Exchange Rate Economics: Theories and Evidence

The sticky-price monetary model 119
announcements about their money supply intentions in order to affect agents’
expectations. For example,this was one of the main objectives of the monetary
targeting regimes of central banks such as the Bundesbank and Bank of England
in the 1980s: conditional on the credibility of the policy,the announcement of
a future monetary contradiction could,it was argued,modify wage bargainers’
price expectations,making a disinflation policy less painful. In practice,
such targeting was,of course,concerned with reducing monetary growth rates
(as have been the monetary targets adopted by other central banks). Although
we shall discuss the effect of an anticipated reduction in monetary growth in
a version of the SPMA in Section 5.2.3,it will,nonetheless,be useful to analyse
the effect of an anticipated once-for-all decrease in the money supply at this
stage.
Consider,again,the version of the SPMA model as portrayed by Figure 5.8 with
steady-state equilibrium initially at A. The monetary authorities then announce
in period t 0 that they will reduce the money supply in period t 1 . What effect does
this have if the new steady-state equilibrium is at C? Agents in period t 0 ,although
governed by the initial steady-state equilibrium,will,nevertheless,be expecting an
exchange rate appreciation. Thus when the money supply announcement is made
the exchange rate jumps and appreciates to a point such as X (notice that the ṡ = 0
schedule only moves when the money supply is actually decreased). The exchange
rate must appreciate immediately after the monetary announcement,otherwise
there will be potentially large capital gains to be made. Point X is chosen so that
s and p follow their dynamic trajectories and will be on SP 2 when the actual
money supply decrease takes place. Thus from X the initial exchange rate appreciation
will,through equation (5.14),lead to a reduction in aggregate demand
and a falling price level. The latter effect will increase real money balances,
and reduce the rate of interest which,for UIP,requires an expected appreciation
of the currency. Hence between t 0 and t 1 the economy moves from
X to Y in terms of Figure 5.8,and is then on the new stable saddle path
when the change in the money supply is actually implemented. The economy
thereafter moves along the saddle path SP 2 as in the case of the unanticipated
policy.
An anticipated monetary shock therefore has important implications in terms
of this simple model. Hence even before a reduction in the money supply takes
place,aggregate demand falls short of its full employment level,resulting in an
economic contraction and presumably unemployment. (For a further discussion of
anticipated monetary policy in small rational expectations models see Blanchard,
1981,1984,for the closed economy; Gray and Turnovsky 1979; Wilson 1979;
Blanchard and Dornbusch 1984,for the open economy.)
5.2.2 Aresource discovery and the SPMAmodel
In this section we utilise the SPMA model to analyse the effects of a resource
discovery on a small open economy. For example,this analysis was originally
designed to be suggestive of the effects of an oil discovery for countries such as