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Lecture_10_2007

# Lecture_10_2007 - The Monetary Models of Exchange Rate...

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The Monetary Models of Exchange Rate Determination The Flexible-Price Model The Sticky-Price Model The Portfolio Balance Model
Monetary Models

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Asset Models of the Spot Exchange Rate Portfolio-Balance 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 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 * 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 + = + Ex-Ante PPP is implied by Absolute PPP UIP implies that: Combined with the Fisher equation, Gives Real Interest Parity * t t r r =
The Flexible-Price 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

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The Flexible-Price 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 Flexible-Price 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 - = -

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The Flexible-Price Model t t t t p m y i δ γ = - + Re-write the money demands as: * * * * * * t t t t p m y i δ γ = - +
The Flexible-Price 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

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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: ( 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 Flexible-Price 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 m m y y i i δ γ = - - - + - This last equation represents the basic Flex-Price Model: Using the UIP relationship the Flex-Price model can be equivalently written as:

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