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Volume :27 Issue : 4 1999      Add To Cart                                                                    Download

The Monetary Approach to Flexible Exchange Rates

Auther : Adnan Abbas Ali

Two models of the the monetary approach, which emphasize the rule of money in determining flexible exchange rates, are presented. Equilibrium for the first model involves clear mony markets and parity of purchasing power. The effect of monetary expansion forms when a rise in the money supply results in a long term price increase of the same proportion. A change of this sort affects the equilibrium exchange rate which, because of flexible prices, always is the current exchange rate. The short run response to Dornbuschs model to a monetary shock results in an overshooting of the long run equilibrium exchange rate. For example, if domestic authorities increase the money supply, purchasing power parity requires that in the long run the domestic price level must rise and the exchange rate must depreciate in the same proportion as the money supply increases. Prices, however, are fixed in the short run, allowing the real money supply to increase so that the domestic nominal interest rate must fall to restore money market equilibrium. For open interest rate parity to hold, a fall in the domestic interest rate, given the foreign interest rate, requires an overshooting of the new (higher) long run equilibrium exchange rate such that subsequent expected appreciation just matches the nominal interest rate differential.

Key words: Monetay approach, Exchange rate, Nominal exchange rate, Equilibrium in money market, Equilibrium in asset market. Mundell-Fleming- model, Over shooting- model, Purchasing Power Parity, Nominal interest rate, Elasticity Model, Quantity theory model, Quantity theory of money, Hyperinflation, Stock equilibrium, Flow equilibrium.

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