The Monetary Approach: Flexible Exchange Rates · Outline Key Ingredients of the Monetary Approach The Crude Monetary Approach Model Exchange Rates and Anticipated Monetary Policy

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

The Monetary Approach:Flexible Exchange Rates

Alan G. Isaac

January 21, 2010

Alan G. Isaac Monetary Approach



References

Outline

Key Ingredients of the Monetary ApproachExogenous Real Exchange RatesThe Classical Model of Price Determination

The Crude Monetary Approach Model

Exchange Rates and Anticipated Monetary Policy




References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market




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Qdef=

SP∗

P=⇒ S = Q

P

P∗





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Qdef=

SP∗

P=⇒ S = Q

P

P∗





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Qdef=

SP∗

P=⇒ S = Q

P

P∗





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Qdef=

SP∗

P=⇒ S = Q

P

P∗





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Qdef=

SP∗

P=⇒ S = Q

P

P∗





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Purchasing Power Parity


I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level




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Classical Model: Basic Predictions

I ↑ H =⇒I ↑ P proportionatelyI H/P unchanged

I ↑ i =⇒I ↓ LI ↑ P




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I ↑ i =⇒I ↓ LI ↑ P




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I ↑ i =⇒I ↓ LI ↑ P




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I ↑ i =⇒I ↓ LI ↑ P




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Crude Monetary Approach

P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)




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P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)




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P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)




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P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)




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Core Predictions

1% Increase In: H H∗ Y Y ∗ i i∗

Resulting ∆S : 1% -1% – + + –




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Money, Prices, and Exchange Rates

1

10

100

1000

10000

100000

1e+006

1e+007

1e+008

1e+009

01/90 01/91 01/92 01/93 01/94 01/95 01/96

Mon

ey, P

rice

s, a

nd E

xcha

nge

Rat

es: 0

1/90

= 1

Exchange RateCPI

Currency




References

Early Studies

Estimated Response of the Spot Rate to:Study: Sample: H H∗ Y Y∗ i i∗

DEM/GBP

Frenkel (1976) 1921.02–1923.08 0.975 – – – 0.591 ←Bilson (1978b) 1972.01–1976.04 1.0013 -1.0081 -1.0184 0.9990 0.0228 ←Bilson (1978a) 1970.04–1977.05 1.0026 -0.9846 -0.9009 1.0183 1.3853 ←

USD/DEM

Hodrick (1978) 1973.04–1975.09 1.52 -1.39 -2.23 0.073 2.53 1.93GBP/USD

P&W (1979) 1972–1977 0.63 ← -0.77 ← 0.14 ←Note: The reported “responses” are money supply elasticities, income elasticities, and opportunity-cost semi-elasticities of the spot rate. Opportunity costs of holding money are proxied by interest rates or forward discounts. Adash indicates an omitted variable. A left arrow indicates that the domestic and foreign money demand parametersare constrained to equality.




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MAFER with Forward Discount

L(i ,Y )/L(i∗,Y ∗) = L(i − i∗,Y ,Y ∗)

S = QH/H∗

L(i − i∗,Y ,Y ∗)

fd = i − i∗

S = QH/H∗

L(fd ,Y ,Y ∗)

Used by Frenkel (1976).




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Unanticipated ↑ H

tt0

H

0 tt0

P,S

0 tt0

H/P

0




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Unanticipated ↑ H

tt0

H

0 tt00

P,S

tt0

H/P

0




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Anticipated ↑ H

tt0ta

H

0 tt0ta

P,S

0 tt0ta

HP

0




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Anticipated ↑ H

tt0ta

H

0 tt0ta

P,S

0 tt0ta

H/P

0




References

Bilson, John F. O. (1978a, March). “The Monetary Approach toThe Exchange Rate—Some Empirical Evidence.” InternationalMonetary Fund Staff Papers 25, 48–75.

Bilson, John F. O. (1978b). “Rational Expectations and theExchange Rate.” See Frenkel and Johnson (1978), Chapter 5,pp. 75–96.

Frenkel, Jacob A. (1976, May). “A Monetary Approach to theExchange Rate: Doctrinal Aspects and Empricial Evidence.”Scandinavian Journal of Economics 78(2), 200–224. Reprintedin Frenkel and Johnson (1978).

Frenkel, Jacob A. and Harry G. Johnson, eds. (1978). TheEconomics of Exchange Rates: Selected Studies. Reading, MA:Addison-Wesley.


Documents

The Monetary Approach: Flexible Exchange Rates · Outline Key Ingredients of the Monetary Approach The Crude Monetary Approach Model Exchange Rates and Anticipated Monetary Policy