OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

The Monetary Approach:Flexible Exchange Rates

Alan G. Isaac

January 21, 2010

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Outline

Key Ingredients of the Monetary ApproachExogenous Real Exchange RatesThe Classical Model of Price Determination

The Crude Monetary Approach Model

Exchange Rates and Anticipated Monetary Policy

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Monetary Approach: Key Ingredients

I exogenous real exchange rate

Qdef=

SP∗

P=⇒ S = Q

P

P∗

I Classical model of PI stable money demand: L(i ,Y )I H/P = L(i ,Y ) continuouslyI exogenous: Y , r , and HI P (not i) clears money market

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Purchasing Power Parity

I exogenous real exchange rate

I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Purchasing Power Parity

I exogenous real exchange rate

I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Purchasing Power Parity

I exogenous real exchange rate

I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Purchasing Power Parity

I exogenous real exchange rate

I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Purchasing Power Parity

I exogenous real exchange rate

I invariant real exchange rateI obviously false?

I relevant P and P∗ not observable

I implication: exchange rate proportional to relative price level

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Classical Model: Basic Predictions

I ↑ H =⇒I ↑ P proportionatelyI H/P unchanged

I ↑ i =⇒I ↓ LI ↑ P

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Classical Model: Basic Predictions

I ↑ H =⇒I ↑ P proportionatelyI H/P unchanged

I ↑ i =⇒I ↓ LI ↑ P

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Classical Model: Basic Predictions

I ↑ H =⇒I ↑ P proportionatelyI H/P unchanged

I ↑ i =⇒I ↓ LI ↑ P

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Exogenous Real Exchange RatesThe Classical Model of Price Determination

Classical Model: Basic Predictions

I ↑ H =⇒I ↑ P proportionatelyI H/P unchanged

I ↑ i =⇒I ↓ LI ↑ P

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Crude Monetary Approach

P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Crude Monetary Approach

P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Crude Monetary Approach

P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Crude Monetary Approach

P =H

L(i ,Y )

P∗ =H∗

L∗(i∗,Y ∗)

P

P∗ =H/H∗

L(i ,Y )/L∗(i∗,Y ∗)

S = QH/H∗

L(i ,Y )/L∗(i∗,Y ∗)

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Core Predictions

1% Increase In: H H∗ Y Y ∗ i i∗

Resulting ∆S : 1% -1% – + + –

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Money, Prices, and Exchange Rates

1

10

100

1000

10000

100000

1e+006

1e+007

1e+008

1e+009

01/90 01/91 01/92 01/93 01/94 01/95 01/96

Mon

ey, P

rice

s, a

nd E

xcha

nge

Rat

es: 0

1/90

= 1

Exchange RateCPI

Currency

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Early Studies

Estimated Response of the Spot Rate to:Study: Sample: H H∗ Y Y∗ i i∗

DEM/GBP

Frenkel (1976) 1921.02–1923.08 0.975 – – – 0.591 ←Bilson (1978b) 1972.01–1976.04 1.0013 -1.0081 -1.0184 0.9990 0.0228 ←Bilson (1978a) 1970.04–1977.05 1.0026 -0.9846 -0.9009 1.0183 1.3853 ←

USD/DEM

Hodrick (1978) 1973.04–1975.09 1.52 -1.39 -2.23 0.073 2.53 1.93GBP/USD

P&W (1979) 1972–1977 0.63 ← -0.77 ← 0.14 ←Note: The reported “responses” are money supply elasticities, income elasticities, and opportunity-cost semi-elasticities of the spot rate. Opportunity costs of holding money are proxied by interest rates or forward discounts. Adash indicates an omitted variable. A left arrow indicates that the domestic and foreign money demand parametersare constrained to equality.

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

MAFER with Forward Discount

L(i ,Y )/L(i∗,Y ∗) = L(i − i∗,Y ,Y ∗)

S = QH/H∗

L(i − i∗,Y ,Y ∗)

fd = i − i∗

S = QH/H∗

L(fd ,Y ,Y ∗)

Used by Frenkel (1976).

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Unanticipated ↑ H

tt0

H

0 tt0

P,S

0 tt0

H/P

0

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Unanticipated ↑ H

tt0

H

0 tt00

P,S

tt0

H/P

0

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Anticipated ↑ H

tt0ta

H

0 tt0ta

P,S

0 tt0ta

HP

0

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Anticipated ↑ H

tt0ta

H

0 tt0ta

P,S

0 tt0ta

H/P

0

Alan G. Isaac Monetary Approach

OutlineKey Ingredients of the Monetary Approach

The Crude Monetary Approach ModelExchange Rates and Anticipated Monetary Policy

References

Bilson, John F. O. (1978a, March). “The Monetary Approach toThe Exchange Rate—Some Empirical Evidence.” InternationalMonetary Fund Staff Papers 25, 48–75.

Bilson, John F. O. (1978b). “Rational Expectations and theExchange Rate.” See Frenkel and Johnson (1978), Chapter 5,pp. 75–96.

Frenkel, Jacob A. (1976, May). “A Monetary Approach to theExchange Rate: Doctrinal Aspects and Empricial Evidence.”Scandinavian Journal of Economics 78(2), 200–224. Reprintedin Frenkel and Johnson (1978).

Frenkel, Jacob A. and Harry G. Johnson, eds. (1978). TheEconomics of Exchange Rates: Selected Studies. Reading, MA:Addison-Wesley.

Alan G. Isaac Monetary Approach