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Unformatted text preview: The Monetary Models of Exchange Rate Determination • The FlexiblePrice Model • The StickyPrice Model • The Portfolio Balance Model Monetary Models Asset Models of the Spot Exchange Rate PortfolioBalance Approach imperfect capital substitutability Monetary Approach perfect capital substitutability Small Country Model Preferred Local Habitat Model Uniform Preference Model Monetarist Model Overshooting Model completely flexible commodity prices sticky commodity prices Asset Model Approach perfect capital mobility The FlexiblePrice 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 FlexiblePrice Model * 1 1 1 % e e e t t t s π π + + + ∆ = * 1 % e t t t s i i + ∆ = 1 e t t t i r π + = + ExAnte PPP is implied by Absolute PPP UIP implies that: Combined with the Fisher equation, Gives Real Interest Parity * t t r r = The FlexiblePrice Model Further assume that money demand in each country is given by the liquidity preference theory. t t t t m p 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 The FlexiblePrice Model A similar money demand exists for the foreign country * * * * * * t t t t m p 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. The FlexiblePrice Model * t t t s p p = * t t t s p p = t t t t m p y i δ γ = The assumption of PPP implies: Combine the PPP relationship with the two money demands: * * * * * * t t t t m p y i δ γ =  The FlexiblePrice Model t t t t p m y i δ γ = + Rewrite the money demands as: * * * * * * t t t t p m y i δ γ = + The FlexiblePrice Model * * * * * * t t t t t t t t p p m m y y i i δ δ γ γ = + + Using PPP to combine the two money demands yields: * * * * * t t t t t t t s m m y y i i δ δ γ γ = + + or The FlexiblePrice Model We can simplify this equation further by assuming that the money demand elasticities are the same in both the foreign and domestic economies: ( 29 ( 29 ( 29 * * * t t t t t t t s m m y y i i δ γ = + * * and δ δ γ γ = = The FlexiblePrice Model ( 29 ( 29 * * 1 % e t t t t t t s m m y y s δ γ + = + ∆ ( 29 ( 29 ( 29 * * * t t t t t t t s...
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This note was uploaded on 07/16/2011 for the course ECON 5327 taught by Professor Staff during the Spring '08 term at UT Arlington.
 Spring '08
 Staff

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