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 *m*_{t} being the log-money supply, *p*_{t} the log-price level, *y*_{t} the log-output level, and *i*_{t} 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. ψ_{t} is the deviation from uncovered interest rate parity (UIP).

Substituting Equations (13.1)–(13.3) into Equation (13.4) we obtain a first-order difference equation with a familiar solution

13.5

where and λ = α/(1 + α).

With full information, expectations ...

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