Real Adjustment and Exchange Rate Dynamics.pdf

Domestic and foreign interest bearing assets are

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Domestic and foreign interest-bearing assets are assumed to be perfect substitutes, so domestic and foreign nominal interest rates are linked by the uncovered interest rate parity (IRP) condition, i = i* + x, where x is the expected rate of change of the nominal exchange rate. We restrict our attention to equilibrium dynamic paths so we impose long-run perfect foresight on the model. With x equal to the actual change in the exchange rate, we write the IRP condition as: (20) / = i f + e. According to equation (20), the domestic interest rate can exceed the foreign interest rate only if there is a (fully anticipated) depreciation of the domestic currency to offset the nominal yield differential. Alterna- tively, depreciation of the domestic currency is only consistent with asset-market equilibrium if holders of domestic assets are compensated by a yield premium. The demand for domestic money balances in real terms depends on real income and the nominal interest rate, (21) m —p = ay - h~ l i. The domestic price index, p, is given by (22) p = pp s + ( l - p ) e , where (3 is the expenditure share of nontraded goods. 13. If TT rises in the long run, then, rather than overshooting, the short-run response is in the wrong direction.
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300 J. Peter Neary/Douglas D. Purvis 9.3.1 Monetary Equilibrium Using the definition of the real exchange rate (3), the price index can be rewritten asp e (BIT; using the definition of real income (2) the money market equilibrium condition becomes (23) m e = aQ v v - 8 This is depicted in figure 9.6 as the positively sloped locus MM drawn for given values of TT, V, and m; its upward slope reflects the fact that an increase in e creates an excess demand for money by reducing the supply of real balances, while an increase in / creates an excess supply by reducing demand. Above and to the left of MM there is excess supply of money balances; below and to the right there is excess demand. A resource boom shifts the MM curve left for given TT; but since IT itself adjusts in response to a resource boom, a full analysis of the effects on e is deferred. For simplicity, we abstract from domestic or foreign inflation so in long-run equilibrium the exchange rate must be constant. Imposing e - 0 Fig. 9.6 Monetary equilibrium and the nominal exchange rate.
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301 Real Adjustment in (20) and substituting into (23), we can solve for the long-run nominal exchange rate: (24) e*=m + b~ 1 i f +^'n*-aQ v v, where we also have set the real exchange rate at its long-run value. Note that for a given real exchange rate there is an additional force, -ct0 v (which we term the liquidity effect), working toward nominal apprecia- tion in response to a resource boom: the effect of the resource boom on real income increases the demand for money and hence tends to cause e to fall. Thus a long-run real appreciation in response to a resource boom is sufficient (but not necessary) to also ensure a nominal appreciation.
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