1. Introduction 2. Flow models of exchange rate determination

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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).
Page 1 and 2: Monetarist Models of Exchange Rate
Page 3 and 4: e no longer the long-term equilibri
Page 5 and 6: m* - p* = ηηηηy* - σσσσr*
Page 7 and 8: Es = θθθθ(! - s) ....(10) where
Page 9: There follows a gradual adjustment

1. Introduction 2. Flow models of exchange rate determination

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