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Chapter 4The Lucas ModelThe present-value interpretation of the monetary model underscores theideathatweshouldexpecttheexchangeratetobehavelikethepricesof other assets–such as stocks and bonds. This is one of that model’sattractive features. One of its unattractive features is that the modelis ad hoc in the sense that the money demand functions upon whichit rests were not shown to arise explicitly from decisions of optimizingagents. Lucas’s [95] neoclassical model of exchange rate determinationgives a rigorous theoretical framework for pricing foreign exchange andother assets in a ßexible price environment and is not subject to thiscriticism. It is a dynamic general equilibrium model of an endowmenteconomy with complete markets where the fundamental determinantsoftheexchangeratearethesameasthoseinthemonetarymodel.The economic environment for dynamic general equilibrium analysisneeds to be speciÞed in some detail. To make this task manageable,we will begin by modeling the real part of the economy that operatesunder a barter system. We will obtain a solution for the real exchangerate and real stock-pricing formulae. This perfect-markets real generalequilibrium model is sometimes referred to as an Arrow [3]—Debreu [34]model because it can be mapped into their static general equilibriumframework. We know that the Arrow—Debreu competitive equilibriumyields a Pareto Optimum. Why is this connection useful? Because ittells us that we can understand the behavior of the market economy bysolving for the social optimum and it is typically more straightforwardto obtain the social optimum than to directly solve for the market105