Exchange Rate Economics: Theories and Evidence

The flexible price monetary approach 95
(see MacDonald 1988). Within the asset approach there are two competing classes
of models: the monetary approach and the portfolio-balance approach. In the former
class of models non-money assets – namely bonds – are assumed to be perfect
substitutes,while in the latter they are assumed imperfectly substitutable. As noted
earlier,the focus in this chapter is on monetary models; aspects of the portfoliobalance
model are discussed in Chapters 7 and 15. One key contribution of the asset
approach is that exchange rates are inherently forward looking – today’s price is
inextricably linked to the price in the next period,and so on. This forward-looking
aspect of exchange rates is brought out in our theoretical discussions of the models.
The outline of this chapter is as follows. In the next section we consider what
we refer to as the ad hoc flex-price monetary approach (FLMA),which explains
excessive exchange rate volatility in terms of a magnified response of the current
exchange rate to expected future excess money supplies. The approach is referred
to as ad hoc because it is derived on the basis of money market equilibrium conditions
rather than the optimising behaviour of agents. We also consider the implications
of rational speculative bubbles for exchange rate volatility using the FLMA.
In Section 4.3 we consider the Lucas–Stockman variant of the flexible price
monetary model. This version has at its core the optimising behaviour of agents
and offers another explanation for exchange rate volatility which is consistent
with rational behaviour.
4.1 The flex-price monetaryapproach
A popular variant of the monetary approach is the,so-called,flex-price monetary
approach (FLMA). This model is usually presented as a two-country,two money,
two bonds and a single homogenous traded good (alternatively,absolute PPP holds
continuously for identical baskets of goods). Crucially,bonds are assumed to be
perfect substitutes,and so uncovered interest rate parity holds continuously:
E t (s t+k ) = (i t − it ∗ ). (4.1)
The perfect substituability of home and foreign bonds means they may be lumped
together into a composite bond term and the wealth constraint effectively features
three assets,namely,domestic money,foreign money and the composite bond.
Since the bond market may be thought of as a residual, 1 attention then focuses on
money market equilibrium conditions. Money demand relationships are given by
standard Cagan-style log-linear relationships of the following form:
m D t − p t = β 0 y t − β 1 i t , β 0 , β 1 > 0,(4.2)
m D∗
t − p ∗ t = β 0 y ∗ t − β 1 i ∗ t ,(4.2′ )
where,for simplicity,the income elasticity,β 0 ,and the interest semi-elasticity,
β 1 ,are assumed equal across countries. If it is additionally assumed that money