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84 CHAPTER 3. THE MONETARY MODEL0 < φ < 1 is the income elasticity of money demand, 0 < λ is theiidinterest semi-elasticity of money demand, and ² t ∼ (0, σ² 2 ).Assume that purchasing-power parity (PPP) and uncovered interestparity (UIP) hold. Since the exchange rate is Þxed, PPP implies thatthe price level p t =¯s + p ∗ t is determined by the exogenous foreign pricelevel. Because the Þx is perfectly credible, market participants expectno change in the exchange rate and UIP implies that the interest ratei t = i ∗ t is given by the exogenous foreign interest rate. Assume that themoney market is continuously in equilibrium by equating m d t in (3.2)to m t in (3.1) and rearranging to getθr t =¯s + p ∗ t + φy t − λi ∗ t − (1 − θ)d t + ² t . (3.3)(3.3) embodies the central insights of the monetary approach to thebalance of payments. If the home country experiences any one or acombination of the following: a high rate of income growth, declininginterest rates, or rising prices, the demand for nominal money balanceswill grow. If money demand growth is not satisÞed by an accommodatingincrease in domestic credit d t , the public will obtain theadditional money by running a balance of payments surplus and accumulatinginternational reserves. If, on the other hand, the central bankengages in excessive domestic credit expansion that exceeds money demandgrowth, the public will eliminate the excess supply of money byrunning a balance of payments deÞcit.We will meet this model again in chapters 10 and 11 in the study oftarget zones and balance of payments crises. In the remainder of thischapter, we develop the model as a theory of exchange rate determinationin a ßexible exchange rate environment.3.3 The Monetary Model under FlexibleExchange RatesThe monetary model of exchange rate determination consists of a pairof stable money demand functions, continuous stock equilibrium in themoney market, uncovered interest parity, and purchasing-power parity.