The simplest dynamic model of exchange rate determination is the monetary model. We examine the impact of incomplete information within a two-country version of this standard framework. The model is described by the following four equations:
Equation (13.1) is a standard money market equilibrium equation, with mt being the log-money supply, pt the log-price level, yt the log-output level, and it the interest rate. Equation (13.2) is the analogous equation for the Foreign country.1 Equation (13.3) is a purchasing power parity equation and Equation (13.4) is an interest rate parity equation. ψt is the deviation from uncovered interest rate parity (UIP).
where and λ = α/(1 + α).
With full information, expectations ...