ECON5319-Lecture11-2011

ECON5319-Lecture11-2011 - The Global Economy ECON 5319 The...

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The Global Economy ECON 5319 The Monetary Models of Exchange Rate Determination William J. Crowder Ph.D.
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The Monetary Models of Exchange Rate Determination •The Flexible-Price Model •The Sticky-Price Model •The Portfolio Balance Model
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Monetary Models
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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 *
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The Flexible-Price Model * 11 1 % ee e tt t s π + ++ Δ= * 1 % e t si i + Δ =− 1 e t ir + =+ Ex-Ante PPP is implied by Absolute PPP UIP implies that: Combined with the Fisher equation, Gives Real Interest Parity * rr =
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The Flexible-Price Model Further assume that money demand in each country is given by the liquidity preference theory. tt t t mp y i δ γ =− where m t 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 t is the domestic nominal interest rate
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The Flexible-Price Model A similar money demand exists for the foreign country ** * * * * tt t t mp y i δ γ −= Note: The use of logarithms allows us to make an otherwise non- linear relationship linear. Linear models are much easier to work with.
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The Flexible-Price Model * tt t s pp = * t s = t t mp y i δ γ =− The assumption of PPP implies: Combine the PPP relationship with the two money demands: ** * * * * t t y i −=
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The Flexible-Price Model tt pm y i δ γ =− + Re-write the money demands as: ** * * * * t t p my i +
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The Flexible-Price Model ** * * * * tt t t t t t t p pm m y y i i δ δγ γ −=−− + +− Using PPP to combine the two money demands yields: * * * t t t t t s mmyyii =− + or
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The Flexible-Price Model We can simplify this equation further by assuming that the money demand elasticities are the same in both the foreign and domestic economies: () ( ) ( ) ** * tt t t t t t sm m y y i i δγ =−− + and δ γ = =
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The Flexible-Price Model () ( ) ** 1 % e tt t t t t s mm y y s δγ + =−− + Δ ( ) ( ) ( ) * t t t t t s y y ii + This last equation represents the basic Flex-Price Model: Using the UIP relationship the Flex-Price model can be equivalently written as: or ( ) ( ) ( ) * 11 ee t t t t t sm m y y π ++ +
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Implications of the Flex-Price Model for Exchange Rate Behavior * t t s i γ =− t t s i = t t s y δ = − * t t s y = 1 t t s m = * 1 t t s m 1 t e t s π + = * 1 t e t s + = − 1 % t e t s s + = ∂Δ
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ECON5319-Lecture11-2011 - The Global Economy ECON 5319 The...

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