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The Monetary Model; An Economic Model of Exchange Rates

Developed in the 1970’s - monetary approach to exchange rate determination is an outgrowth of PPP and quantity of money theory and best distinguished as a long-run model of exchange rate behaviour. The model also makes close work of the Fisher effect, distinguishing the relationship between inflation and interest rates in the long run. INTERPRETING THE MONETARY APPROACH The approach was established by 1) PPP, and 2) Quantity theory of money and combining these two theories results in the fundemantal equation of the monetary approach

Where R = the nominal interest rate, Y = real income and L(R,Y) is the demand for real money balances (increases when interest rates drop).









This states the monetary fundamentals that determine the long-run values of nominal exchange rates. Main Assumption of the Model

  • Aggregate supply curve is fixed vertical meaning that prices are fully flexible, however output can still vary as a result of capital accumulation and labour force changes

  • The assumption is that real money balances depend only on real money income. At equilibrium Md = Ms =KY where K is a parameter that implies a relation of proportionality. This states, money demand is equal to supply which is equal to Income * said parameter

  • The law of one price always holds in the absence of transport costs; however, in the monetary model, LOP appears in the form of PPP (Purchasing Power Parity) and IRP (Interest Rate Parity) where cross border interest rate and price movements are linked to the foreign exchange market. However, the monetary model does not directly link changes in exchange rates to traditional price indices as prices adjust slower in the short run.

MAIN PREDICTIONS OF THE MODEL The monetary approach proceeds as if prices can adjust instantly, maintaining full employment as well as PPP. Money supply Ceteris parabus, a rise in money supply would cause an increase in long run price level as determined quantity theory => however the exchange rate also rises in the long run as a result of increasing money supply (for example, US money supply increases by 10%, price in the US and the $/€ exchange rate would also rise by 10%) So an increase in money supply ultimately causes a proportional depreciation in the dollar. Therefore R,Y are unaffected by increasing money supply. Interest Rates A positive shock to domestic money growth – quantity theory implies expected inflation will increase instantly, and rising dollar interest rates lowers real money demand in the US. The long run price level rises and under PPP the dollar must depreciate proportionately to the increase in prices. The Fisher effect implies that the US nominal interest rate will adjust to the higher inflation rate. But prices and exchange rate adjust instantly as the increase in interest rates decreases the demand for real balances so for equilibrium to remain, prices jump;









Output Levels A rise in US output Y raises real US money demand leading to fall in long run US price level. R remains unchanged. This would cause an appreciation of the dollar. A rise in real US output raises transaction demand for US money – according to the monetary approach the US price level drop immediately for the market to clear. Further, PPP states that price deflation in the US is accompanies by instant appreciation in the dollar. The monetary model is similar in many ways to the Dornbusch overshooting model; however, the key difference is the manner in which exchange rate react to shocks; also, the Dornbusch model considers adjustment phases unlike the monetary model which analyses instant shocks only.

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