Monetary Model of Exchange Rates

For Floating Exchange Rates

Assumptions:
1. AS curve is vertical. Therefore, the long run determinants only effect the output. Further, prices are flexible (another long run phenomenon).
2. Real money demand is a function simple function of real income only (Y). Md/P = kY. Therefore, the AD relation with money market equilibrium condition is given by: Ms = kPY
3. PPP holds (openness in goods market but since there is no mention of UIP so the financial market might not be open) i.e. P = SP*

So, basically, the objective is to discuss the long term effect under the floating exchange rate regime. From 1,2,3 the obtained equation is, S = Ms/(kP*Y).

Therefore, it can be observed that:
1. If the money supply rises, AD increases since agents have more money to spend. At older price level there exists excess demand. Therefore, prices rise until the supply-demand difference is eliminated. Increased prices make the home country's goods under-competitive at older exchange rates and put depreciationary pressure. Thus S rises or domestic currency depreciates.

2. If the real income rises, AS increases, which means there is a higher demand for money. Since the nominal money supply is fixed, so prices fall until the demand-supply gap vanishes. Lower prices, therefore, put appreciationary pressure on the exchange rates. Thus, S falls or domestic currency or domestic currency appreciates.

3. If the foreign price rises the home country's goods become over-competitive at older exchange rates. Thus, S falls or domestic currency depreciates.

The floating exchange rate acts as a valve, sliding up and down as required to preserve PPP in the face of disturbance originating either in the country's domestic money markets.

For Fixed Exchange Rates

Assumptions:

1. AS curve is vertical. Therefore, the long run determinants only effect the output. Further, prices are flexible (another long run phenomenon).

2. Real money demand is a function simple function of real income only (Y). Md/P = kY

Therefore, the AD relation with money market equilibrium condition is given by: Ms = kPY

3. PPP holds (openness in goods market but since there is no mention of UIP so the financial market might not be open) i.e. P = SP*

4. No checkable deposits or no banks in the economy. Therefore money multiplier, h = 1.

Central bank's balance sheet is given by:

In the presence of banks or checkable deposits money supply in the economy Ms = hH, where h is the money multiplier. However, if h=1 then Ms = h = F+D.

Under floating exchange rate regime the money supply was exogenous. However, under the fixed exchange rate regime, the exchange rate is exogenous which endogenises the money supply. Central banks adjust F (foreign reserves) to control the money supply in order to maintain it coherent with the exogenous variable like the exchange rate.

Therefore, it can be observed that:

1. If the money supply rises, AD rises. This increases prices in the domestic markets making them uncompetitive and puts depreciationary pressures on the domestic currency. The central bank reduces its foreign exchange reserves to buy domestic currency. Thus, the increase in D is offset by a decrease in F, keeping money supply constant with changed composition.

2. If the real income rises, there is an excess supply which puts downwards pressures on the domestic price level. Domestic markets become overcompetitive and put appreciationary pressures on the domestic currency. The central bank, therefore, increases its foreign exchange reserves and increases the money supply, which increases the AD to bring prices back to the old level.

3. If the foreign price level rises, domestic markets become overcompetitive at the given exchange rate and there is put appreciationary pressures on the domestic currency. The central bank, therefore, increases its foreign exchange reserves and increases the money supply, which increases the AD to increase prices such that the exchange rate peg is maintained