Exchange Rate Economics: Theories and Evidence

monies are:
The flexible price monetary approach 103
M = m 1 + m 2 ,(4.27)
M ∗ = m ∗ 1 + m∗ 2 ,(4.27′ )
where m 2 and m2 ∗ are,respectively,the foreign country holdings of domestic and
foreign money. These adding-up constraints,combined with the binding cash-inadvance
constraints,imply a unitary velocity of money in each country:
and
M t = P t y t (4.28)
M ∗
t
= P ∗
t y ∗ t (4.28 ′ )
using (4.28) in (4.26) we obtain:
S t M ∗
t
M t
y t
yt
∗
= u∗ c t
u ct
,(4.29)
and on rearranging this equation we may get an expression for the nominal
exchange rate as:
S t = u∗ c t
M t yt
∗
u ct Mt
∗ . (4.30)
y t
As in the flex-price monetary model,we see that the nominal exchange rate is here
determined by relative money supplies and output,but in contrast to the FLMA,
the exchange rate now depends on marginal utilities (preferences) and does not
explicitly depend on future expectations (although they could be brought in). As
Stockman (1980) notes,the fact that the exchange rate depends here on marginal
utilities can have an important bearing on understanding exchange rate behaviour,
particularly the behaviour of the real exchange rate. To illustrate this,we consider
an example from Stockman (1980).
In Figure 4.1 we have an initial equilibrium at point A. Some exogenous
shock then occurs which alters the home and foreign endowments to y 2 and y2 ∗,
respectively. Given nominal money supplies,the new price levels will be determined
by M /y 2 and M ∗ /y2 ∗ ,respectively. Suppose at the old nominal exchange
rate this results in a relative price P 2 /SP2
∗ given by ll in Figure 4.1. Clearly,
the highest indifference curve that can be reached at B is U. If the exchange
rate stayed unchanged the representative agent would attempt to move along
ll to a preferred position by buying less of the home good and more of the
foreign good. This process will result in the representative agent in the home
country increasing their demand for foreign exchange and those in the foreign
country decreasing their demand for foreign exchange. This process will
result in a change in export prices and the nominal exchange rate until the real