Foreign Inflation Transmission under Flexible Exchange Rates

In 1970s, there was a belief that by floating the currency rates of that country. The forex rates movements depend on the inflation rate and flexible exchange rates. Inflation and other exchange rates matter a lot, while you see any movement in it. Individual nations would allow a floating exchange rate system, by the inflation trends and monetary police; otherwise, it would dominate for using monetary policy for domestic purpose. The floating exchange rates were introduced dates back by Friedman in 1953.

Theoretically, it was expected that under the exchange, possibility to function the floating exchange rate system was alert under currency substitution. One can observe the effects of higher foreign inflation rates, on demand for domestic real balances, with flexible prices and exchange rates. The domestic velocity of money, and the domestic inflation rate, under currency substitution, is a small open economy for foreign interest.
Two features of domestic economy can be identified and analyzed in details through which flexible exchange rates and the insulation properties were affected: the elasticity of demand for, and initial stock of, foreign real balances.
Several phenomena of concern, like the transmission of international disturbances, and currency substitution are examined here, jointly or separately, either theoretically or empirically. On international inflation Darby and Lothian presented abundant empirical evidence in 1983. Including currency substitution, several possible channels were analyzed. Concentrating on this study, some major industrialized countries during the Bretton Woods era, mainly due to the U.S. monetary policies and increase in oil prices explains the bulk of inflation for these countries. Empirically and theoretically the phenomena of international inflation transmission in a currency was explored by McKinnon in 1982. In addition, Cuddington in 1983, explored the substitution framework, concentrating on his empirical analysis of currency substitution on the industrialized countries.