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Chapter 3The Monetary ModelThe monetary model is central to international macroeconomic analysisand is a recurrent theme in this book. The model identiÞes a set of underlyingeconomic fundamentals that determine the nominal exchangerate in the long run. The monetary model was originally developed asa framework to analyze balance of payments adjustments under Þxedexchange rates. After the breakdown of the Bretton Woods system themodel was modiÞed into a theory of nominal exchange rate determination.The monetary approach assumes that all prices are perfectly ßexibleand centers on conditions for stock equilibrium in the money market.Although it is an ad hoc model, we will see in chapters 4 and 9 thatmany predictions of the monetary model are implied by optimizingmodels both in ßexible price and in sticky price environments. Themonetary model also forms the basis for work on target zones (chapter10) and in the analysis of balance of payments crises (chapter 11).A note on notation: Throughout this chapter the level of a variablewill be denoted in upper case letters and the natural logarithm in lowercase. The only exception to this rule is that the level of the interestrate is always denoted in lower case. Thus i t is the nominal interestrate and in logs, s t is the nominal exchange rate in American terms,p t is the price level, y t is real income. Stars are used to denote foreigncountry variables.79