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3.3. THE MONETARY MODEL UNDER FLEXIBLE EXCHANGE RATES85Under ßexible exchange rates, the money stock is exogenous. Equilibriumin the domestic and foreign money markets are given bym t − p t = φy t − λi t , (3.4)m ∗ t − p∗ t = φyt ∗ − λi∗ t , (3.5)where 0 < φ < 1 is the income elasticity of money demand, and λ > 0is the interest rate semi-elasticity of money demand. Money demandparameters are identical across countries.International capital market equilibrium is given by uncovered interestparityi t − i ∗ t =E ts t+1 − s t , (3.6)where E t s t+1 ≡ E(s t+1 |I t ) is the expectation of the exchange rate atdate t+1 conditioned on all public information I t , available to economic ⇐(61)agents at date t.Price levels and the exchange rate are related through purchasingpowerparitys t = p t − p ∗ t . (3.7)To simplify the notation, callf t ≡ (m t − m ∗ t ) − φ(y t − y ∗ t )the economic fundamentals. Now substitute (3.4), (3.5), and (3.6) into(3.7) to gets t = f t + λ(E t s t+1 − s t ), (3.8)and solving for s t giveswheres t = γf t + ψE t s t+1 , (3.9)γ ≡ 1/(1 + λ),ψ ≡ λγ = λ/(1 + λ).(3.9) is the basic Þrst-order stochastic difference equation of the monetarymodel and serves the same function as an ‘Euler equation’ inoptimizing models. It says that expectations of future values of the