1. Introduction 2. Flow models of exchange rate determination

Monetarist Models of Exchange Rate Determination
1. Introduction
Fundamentalist models, referred to by Södersten and Reed as economic models, are simply
models which attempt to explain exchange rates and changes in them from economic theory.
Such a model may assume that the exchange rate is determined largely by a country's current
account performance. Models of this kind are often referred to as flow models. They assume
that the demand for foreign currencies is derived from the domestic demand for the goods and
services produced by other countries and that the supply of foreign currency reflects foreign
demand for domestically-produced goods and services.
We have looked at a special model of this kind - Purchasing Power Parity. This, you'll
remember, assumes perfect goods arbitrage and thus the only basis for choosing between home
and foreign goods and services is the respective prices of the goods when expressed in a
common currency. Consequently, exchange rates should reflect the different price levels
(absolute PPP) or the different rates of inflation (relative PPP) in different countries.
More complex flow models may contain separate equations for exports and imports, which
are taken to explain the demand for and supply of foreign currency. PPP will commonly be
found as an important element in these models, although they may also include variables such
as differences among countries in the rate of productivity increase, and the relative rates of
growth of domestic and world income.
Pilbeam (p. 159) points out an obvious problem with this type of model: they have nothing
to say about international capital movements, although we know that international capital
movements are very large and dominate the foreign currency market. This inadequacy in flow
models led to the development of fundamentalist models that stressed the role of the capital
account of the balance of payments (often known as stock models or asset models of exchange
rate determination). As we shall see, asset models are likely to regard relative interest rates,
relative rates of growth of money supplies or exchange rate expectations as fundamentals.
2. Flow models of exchange rate determination
As mentioned above, flow models derive from the view that exchange rates should reflect the
current account conditions of the balance of payments i.e. the international competitiveness of
countries. In such models, capital is assumed to be internationally immobile. In other words,
countries whose goods are in strong international demand should have strong currencies and
vice versa. There are clearly two elements to this.
(a) Real exchange rates should be determined by underlying real competitiveness
Thus, we may talk of structural factors such as the changing position of demand and supply
curves of goods in different countries caused by changing tastes, different or changing income
elasticities of demand, changing costs of production, differing speeds of technological change
or resource discoveries (e.g. North Sea oil) i.e. real factors. These might be expected to change
only slowly over time, leading real exchange rates to be stable, rather than volatile and we
should be able to predict fairly accurately the direction and size of exchange rate changes.
(b) Given real exchange rates, nominal rates of exchange should be determined by relative
price levels or rates of inflation (PPP)
Nominal exchange rates should adjust to reflect differential inflation rates and to keep real
exchange rates constant. A high rate of inflation should lead to a current account deficit, which
in turn should cause the exchange rate to fall. However, as we know from the monetary model
of the balance of payments, the essential cause of inflation in this view is the government's
acting to cause the country's money supply to grow too rapidly relative to the rate of growth of
the demand for money. That is, the cause is failed government intervention. It follows that if
governments were to keep money supplies growing in line with the demand for money, we
should have no problem. We should be back to (a), with nominal exchange rates also stable.
There would be no uncertainty and no interference with international trade.

The simplest model eliminates (b) above by assuming fixed prices. For such a model to
produce a stable exchange rate, the Marshall-Lerner condition must be satisfied, so that a
current balance deficit will be corrected by the consequent fall in the value of the domestic
currency. However, as we have seen, the Marshall-Lerner condition is unlikely to be satisfied
in the short run - a depreciation of a currency is likely to make the current account worse before
it gets better (the J-curve).
2.1 Flow Models and the J-Curve
The J-curve arises because the effect of a change in exchange rate on the current account
consists of two elements:
(i) the relative prices of home and foreign goods are altered - the fall in the exchange rate means
that firms now pay more for imports in terms of domestic currency than previously (or receive
less foreign currency for exports); and
(ii) the relative price changes lead to quantity changes i.e. an increased foreign demand for
exports and a reduced home demand for imports.
(i) by itself plainly makes the current account worse. It is only when quantity effects begin
to appear that (assuming favourable elasticities) the current account may begin to improve. The
problem is that the impact of (i) is immediate, while quantity changes may take 18 months or
longer to occur. This is due to lack of information, consumer inertia and the fact that some
consumers will be locked into contracts that prevent them switching rapidly from one source of
supply to another.
Let us translate this into the foreign exchange market. Assume that we begin with current
account balance but that then there is a fall in demand for the home country's exports. This
leads to a fall in demand for the home currency (a fall in the supply of foreign currency). In
Fig. 1, the supply of foreign currency shifts up from S1 to S2. The new equilibrium exchange
rate will be at B (the value of the home currency has fallen sufficiently to bring the current
account of the balance of payments back into equilibrium). In practice, however, the price
effect occurs on its own: the fall in the value of the home currency requires foreigners to pay
less foreign currency for the same quantity of imports as before. The supply of foreign
currency falls further than is needed to restore current account balance (the supply curve shifts
to S3, producing a temporary exchange rate of C. As soon as the quantity effects begin to
appear, there will be pressures in the opposite direction. However, this could take a
considerable time to occur and the exchange rate could, in the short run, overshoot its long-run
equilibrium position by a long way.
Exchange
Rate (units of S3 S2 S1
home currency C
per unit of B
foreign currency) A
O
Fig. 1
foreign currency
It is also possible that once the quantity effects begin to dominate and the exchange rate
falls again from C, it will move beyond B. The exchange rate should, within an overall stable
model, eventually settle at B, but there might be considerable volatility around that rate.
Further, before we settle at B, there may have been other long-term changes which cause B to

e no longer the long-term equilibrium exchange rate and the whole process will begin again.
We might never, then, settle at a long-term equilibrium rate.
This provides the simplest exchange rate overshooting model. Note that it is based upon
two things occurring at different speeds: the price effect and the quantity effect. We shall return
to this idea of different speeds of response later.
2.2 Overcoming the J-Curve Problem
The easiest way out of this dilemma is to introduce the capital account of the balance of
payments and allow for capital mobility, but to make particular assumptions regarding the
capital market: that speculators within it are well-informed and act to smooth out excess
demands and supplies of currencies, thus keeping exchange rates stable.
The central support for this assumption comes from the proposition that speculators are
only operating in the market to make a profit and will only stay in the market if they are doing
so. To make a profit, they must guess correctly the longer-term direction of the market so that
they can buy cheap and sell dear. This will cut off the lows and highs of exchange rate
fluctuations and ensure a stable market. Consider Fig. 1 once more. We again commence at A
and again there is an autonomous fall in the demand for home goods.
Speculators know (guess correctly) that the long-run equilibrium rate is B. Thus, as soon as
the rate rises above B, they see that a profit is to be made from buying the home currency now
and selling it later, once the exchange rate has again fallen. The very act of speculators in
buying the home currency now will strengthen it in the market and prevent the exchange rate
from rising to C. Thus it is held that, in a free market, speculators will act to ensure the stability
of exchange rates.
Naturally, there are several objections to this rosy picture. Firstly, there is the possibility of
capital movements from other sources - tourists, central banks, traders who take open positions
in positions in foreign exchange. These may lose. Crucial to the argument is the nature of
expectations held within the market.
If some people hold extrapolative expectations, then, as the value of the home currency
falls, people will sell it and make things worse rather than better. However, this makes things
better for the well-informed speculators who can still act to reduce market fluctuations.
The second objection relates to the depth of the market. The optimistic view of speculation
implies that the market is very deep and thus that individual speculators can have no impact on
prices. It is this which requires them to act with the grain of the market in order to make a
profit. Is this true?
Suppose that there are some very large speculators operating within a thin market.
Imagine, moreover, that other market participants hold extrapolative expectations. Now,
imagine that, as the exchange rate begins to rise, the speculators move into the market in a big
way, selling the home currency, forcing the exchange rate up still further. Other participants
see the value of the home currency falling sharply and they too begin to sell. The exchange rate
rises even beyond C. Speculators then buy back in and take their profit. In this example,
speculators destabilize the market, causing the exchange rate to fluctuate by more than it would
otherwise have done.
A different route of attack on stabilizing speculation is to reject the notion of speculators
being well-informed and knowing the long-run equilibrium rate. Again, once capital
movements are allowed into the model, we can have autonomous capital movements and the
medium-term equilibrium in which the deficit on current account of the balance of payments is
matched by a surplus on capital account (or vice-versa) will not necessarily be determined by
current account changes. This makes it much more difficult for operators to know the longterm
equilibrium rate.
The notion of different levels of equilibrium over different time periods has been
formalized in the classification of exchange rate theories in terms of four periods:
A. very short period: exchange rates mainly determined by capital flows;
B. short period: overall equilibrium in the balance of payments but the capital account and the
current account may both be out of balance;

C. long period: both capital account and current account in equilibrium;
D. very long period: Purchasing Power Parity.
3. Monetary Models of Exchange Rate Determination
Models that concentrate on the capital account of the balance of payments are commonly
known as stock models. These may, in turn, be divided into monetary models and asset (or
portfolio) models. We look at monetary models here and consider asset models in the next
section of the course.
Monetary models develop from the Monetary Approach to the Balance of Payments
(MAB). The exchange rate is seen as a relative asset price. The present value of an asset is
thought to be largely influenced by its expected rate of return. As we have already seen, this
provides the basis of uncovered interest rate parity (UIP). It would be useful at this point to
compare Pilbeam's version of UIP with that presented to you earlier in the course (see notes on
the forward exchange market).
Pilbeam's definition (page 161) is that UIP holds when 'the expected rate of depreciation of
the pound-dollar exchange rate is equal to the interest rate differential between UK and US
bonds'. Thus, if 'the expected rate of depreciation of the pound was 10 per cent, then according
to UIP the UK rate of interest would have to be 10 per cent higher than the US interest rate to
ensure the equalization of expected yields on UK and US bonds' (page 161). For further
explanation see Box 7.1 and Figure 7.1 on page 163 of Pilbeam.
You should note that for UIP to hold continuously, the following assumptions are required:
• capital must be perfectly mobile;
• investors must regard home and foreign bonds as equally risky (or must be risk neutral)
In other words, domestic and foreign bonds must be perfect substitutes. Monetary models of
exchange rate determination make this assumption.
Thus, we can say that in monetary models, economic agents are assumed to be indifferent
as to the proportions of domestic and foreign assets - their only concern is that they yield the
same return. The models assume (a) competitive markets; (b) negligible transactions costs; and
(c) exchange rate expectations held with certainty (or risk-neutral investors). All models thus
assume UIP. Further, they all assume that the key determinants of exchange rates are the
supply of and demand for money.
Pilbeam deals with three monetary models: a flexible-price model, a sticky price model and
a real interest-rate differential model.
3.1 The Flexible-Price Monetary Model
This model assumes that all prices in the economy are perfectly flexible, both upwards and
downwards, even in the short run. Thus, PPP holds continuously and money markets clear
continuously. There is a conventional demand for money function and thus,
MSs = MDd = kpy ηηηη r -σσσσ
....(1)
That is, the demand for money is stably and positively related to real income (py) and
negatively related to the rate of interest.
or, as Pilbeam writes it,
m - p = ηηηηy - σσσσr …. (2)
where m is the log of the domestic money stock, p is the log of the domestic price level, y is the
log of domestic real income and r is the rate of interest. The same relationship is assumed to
hold abroad and thus:

m* - p* = ηηηηy* - σσσσr* …. (3)
Since PPP is assumed to hold, we can write:
s = p - p* ....(4)
UIP holds continuously and thus,
Es = r - r* ....(5)
(the expected rate of depreciation of the home currency equals the difference between the
domestic and foreign interest rates).
Re-arranging and substituting (see Pilbeam for details), gives:
s = (m - m*) - ηηηη(y - y*) + σσσσ(r - r*) ....(6)
That is, the rate of exchange is determined by the supply of money and the stock demand for
money function at home and abroad. Ceteris paribus, the home currency appreciates (s falls):
(a) if the domestic level of income rises relative to the foreign level of income;
Thus, economic growth causes appreciation. This is seemingly in conflict with the standard
Keynesian IS/LM/BP model in which an increase in domestic income causes imports to rise,
worsening the balance of payments and producing a depreciation of the currency. In the
monetary model, the money supply is assumed to be exogenous and thus an increase in
domestic income causes the demand for money to increase. The only way in which money
market equilibrium can be restored is through a fall in prices and, with PPP, the currency
appreciates.
(b) if interest rates fall relative to foreign interest rates;
A fall in interest rates leads to an increase in the demand for money and this (with the
money stock given), requiring a fall in the transactions demand for money to maintain money
market equilibrium. Again, with everything else assumed exogenous, this can only happen if
prices fall and (with PPP) the currency appreciates. Pilbeam develops the reverse argument - an
increase in the domestic interest rate causes the domestic currency to depreciate (s to rise). This
also seems perverse until you look closely at the assumptions of the model. As well as using
the argument I have employed here, Pilbeam (pages 166 and 167) by using the definition of the
nominal interest rate as the real interest rate plus the rate of inflation and assuming (as we did in
our discussion of the Fisher effect) that the real interest rate is constant and identical in all
countries. It follows that an increase in domestic interest rates implies an increase in
inflationary expectations and this causes consumers to reduce their demand for money and
increase their expenditure. Prices, then, do rise in line with expectations and the currency
depreciates to maintain PPP. Hence, Pilbeam provides an alternative version of the monetary
model equation (eqn. 7.9, p. 167) in which expected rates of inflation replace interest rates.
(c) if the domestic money supply increases less rapidly than the foreign money supply.
The underlying mechanism of the monetary model is that the exchange rate adjusts to
maintain the law of one price in the presence of different domestic and world rates of inflation
(caused by different monetary growth rates). As in the monetary balance of payments models,

the inflation rate and the exchange rate cannot be controlled simultaneously by the authorities if
foreign prices are varying.
The problem is that, as we have seen, there is evidence of substantial deviations from the
law of one price since 1973. Consequently, it is hardly surprising (as Pilbeam notes) that the
flexible price monetary model does not perform well in tests.
3.2 Sticky-Price Monetarist Models
We have already provided (through the J-curve) one possible reason for exchange rates to
overshoot long-run equilibrium rates. Overshooting has been explained in several other models
which continue to assume the existence of long-run equilibrium rates of exchange and
incorporate both UIP and PPP. These models also typically assume rational expectations and
so market participants are assumed to make the best available use of all relevant information
and to employ the best available model for forecasting future exchange rates. Therefore, they
are assumed to know what the long-run equilibrium exchange rate is. Despite this, exchange
rates are held to overshoot their long-run equilibrium positions. That is, when the exchange rate
is above its equilibrium it will fall well below the equilibrium rate before once again rising
towards equilibrium. Equally, a rising exchange rate will rise above the equilibrium rate before
falling towards it. This result is achieved by assuming that different elements in the model
adjust at different speeds, as in the case of the J-curve. The best known such model was
developed by the American economist, Dornbusch.
3.2.1 Dornbusch's overshooting model
In a well-known article in 1976, Dornbusch assumed all the usual conditions of a monetary
model, including an exogenous money supply and, in the long run, PPP. Expectations are
assumed to be regressive i.e. it is assumed that any movement away from equilibrium will
immediately be reversed.
Overshooting results in the model from the assumption that the goods and labour markets
are slow to adjust (that is, prices in the goods market and wages in the labour market are sticky)
whereas the asset market adjusts immediately. Exchange rates are determined in the asset
market and, thus, exchange rate changes are not matched, in the short run, by price changes.
That is, we depart from PPP in the short run, although not (as noted above) in the long run.
You should next read Pilbeam's simple explanation of the Dornbusch model (Section 7.7,
pages 167-70). Next, we consider the model more formally.
Formally, the exchange rate in the model is driven by:
(a) uncovered interest parity (UIP)
Es = r - r* ....(7)
(b) the demand for real money balances being a stable function of real income and interest rate
m - p = ηηηηy - σσσσr …. (8)
(c) the long-run exchange rate being determined by PPP:
! = p - p* ....(9)
but the short-run exchange rate being determined by
(d) regressive exchange rate expectations:

Es = θθθθ(! - s) ....(10)
where ! is the equilibrium or long-run exchange rate and θ > 0.
That is, in each period the expected change in the exchange rate is given by a fraction (θ) of
the difference between its current value and the long-run equilibrium value.
Thus, the model has four endogenous variables:
• domestic interest rate;
• the expected change in the exchange rate; and
• the current value of the exchange rate
• the price level.
.
There are four exogenous variables:
• the foreign interest rate;
• the long-run equilibrium exchange rate;
• real income; and
• the stock of money.
Substitution of equations gives:
m - p = ηηηηy - σσσσr + ηηηησσσσ(! -s) ....(11)
allowing us to solve for s.
Alternatively, we could solve equation (8) for r; then solve (7) for Es and (10) for s.
The diagrammatic solution of the model gives a relationship between the exchange rate and
the price level with the asset market always in equilibrium as in Fig. 2, in which equilibrium is
at N, with p e and s e . Note that the exchange rate is here expressed in direct terms. That is, as
we move along the horizontal axis s increases but this means that the value of the home
currency falls (one has to pay more home currency for one unit of foreign currency).
Price
Level A
p e
X
N
O s e
Figure 2
A
PPP
X
S

In this diagram, AA represents asset market equilibrium. Why does it slope down to the
right? There are 3 steps in the argument:
1. If p is low, the real value of the exogenous money supply will be high; thus for equilibrium,
the demand for money must also be high. However, if p is low and y is constant at its full
employment level, the demand for money will only be high if the domestic interest rate is low.
Thus, in equilibrium if p is low, r must also be low (p and r positively related).
2. If r is low, then to satisfy UIP and persuade investors to hold domestic bonds, they must
expect a future appreciation of the exchange rate. That is, given r*, if r is low, Es must be high
and positive.
3. But, with regressive expectations, people will expect an appreciation of the domestic
currency (a fall in s) only if the value of the currency is now below its long-run equilibrium
level (i.e. if s is above its long-run equilibrium level). Thus, if r is low, s must be high (r and s
negatively related).
Therefore, for asset market equilibrium, a low p will be associated with a relatively high s
(and vice versa) (p and s negatively related). That is, if interest rates on domestic bonds fall,
currency will flow out to buy foreign currency bonds; if the exchange rate is fixed, this flow
will continue until people come to expect a sufficient appreciation of the currency to balance
the interest rate differential.
XX represents equilibrium in the goods market. This slopes up because an increase in p
will lead to a fall in domestic demand. There are two reasons for this:
(i) an increase in p causes the real exchange rate to fall (competitiveness declines). To restore
competitiveness, the value of the domestic currency must fall (s must rise). Thus, a high p is
associated with a high s. If this were the only effect, the goods market would clear along a ray
from the origin indicating PPP. But:
(ii) an increase in p causes the real value of the exogenous money supply to fall. Domestic
interest rates will rise causing aggregate demand to fall. Thus, for the goods market to clear, s
need not rise by as much as is suggested by the change in the real exchange rate. Hence, XX is
flatter than the PPP line through the origin.
Note that below XX there is excess demand for goods and prices will be rising. Above XX
there is excess supply of goods and prices will be falling. We assume that the asset market is
always in equilibrium (i.e. we are always on AA). Thus, if we are at M1, there will be an excess
demand for goods and prices will rise slowly. We shall move along AA towards N (in fig. 2).
As prices increase, aggregate demand falls and s falls (the domestic currency appreciates),
compensating investors for low domestic interest rates caused by the high real money balances.
Assume now a once and for all increase in the supply of money. The AA curve shifts out
to A 1 A 1 . There will be no permanent effect on the current account of the balance of payments
and PPP will hold at the new equilibrium at N 1 (X 1 X 1 shifts up). Investors (holding rational
expectations) realize this. The movement to long-run equilibrium takes place in two stages.
We start at N. The unexpected increase in the money supply pushes up XX and the market
knows that the new equilibrium will be at N 1 with an exchange rate of s e1 i.e. the market knows
the domestic currency will depreciate.
But because domestic prices are slow to rise, the initial effect is to increase real money
balances and lower domestic interest rates, causing people to sell domestic currency, pushing
the exchange rate instantaneously to s2. At s2, investors can see the prospect of a sufficient
exchange rate appreciation to compensate for the lower interest rate on domestic bonds and the
currency depreciation ceases.

There follows a gradual adjustment to the new equilibrium exchange rate, s e1 , as prices
increase in the goods market. Therefore, we have overshooting of the exchange rate even with
rational expectations. If we dropped this assumption and assumed that the market did not know
the long-run equilibrium position, they would try to infer the truth from what others were doing
and there would be much wilder movements in s.
Price
Level A
p e
X
N
N 1
O s e s e1 s 2
Figure 3
The Dornbusch model can be used to show that there will be no overshooting with fiscal
policy. As is to be expected, the Dornbusch model does have its problems. These include:
(a) It is very short run and doesn't allow for any adjustment to wealth.
(b) The assumptions of infinite speed of adjustment of asset markets, risk-neutral investors and
perfect substitutability of domestic and foreign bills are unrealistic.
Many other similar models have been developed, distinguishing for example between the
speeds of adjustment of the prices of tradeable and non-tradeable goods or of volumes and
prices of exports and imports (known in the balance of payments literature as the J-curve). The
central feature of all of these models is that they retain most of the assumptions of the standard
economic approach to forex markets while attempting to produce results that are closer to the
apparent reality of volatile exchange rates. Thus, they can be grouped as part of the
fundamentalist approach to forecasting exchange rates.
3.2.2 Overshooting in Australian Two-Sector (dependent economy) models
In equilibrium, MSs = p.MDd where p is a geometrically weighted average of the domestic
prices of traded and non-traded goods. The price of traded goods is given by world prices and
the exchange rate. The demand for real balances is a function of output and interest rates. In
the short run, output, the interest rate and the price of non-traded goods are all fixed since the
adjustment of output and the price level take time and since interest rates are determined in the
world capital market independently of domestic forces.
Thus, the only variable which can adjust immediately is the exchange rate. When the
exchange rate adjusts, the price of traded goods changes proportionately but since the price of
non-traded goods is fixed in the short run, the domestic price level, p, adjusts less than
proportionately. Now, assume an increase in the money supply leading to an excess money
supply in the domestic economy. To maintain equilibrium, depreciation of the currency must
be sufficiently large to increase p in the same proportion as the increase in MSs since the
demand for real balances is fixed in the short run. To achieve this, the exchange rate must
change more than proportionately to the money supply. The long run equilibrium position of
A
PPP
X
S

the exchange rate is given by the percentage change in the money supply, but in the short run
the exchange rate overshoots.
The initial large depreciation causes a shift of demand to domestic goods and output
increases, the demand for real balances rises and the exchange rate is able to rise back towards
its long-run equilibrium value. Eventually, the price of non-traded goods is pushed up and also
rises in proportion to the increase in the money stock. The movement of the exchange rate will,
however, be smoothed out to the extent that world asset holders anticipate the overshooting.
This will cause a forward premium to arise on the domestic currency. Interest parity in turn
will require a temporary fall in domestic interest rates and the demand for real balances will
increase for this reason, in advance of the increase in output.
3.3 The Real Interest-Rate Differential Model
Pilbeam completes this chapter by presenting a model that seeks to combine the inflationary
expectations element of the flexible price model with the sticky price element of the
Dornbusch model. The version used is taken from Frankel (1979). I shan't repeat this
model here since you can find it on page 178-80 of Pilbeam. You will see that it continues
to assume stable demand for money functions and UIP and long-run PPP. As in Dornbusch,
the expected rate of depreciation of the domestic currency is positively related to the
difference between the current exchange rate and the equilibrium exchange rate, but here it is
also a function of the expected long-run inflation differential between the domestic and
foreign economies. That is:
Es = θθθθ(! - s) + P" - P" * …(12)
As Pilbeam then shows, the model produces different results for the long-run equilibrium
exchange rate and the short-run exchange rate. The long-run equilibrium exchange rate is
determined by the relative supplies of and demands for money in the two countries just as in
the flexible monetary model.
The gap between the current exchange rate and its long-run equilibrium value is now
proportional to the real interest rate differential between the two countries. As Pilbeam says
(page 179), if the expected real rate of interest on foreign bonds is greater than the expected
real rate of interest on domestic bonds, there will be a real depreciation of the domestic
currency until the long-run equilibrium exchange rate is reached. When this occurs, real
interest rates will be the same in the two countries and any difference in nominal interest rates
must be the result of differences in inflation rates.
You might well ask at this stage how this is related to the flexible price model with which
we started this section on monetary models. Well, to see this, we need to return to Equation 6
above (equation 7.8, page 165 in Pilbeam):
s = (m - m*) - ηηηη(y - y*) + σσσσ(r - r*) ....(6)
Consider the final term. If we assume that real interest rates are the same everywhere (the
Fisher effect), nominal interest rates differ only because of differences in expected rates of
inflation and Equation 6 becomes:
s = (m - m*) - ηηηη(y - y*) + σσσσ(P" - P"* ) ....(13)
This is exactly the same as the equation for the long-run equilibrium exchange rate in the
Frankel model (eqn. 7.30 on page 179) in Pilbeam. Thus, all the Frankel model does is to take
the equilibrium position of the flexible price model and add in a short-run adjustment to that
equilibrium in the form of a Dornbusch sticky-price mechanism. As in Dornbusch, an

unanticipated monetary expansion in the home economy causes the exchange rate to overshoot
its long-run equilibrium level.
3.4 Policy implications of monetary models
In a flexible price monetary model, money is neutral. That is, monetary policy has no effect
on real variables. A domestic monetary expansion will push the nominal exchange rate up
(the domestic currency weakens) to maintain PPP, but the real exchange rate is unchanged.
This is the same as in the Monetary Approach to the Balance of Payments (MAB) with
flexible exchange rates, in which countries maintain control of domestic inflation rates but
have no control of exchange rates.
Sticky-price models restore power to monetary authorities to influence real variables in
the short run but not in the long run. How important this is in practice depends on the length
of time taken for prices and the nominal exchange rate to move to their long-run equilibrium
positions. Keynesians could argue that expansionary monetary policy could obtain
worthwhile reductions in unemployment. If the sticky-price model was then combined with a
labour market model with hysteresis, these 'short-run' employment gains could become longrun
gains.
Sticky-price models can also provide a justification for a gradual approach to monetary
policy. For example, assume the monetary authorities wish to reduce the rate of inflation. If
they reduce the rate of growth of the money supply sharply and interest rates rise, but prices
do not change in the short run, the nominal and real exchange rates fall sharply (overshooting
the long-run equilibrium level), causing problems for exporters and import-competing
industries. Unemployment results. If prices were slow to change, these real problems would
persist for a considerable time. The position would be worse if the short-run overvaluation of
the currency caused bankruptcies of domestic firms and serious loss of market share in
important industries. The 'short-run' cost of reducing inflation could be high. This leads to
the view that monetary policy should be applied gradually to allow the economy to adjust
slowly over time.
Pilbeam raises another policy point. Let us tell a standard story of sterilization. Suppose
the monetary authorities of a country seek to lower the value of the currency in order to
improve the competitiveness of an industry and tries to overcome the consequent inflation by
sterilization. That is, they buy foreign bonds with domestic currency, increasing the supply
of the domestic currency to fall and improving the current account of the balance of
payments. However, this increases the country's holding of foreign exchange reserves and
the money supply rises, creating inflationary pressure. The inflation then removes the
competitive advantage obtained from the higher exchange rate of the domestic currency. The
monetary authorities seek to counter this by selling domestic bonds to reduce the domestic
component of the money stock. That is, the monetary authorities seek 'an exchange of
domestic for foreign bonds that leaves the supply of money in relation to the demand for it
unaffected' (Pilbeam, p. 181). Consider this in terms of the equation we used in explaining
the MAB earlier in the course:
Ms = D + R …(14)
The authorities are attempting to increase R and reduce D so that the money supply does not
change, but the exchange rate does. However, this type of operation is not possible within the
framework of a monetary model of exchange rate determination because domestic and
foreign bonds are perfect substitutes for each other. Changes in D and R have equivalent
effects on the exchange rate. This is just another way of saying that in a monetary model, the
monetary authorities cannot influence the real exchange rate (except in the short-run, in
sticky price models).

References
R. Dornbusch (1976), 'Expectations and exchange rate dynamics', Journal of Political
Economy, Vol. 84, pp. 1161-76
J.A. Frankel (1979), 'On the Mark: a theory of floating exchange rates based on real interest rate
differentials', American Economic Review, vol. 69, pp.610-22
K. Pilbeam (1998, 2 nd edition), International Finance, Basingstoke: Macmillan