Exchange Rate Economics: Theories and Evidence

128 The sticky-price monetary model
reduced monetary growth rate increases,as we have seen,agents’ demand for real
money balances,but with the level of the money supply given the only way the
real money supply can increase is via a fall in p. The latter,due to the specification
of the price adjustment equation,cannot happen instantly: p falls because d < y.
Clearly,one way to circumvent this would be to increase the level of the money
supply in tandem with the decrease in the growth of the money supply. This is
illustrated in Figure 5.13 where ¯q is the level of competitiveness consistent with
equilibrium before and after the change in the money supply and SP 2 is the stable
path associated with the new equilibrium at B. As we have seen,a reduction in
m moves the system from A to X in the short-run period,the economy gradually
adjusting to B over time. If,however,the authorities simultaneously increase the
level of the money supply by the correct amount (i.e. to l 2 ) the system would move
immediately to B (i.e. a level only increase puts the system to Y). Buiter and Miller
(1981b) argue that the UK authorities’ decision not to claw back the sterling M3
overshoot in the second half of 1980 amounted to the type of joint policy illustrated
in Figure 5.13 and this prevented the economy from suffering further deflation.
5.3 A stochastic version of the
Mundell–Fleming–Dornbusch model
In this section we present a stochastic version of the Mundell–Fleming–Dornbusch
model. This model is based on Obstfeld (1985) and Clarida and Gali (1994) and
since most of the relationships are familiar from previous chapters,our discussion
here will be relatively brief. The open economy IS equation in the model is given by:
y d ′
t = d ′
t + η(s t − p ′ t ) − σ(i′ t − E t(p ′ t+1 − p′ t )),(5.40)
where a prime denotes a relative (home minus foreign) magnitude. The expression
indicates that the demand for output is increasing in the real exchange rate and
a demand shock (which captures,say,fiscal shocks) and decreasing in the real
interest rate. The LM equation is familiar from our previous discussions
m s′
t − p ′ t = y ′ t − λi′ t ,(5.41)
where the income elasticity has been set equal to one. The price-setting equation
is taken from Flood (1981) and Mussa (1982) and is given as:
p ′ t = (1 − θ)E t−1 p e′
t + θp e′
t . (5.42)
Expression (5.42) states that the price level in period t is an average of the marketclearing
price expected in t − 1 to prevail in t,and the price that would actually
clear the output market in period t. With θ = 1 prices are fully flexible and output
is supply-determined while with θ = 0,prices are fixed and predetermined one
period in advance. The final equation in this model is the standard UIP condition:
i ′ t = E t (s t+1 − s t ). (5.43)