other models. The price of the complications is not only the problem. There exist some variables (such as wealth) that are difficult to measure in the model. Therefore, application of PBM is difficult in practice [4, 5, 9].

Individuals have more than one currency in their portfolio in currency substitution models. In other words, individuals'demand for money is defined not only for domestic currency but also for a group of currencies. There are two types of currency substitution models. The first type interprets either current account deficit or surplus as reflecting excess supply or demand of domestic currency relative to the foreign one. The second type of CSM considers money supply as being a worldwide object within the context of a highly integrated world capital market [18–20].

The plan of this chapter is as follows. The second section is titled "Capital mobility and IS-LM-BP model and effects on firms" and deals with types of capital mobility information and Mundell-Fleming approach that is one of the exchange rate determination models under different types of capital mobility. Thus, open macroeconomic policies will completely be examined for the emerging countries and firms of these countries. The exchange rate will play an important role for firms that export goods and import raw materials. Essentially, a depreciation (devaluation) will make exports cheaper, and exporting firms will benefit. However, firms importing raw materials will face higher costs of imports. An appreciation makes exports more expensive and reduces the competitiveness of exporting firms. However, at least raw materials (e.g., oil) will be cheaper following an appreciation. The final section will give the conclusions.
