The Monetary Models of Exchange Rate Determination.pdf

The Global Economy ECON 5319 The Monetary Models of Exchange Rate Determination William J. Crowder Ph.D. The Monetary Models of Exchange Rate Determination •The Flexible-Price Model •The Sticky-Price Model •The Portfolio Balance Model Monetary Models The Flexible-Price Model We start with the following assumptions: 1. PPP holds continuously 2. Bonds denominated in different currencies are perfect substitutes →UIP 3. Perfect capital mobility 1, 2 and 3 together imply that real interest rates are equal internationally →r = r* The Flexible-Price Model Ex-Ante PPP is implied by Absolute PPP e e e* %Δs π =−π t+1 t+1 t+1 UIP implies that: %Δse i =−i * t+1 t t Combined with the Fisher equation, i r =+πe t t t+1 Gives Real Interest Parity * r r t t The Flexible-Price Model Further assume that money demand in each country is given by the liquidity preference theory. m −p δy =−γi t t t t where • mt is the domestic money supply in logs • p t is the log of domestic price level • y t is the log of domestic real income • i is the domestic nominal interest rate t The Flexible-Price Model A similar money demand exists for the foreign country * * * * * * mt −pt δ yt =−γ it Note: The use of logarithms allows us to make an otherwise non- linear relatio