The flexible price monetary model

• Frenkel (1976)
• Mussa (1976)
• Bilson (1978)
• Assumptions:
• PPP holds continuously
• Prices are perfectly flexible
• UIP condition holds
• m = log of domestic money stock
• p = log of the domestic price level
• Y = log of domestic income
• r = log of domestic nominal interest rate
•  = income elasticity of the demand for real cash balances
•  = interest elasticity of the demand for real cash balances
• The demand for real cash balances is positively related to
the domestic income and inversely related to the domestic
nominal interest rate
•Foreign money demand
•Purchasing power parity holds
continuously
•S= P-P*
•S= log of the exchange rate in domestic
currency: £/$
•Foreign and domestic bonds are perfect
substitutes: UIP holds
• Es= expected rate of depreciation/
appreciation of the domestic currency
• Es is equal to the interest rate differential
between domestic and foreign bonds.
• Re- arranging and substituting:
• “reduced form” exchange rate equation
• Spot exchange rate is determined by the variables
on the right hand side.
• Effects of a change in any of the variables on S:
• A) Relative money supplies
• increase in domestic money supply (m-m*):
equivalent depreciation of the domestic currency
• Increase in foreign money supply: equivalent
appreciation of the currency
• B) Relative levels of national income:
• Rise in domestic national income (constant money stock and interest
rates): increase in transactions demand for money: prices fall and real
cash balances increase: appreciation of the domestic currency to
maintain PPP.
• C) Relative interest rates:
• Increase in domestic interest rate leads to a depreciation of the domestic
currency.
• Explanation:
• I) reduction in the demand for real balances
• II) increase in domestic price inflation expectations : decreased demand
for cash balances and increased demand for goods: rise in domestic
prices: depreciation of the domestic currency
• Nominal interest rate= real interest rate + expected rate of inflation
• Use of price inflation differentials instead of interest rate differentials
• Flexible price monetary model: assumes flexible prices and UIP
• What matters for the exchange rate determination is the relationship
between supply and demand for money
• Countries with high monetary growth will have high inflationary
expectations: reduction in the demand for real cash balances: increased
demand for goods: rise in domestic price level: depreciation of the
domestic currency to hold PPP.
• Model has been proven
The Dornbusch Sticky- Price
monetarist model
• PPP does not always hold (as the flexible price
monetarist model assumes)
• Rudiger Dornbusch (1976)
• Sticky Price model: goods and labour markets adapt
slowly in response to shocks such as changes in money
supply.
• PPP holds only on the long run, however foreign
exchange markets adapt quickly:
• Exchange rates appreciate and depreciate in response
to shocks
• Consequence: price movements don’t match PPP
• Dornbusch model assumptions:
• UIP holds continuously : perfect arbitrage of expected
returns in the capital markets
• Goods and labour prices (wages) adapt slowly: wages
are revised periodically and firms adjust prices slowly.
• Belief that long- run exchange rates will be determined
by PPP
• Economy is initially in equilibrium r1which equals
world interest rate
• No expected appreciation or depreciation of the currency
• M1= Domestic money stock
• P1= Domestic price level
• S1= exchange rate
• Foreign price level corresponds to PPP
• t1: M1 increases to M2
• LR: ΔM=ΔP=ΔS
• SR: Prices remain at P1
• Excess money supply: Lower interest rate
domestically than in the rest of the world
• 2 effects on S:
• a)ΔM: corresponds to long- run change in
S
• b)Δr: as r drops, capital flows out and S
depreciates in the short run (IS-LM)
• Consequence: Overshooting:
• exchange rate depreciates more than
• ΔM=ΔP=ΔS
• Depreciation of S:
• Increase in demand for domestic goods
• Output is fixed: Prices rise: increased demand for
money
• Interest rate drops:
• Increase in demand for goods: exchange rate
appreciates
• Over time: price level rises fromP1 to P and r
decreases due to an increase in money demand.
Exchange rate appreciates from S2 to Ŝ
Figure 7.2 The dynamics of the Dornbusch
overshooting model
The Frankel interest rate
differential model
• Dornbusch model: does not take into
account inflation expectations
• 1970’s: Inflationary scenarios
• Frankel (1979): model accommodates the
“flexible price” and “sticky price”
monetarist models as special cases.
The model
• Expected rate of depreciation of the
exchange rate is:
• 1. a positive function of the gap between
Ŝ: long run and S: spot exchange rate
• 2. a function of the expected long- run
inflation rate differential between the
domestic and foreign economies
• Θ= speed of adjustment to equilibrium
• P˚e= expected long- run domestic inflation rate
• P˚e*= expected long- run foreign inflation rate.
• The last equation states that in the short run:
exchange rate is given by S: is expected to
return to Ŝ at a rate θ
• LR: S=Ŝ: the expected rate of depreciation of
the currency is equal to the difference between
domestic and foreign inflation rates via the PPP
condition
• Equation results from combining last 2 equations
• The gap between the current exchange rate and
its long- run equilibrium value is proportional to
the real interest rate differential
• The real rate of interest of domestic bonds is
greater than the real rate of interest on foreign
bonds: there will be a depreciation of the
domestic currency until interest rates equalize in
a long- run steady- state.
• Long- run PPP:

• Long run: expected real interest rates are

equalized: interest rate differentials are explained
by differences in steady- state inflation rates

• Long- run steady- state equilibrium exchange

rate
• Long- run equilibrium exchange rate given
by: relative supply and relative demands of
the two national money stocks
• Last equation: long run exchange rate:
identical to the flexible price monetarist
model equation for the short run exchange
rate
• Frankel: sticky prices in the short run
• Frankel generalization of the Dornbusch model:
speed of adjustment of goods market: important
determining the short- run exchange rate

• Disequilibrium of the real interest rates:

exchange rate will deviate from its long- run
equilibrium value
• Domestic interest rate lower than foreign interest
rate: expected appreciation of the exchange
rate.
• Fully flexible monetarist school: markets clear
instantaneously: θ=∞
• Frankel model: goods and labour market prices
adjust slowly to shocks: θ<∞
• Rational expectations holds for foreign
exchange markets but not for domestic markets
• Unanticipated monetary expansion: fall in
domestic interest rate in respect to foreign
interest rate
• Price level: unchanged, but expected to
rise.
• Result: short run exchange rate
overshoots long- run equilibrium so that
there are expectations of future
appreciation to compensate for lower
return on domestic bonds
Implications of the monetary views
of exchange rate determination
• Monetary policy: the only predictable and
effective means of influencing the exchange rate
• Domestic an foreign bonds are perfect
substitutes
• LR: real interest rate is determined by real, not
monetary factors
• LR: authorities should not try to influence
interest rate
• LR: Authorities should focus on stabilizing price
level through exchange rate management
• Stability of nominal exchange rate through
stabilising prices will depend on:
• The stability of foreign price level
• The monetary policies of foreign countries
• Trying to stabilise the exchange rate
through monetary policy may involve
destabilising the domestic price level if the
foreign authorities are not pursuing stable
monetary policies