Handbook of Exchange Rates

13.2 Basic Monetary Model

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:

13.1

13.2

13.3

13.4

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 ...