Exchange Rate Economics: Theories and Evidence

5 The sticky-price monetary
model
In this chapter we consider a number of sticky-price variants of the monetary model.
Our discussion starts,in Section 5.1,with the classic Mundell–Fleming model in
which prices are rigidly fixed and therefore this model may be viewed as the polar
opposite to the flex-price monetary model. In Section 5.2 we go on to discuss the
Dornbusch (1976) extension of the Mundell–Fleming model,which we label the
sticky-price monetary approach (SPMA). This latter model offers an explanation
for excess exchange rate volatility in terms of the assymetrical adjustment of goods
and asset markets. In Section 5.3 we consider a stochastic version of the Mundell–
Fleming–Dornbusch model. Much as in the previous chapter,the variants of
the monetary model mentioned here are all ad hoc,relying primarily on money
market equilibrium conditions rather than on the optimising behaviour of agents.
In Section 5.4 we therefore consider the sticky-price analogue to the Lucas model
introduced in the previous chapter.
5.1 The Mundell–Fleming model
In this section we examine a model which has had a fundamental influence on
international monetary economics,particularly the branch dealing with floating
exchange rates: namely,the Mundell–Fleming (MF) model (the original references
to this model are: Fleming (1962); Mundell (1963,1968); Sohmen (1967);
more recent references are: MacDonald (1988); Obstfeld and Rogoff (1996); Mark
(2000)). The basic focal point of the MF model is a small open economy with
unemployed resources,a perfectly elastic aggregate supply curve,static exchange
rate expectations and perfect capital mobility. Given such assumptions it can be
demonstrated that with flexible exchange rates monetary policy is extremely powerful
in altering real output but fiscal policy is completely impotent. The inefficacy
of fiscal policy under floating exchange rates has been one of the most enduring
results in international economics,although it is of course crucially contingent on
the underlying assumptions of the basic model.
Indeed,the base-line MF has come in for some considerable criticism because
it is relatively ad hoc and,for example,it is essentially static in nature,both in
terms of its failure to model expectations and also because dynamic interactions
stemming from current account imbalances are not addressed. Despite this,the