Exchange Rate Economics: Theories and Evidence

96 The flexible price monetary approach
market equilibrium holds continuously in each country:
m d t = m s t = m t ,
m ∗,d
t
= m ∗,s
t = m ∗ t ,
then using these conditions in (4.2),and rearranging for relative prices,we obtain:
p t − pt ∗ = m t − mt ∗ − β 0 (y t − yt ∗ ) + β 1(i t − it ∗ ). (4.3)
On further assuming that PPP (or the LOOP) holds for the relative prices (see
Chapter 2) we obtain a base-line monetary equation as:
s t = m t − mt ∗ − β 0 (y t − yt ∗ ) + β 1(i t − it ∗ ). (4.4)
In words,the nominal exchange rate is driven by the relative excess supply of
money. Holding money demand variables constant,an increase in the domestic
money supply relative to its foreign counterpart produces an equiproportionate
depreciation of the currency. Changes in output levels or interest rates have their
effect on the exchange rate indirectly through their effect on the demand for money.
So,for example,an increase in domestic income relative to foreign income,ceteris
paribus,produces a currency appreciation,while an increase in the domestic interest
rate relative to the foreign rate generates a depreciation. Although some proponents
of the flex-price monetary model view equation (4.4) as holding continuously it
seems more appropriate to think of it as a long-run equilibrium relationship,where
the nominal interest rates,via the Fisher condition,capture expected inflation.
4.1.1 The forward-looking monetary relationship and
the magnification effect
One of the useful features of the monetary model is that it includes forward-looking
expectations and this introduces the possibility of excessive exchange rate movements
relative to fundamentals. This may be seen more clearly in the following
way. By noting from (4.1) that the expected change in the exchange rate is equal
to the interest differential in (4.4),we may rewrite (4.4) as:
s t = m t − m ∗ t − β 0 (y t − y ∗ t ) + β 1E t (s t+1 − s t ),(4.5)
which,in turn,may be rearranged for the current exchange rate as:
where:
s t = z t + θE t (s t+1 ),(4.5 ′ )
z t = (1 + β) −1 [m t − m ∗ t − β 0 (y t − y ∗ t )],