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5 Flexible prices: the monetary

model

Introduction
5.1 The simple monetary model of a floating exchange rate
5.2 The simple monetary model of a fixed exchange rate
5.3 Interest rates in the monetary model
5.4 The monetary model as an explanation of the facts
5.5 Conclusions
Summary
Reading guide

Introduction
There are a number of reasons why we choose to look at the monetary model first.
For one thing, it was the earliest approach to explaining the related phenomena of
exchange rate variations, on the one hand, and the balance of payments, on the
other. It also had a brief renaissance in the early 1970s. More importantly, it rep-
resents an obvious benchmark for comparing the other approaches to modelling
exchange rate determination, many of which themselves grew out of the monetary
model. Finally, while it is completely inadequate in explaining the wild day-to-day,
month-to-month gyrations seen in recent years, it nonetheless provides some useful
insights into the broader picture of long-run trends.
What we now call the monetary model is rooted in an approach to the balance of
payments that dates back at least as far as the work of David Hume in 1741. It will
be seen to consist of two basic building blocks: the purchasing power parity rela-
tionship, familiar from Chapter 2, and the demand for money, which was covered in
Chapter 4.
In the first section, these two relationships will be incorporated in a particularly
simple version of the aggregate demand and supply model, which will then be used
in succeeding sections to analyse the effect of increases in the money supply, income
and foreign prices on a floating exchange rate. In Section 5.2, we examine the implica-
tions of the same disturbances for the balance of payments under a fixed exchange
rate regime. Section 5.2.4 analyses the effect of devaluation. Section 5.3 looks at the
role played by interest rates. The final section provides a brief survey of the evidence
for and (mostly) against the monetary model.
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146 Chapter 5 · Flexible prices: the monetary model

5.1 The simple monetary model of a floating exchange rate

We start by setting the scene. The model to be set out in this section is very much a
simplification, but it will suffice nonetheless to generate the conclusions typical of
international monetarism.

5.1.1 Setting

The monetary model rests essentially on three assumptions: a vertical aggregate sup-
ply curve, a stable demand for money and purchasing power parity (PPP). We shall
examine these assumptions in that order.

Assumption 5.1. The aggregate supply curve is vertical.

Two points should be remembered in this regard from Chapter 4. First, this
does not imply that output is constant – simply that it can only vary as the result
of a change in the productivity of the economy, broadly defined, that is through
technical progress, the accumulation of capital, growth in the labour force or its
educational level and so on.
Second, a vertical supply curve presupposes perfect price flexibility in all markets.

Assumption 5.2. The demand for real money balances is a stable function of only
a few domestic macroeconomic variables. In fact, for the moment and until fur-
ther notice, we shall work with the Cambridge quantity equation (Equation 4.7):
M d = kPy k>0
where y is real national income and k is a positive parameter.

This particular formulation simplifies matters considerably. Consider what it

implies for the aggregate demand schedule. Given a money stock, M 0s , equilibrium
means we have:
M 0s = kPy = kY (5.1)
It follows that nominal income, Y, must be constant along the aggregate demand
curve, since it is drawn for a given value of the money stock.
Look at Figure 5.1. The nominal national income Y = Py associated with any
point on the curve labelled AD0(M 0s ) is simply the area of the rectangle between it
and the axes, for example OP0 Ay0 at A and OP2 Dy1 at D. If these areas are to be
equal it must follow that, as we move from A to D, the fall in the price level is of the
same proportion as the rise in income.1
More important for present purposes, consider the effect of an increase in the
nominal money stock. As we saw in Chapter 4 this change shifts the aggregate
demand curve upward and to the right. By how much, in the present case? Compare
points A and B. Obviously, P1 must be greater than P0 by the same proportion as M 1s
is greater than M 0s .
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5.1 The simple monetary model of a floating exchange rate 147

Figure 5.1 Aggregate demand with the quantity equation

For example, if the change in question is a doubling of the money stock, the out-
come has to be a doubling of nominal demand. At any given real income, y0, that
implies a doubling of the price level.

Assumption 5.3. Purchasing power parity (PPP) obtains at all times.

Remember from Chapter 2 (Equation 2.4) that the PPP hypothesis stated
that, given a domestic (UK) price level of P, and a foreign (US) price level of P*,
equilibrium would be obtained when the two price levels stood in the following
relationship:
SP* = P
so that nothing could be gained by shipping goods from one country to the other.
Remember also that this is equivalent to stating that the purchasing power of each
country’s currency must be the same whether spent on the domestic market or con-
verted into foreign currency and spent abroad.
Now consider Figure 5.2(a), where the vertical axis plots the domestic price level
and the horizontal plots the sterling price of US dollars. The line drawn out from the
origin is the locus of all combinations of S and P that satisfy Equation 2.4 – call it
the PPP line. Plainly, it has a gradient equal to P*. Points above and to the left of the
line are ones where the UK economy is uncompetitive (the domestic price level is
too high), so that it is worth importing goods from the USA in place of relatively
expensive UK products. The opposite is true below the line.
In terms of the real exchange rate (look back at the definition in Section 2.4, if
necessary), above the PPP line a real depreciation is required to restore equilibrium
and, below it, the opposite is true.
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148 Chapter 5 · Flexible prices: the monetary model

Figure 5.2 Money supply increase under floating rates

5.1.2 Equilibrium
In Figure 5.2(b), the aggregate demand and supply curves are plotted for given
values of the money stock and output capacity. With an initial money supply of M 0s ,
P0 is the ‘closed economy’ equilibrium price level, that is, the one consistent with
conditions in the domestic economy.
In fact, P0 is still the equilibrium price level, even in this open economy model.
Furthermore, its value is determined without any reference to conditions in the exter-
nal sector of the economy.
However, in the external sector, PPP requires that a price level of P0 be associated
with an exchange rate of S0. A lower value of S would leave domestic output uncom-
petitive on world markets and hence result in an excess supply of the home currency
and vice versa at a higher level of S.
We can see the nature of equilibrium formally by combining Equations 2.4 and 5.1
to give:
M 0s = kPy = kSP*y (5.2)
so that we can solve for S as:
M0s
S= (5.3)
kP*y
So the exchange rate in this ultra-simple model is the ratio of the money stock to
the demand, measured at the foreign price level. Whatever serves to raise that ratio,
in other words to increase the numerator or decrease the denominator, will cause the
price of foreign exchange to rise (the domestic currency to depreciate).
Now consider the effect on this equilibrium of three types of disturbance: a mon-
etary expansion and a rise in real income respectively in the domestic economy and
an increase in the world price level.
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5.1 The simple monetary model of a floating exchange rate 149

5.1.3 Money supply increase under floating exchange rates

Start with an expansion of the money stock to a new level, M 1s . Assume the other
exogenous variables (real income, y, and the foreign price level, P*) are unchanged.
At the old price level, P0, there is clearly an excess supply of money, which will
cause economic agents to increase spending so as to reduce their money balances.
(Recall that the quantity theory is based on the assumption that the only way for
agents to reduce their money balances is by buying goods and services.) The coun-
terpart of the excess supply of money is therefore an excess demand for goods, as
measured by the distance ( y d1 − y0 ) in Figure 5.2(b).
Given our assumption of a fixed real income and output, the extra spending must
drive up prices (hence the arrows between points c and b, and points A and B). As
the price of goods rises, the price of dollars must increase (the pound depreciate) in
order to keep domestic output competitive, in other words, to prevent a flood of
relatively cheap US output into the UK economy in response to the real exchange
rate appreciation.
It is easy to see how great a depreciation is required to restore equilibrium. With
domestic prices higher in proportion to the monetary expansion and the US price
level unchanged, preservation of PPP implies an increase of the same proportion in
the price of dollars.
We have reached the first important conclusion in our analysis of the monetary
model:

Proposition 5.1. In the monetary model, a given percentage increase in the

domestic money supply leads, other things being equal, to a depreciation of the
same proportion in the value of the domestic currency.

Box 5.1 Proof of proposition 5.1

Formally rewrite Equation 5.1, taking logs of both sides, then differentiate, to
give:
dM dP dy
− =
M P y
remembering that, for any variable X, d (log X ) = dX/X. Since we are assuming
that y is constant for present purposes, the right-hand side is zero. Hence, the
domestic price level has to change in proportion to the money stock.
Now treat the PPP equation in the same way, to give:
dS dP* dP
+ =
S P* P
Since P* is assumed constant, this says that the exchange rate must depreciate in
proportion to the rise in UK prices.
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150 Chapter 5 · Flexible prices: the monetary model

Figure 5.3 Income increase under floating rates

5.1.4 Income increase under floating exchange rates

Now consider the effect of an increase in real income, from y0 to y1, with no change
in the money stock (Figure 5.3).
At any price level, higher real income implies a greater demand for money. Put dif-
ferently, with a given money supply we must have constant nominal income, Py. So,
the higher real income, the lower must be the price level.
Since nominal income has jumped to P0 y1 (at point c in Figure 5.3(b) ), the impact
effect must be to create an excess demand for money and an excess supply of goods
equal to the gap (y1 − y0) at the original price level, P0. As we have already seen, real
balances can only be replenished by reducing spending.
The result must be deflation, bringing the price level down from P0 to P1. In the
new equilibrium, at b, both money and goods markets clear, with the same demand
and supply as before the income increase and with the same nominal income.
In the open sector of the economy, however, the exchange rate must have fallen
(that is, the pound appreciated) from S0 to S1. Otherwise, the fall in domestic prices
(depreciation in the real exchange rate) would have made the UK overcompetitive,
causing a massive excess demand for sterling (as would have been the case at G, for
example). PPP is preserved by appreciation, so that the fall in the price of UK out-
put is offset by a rise in the price of sterling relative to the dollar.
We conclude then as follows:

Proposition 5.2. In the monetary model, a rise in domestic real income leads, other
things being equal, to an appreciation of the home currency.

Notice that we associate an increase in real income with an appreciation of the

currency. This conclusion flatly contradicts the wisdom of the DIY model that, as
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5.1 The simple monetary model of a floating exchange rate 151

income rises, the domestic economy tends to suck in imports, causing a depreciation
in a floating exchange rate.
The reason we have the opposite result here is that the monetary model concen-
trates on the impact of an income increase on the demand for money, rather than
goods. Since it swells the demand for money, it must cause a contraction in the
demand for goods, which in turn must lead to a fall in the domestic price level.

5.1.5 Foreign price increase under floating exchange rates

An important feature of the model is its conclusion regarding the effect of a change
in the remaining exogenous variable, P*, the foreign price level.
Concentrate on the PPP line in Figure 5.4(a). How will it change when P*
increases? Since its gradient is P/S = P*, it will become steeper, so that the original
UK price level P0 is associated with a lower price of US dollars, in other words, a
higher exchange rate for the pound.
The reason for this result should by now be obvious. With higher US prices, UK
goods are overcompetitive at the old exchange rate. The demand for sterling by
potential US importers of cheaper UK goods is overwhelming and drives the
pound’s value up until US competitiveness is restored.
In the new equilibrium, the fact that US output is higher priced in dollar terms
than previously is offset by the higher relative price of the UK currency. We conclude:

Proposition 5.3. In the monetary model, a rise in the foreign price level, other
things being equal, is associated with an appreciation of the domestic currency
(that is, a fall in the price of foreign exchange, S ) and no other change in the
domestic economy.

Figure 5.4 Foreign price increase under floating rates

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152 Chapter 5 · Flexible prices: the monetary model

From the point of view of macroeconomic policy, this proposition is highly

significant. It suggests that world inflation need have no impact on the domestic
economy. The UK price level is determined in UK money markets in exactly the
same way it would be if the rest of the world never existed. The floating exchange rate
acts like a valve, continually sliding up or down as required to preserve PPP in the
face of disturbances originating in either country’s (or both countries’) domestic
money markets.
The implication is that the sovereignty of each country’s macroeconomic policy is
preserved by exchange rate flexibility. Each can independently choose its inflation
rate2 without regard to the actions of the other. If national independence is to be
regarded as a desirable feature of an international monetary order, the floating
exchange rate system appears highly attractive on the basis of the analysis in this
section.
Notice that, in arriving at Proposition 5.3, we had no need to consult Figure 5.4(b).
Does that mean the money markets are irrelevant to the outcome?
There are two reasons why the money markets are certainly not irrelevant. First,
it is the fact that money market equilibrium is unaffected by the change in US prices
that keeps the domestic price level fixed at its initial level P0 and forces the burden of
adjustment on to the exchange rate.
Second, ask yourself the following question: what can have caused the US price
level to rise?

5.1.6 Two-country model of a floating exchange rate

The obvious answer to the previous question is: something which has caused an
excess supply to appear in the US money market, for example an increase in the US
money stock or a fall in US income. In fact, if you think about it for a moment, the
way the US price level is determined is likely to be the same as the way the UK price
level is determined, that is to say, in the local US money market.
Look back at our analysis of the effect of a monetary expansion in the domestic
economy (see Section 5.1.3). Why should we not apply the same argument to the
USA as was applied to the UK?
An increase in US money supply would cause an excess supply in local money
markets, causing Americans to spend more, other things being equal, so as to reduce
their balances. The outcome of their attempt to spend more would ultimately be to
drive up their own price level, P*, thereby causing the dollar to depreciate in order
to prevent the US being flooded with what would otherwise be cheaper imports.
We can formalize this symmetrical model by writing the US version of our quant-
ity equation (Equation 4.7) as follows:

M d* = k*P*y* (5.4)

which simply says the US demand for money, M d*, is proportional to US nominal
income, P*y*. Notice the factor of proportionality is k*, to allow for the possibility
that the US demand for money may be quantitatively different from that of the UK,
even though it is qualitatively similar (that is, of the same functional form).
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5.1 The simple monetary model of a floating exchange rate 153

Now assume that, just as UK money stock is initially M 0s , US money supply starts
off at M s0*. Divide the UK demand for money equation (Equation 4.7) by Equation
5.4 and set the respective demands for money equal to supply in each country, to give:
M0s kPy
= (5.5)
M0s* k *P*y*
Since, under PPP, we have P/P* = S, it follows that we can rewrite Equation 5.5
as:
M0s kSy
= (5.6)
M0s* k *y*
Now if we solve for S, we have:
M /M *
S= (5.7)
ky/k* y*
This says the exchange rate equals the ratio of the numerator (relative money
stocks) to the denominator (relative real demands). Therefore, anything that tends to
increase the UK money stock relative to the US or diminish UK demand for money
relative to the US will cause the pound to depreciate (S to rise).
To see how we must modify our previous conclusions, rewrite Equation 5.7 more
simply, as follows:
T
S= (5.8)
ÅZ
where the convention has been introduced (and will be followed wherever necessary
throughout the book) that a tilde over a variable denotes the ratio of its domestic to
foreign value, so T means M/M*, and so on.
Now remember that a 10% increase in the UK money supply relative to the US,
M/M* = T, can come about either from a 10% rise in the UK money stock, from a
10% fall in the US money stock or, more likely, from some combination of both, say
a 15% increase in UK money supply, with a 5% rise in US money.
It follows that, although we can stick to our original conclusion (Proposition 5.1)
that an increase in UK money supply, other things being equal, leads to a depreciation
in sterling (rise in S) of the same proportion, we now recognize that the same is true
of anything that changes relative money stocks. Thus, for example, a 10% fall in US
money while the UK money stock remained constant would cause a 10% depreciation
in the pound’s exchange rate, other things being equal.
Similarly, it is relative real income that counts in determining the demand for one
country’s money relative to another, so an increase in US income has the same
impact as a fall in UK income and we know from Proposition 5.2 that the latter
causes a rise in the relative price of dollars.

It follows, then, that we can generalize both Propositions 5.1 and

5.2 by substituting for the domestic variables their value relative to
the same foreign variables.
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154 Chapter 5 · Flexible prices: the monetary model

5.2 The simple monetary model of a fixed exchange rate

Now consider a situation where the exchange rate is not allowed to move. The analy-
sis here is slightly more complicated, so it will help if we start by clarifying which
variables are being taken as exogenous and which endogenous.
Real income, y, is assumed to be given by factors outside the scope of our model,
as before, and the foreign price level, P*, is determined by foreign money supply,
income and so on, and hence is also taken as given.
Recall the discussion of the money supply in Section 4.1.2 (Equation 4.10). Under
a fixed exchange rate regime, we concluded that the money supply was not an exogen-
ous variable. Instead, the policy variable was domestic credit, DC, and we could
write:
FX + DC ≡ M s
so that the burden of adjustment to changes in the exogenous variables fell on the
foreign currency reserves, FX.
The only remaining exogenous variable is the exchange rate itself, which is fixed
by the decision of the authorities at some level, Q.3

5.2.1 Money supply increase under fixed exchange rates

Now look at Figure 5.5, which shows the effect of an expansionary monetary policy,
in other words, an increase in domestic credit, from an initial level of DC 0 to a higher
level, DC 1.

Figure 5.5 Domestic credit increase under fixed rates (M 0s = P0 = 1)

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5.2 The simple monetary model of a fixed exchange rate 155

Start with Figure 5.5(c), which plots levels of the money stock (vertical axis)
against levels of the foreign exchange reserves, FX (horizontally). Measure off the
quantity DC 0 on the vertical axis, and from that point, extend a 45° line. That ray
then shows how the money stock increases with additions to the reserves, given the
initial quantity of domestic credit, DC 0. For example, if the reserves were nil, the
whole money stock would be credit. As we move to the right, each additional pound
of reserves increases the money stock by one pound exactly.
If we start with reserves of FX0, the money stock must be:
M 0s = FX0 + DC 0 (5.9)
so that the starting point in that diagram is at H.
Now let us set the initial value of the money supply and the price level at unity. In
other words, assume we happen to have: ky0 = 1. This device is for purposes of illus-
tration only. It has the advantage that it allows us to translate the money stock value
on the vertical axis of Figure 5.5(c) directly into the implied price level in Figures
5.5(a) and (b).
Exploiting this fact, the initial price level given a money stock of M 0s must be P0.
Hence the economy starts off at point a in Figure 5.5(b). Notice that as far as aggre-
gate demand and supply are concerned, the diagram is unchanged, since at this stage
we have no reason to believe that the private sector’s behaviour will be any different
under fixed rather than under floating exchange rates.
As with Figure 5.4, the left-hand diagram (Figure 5.5(a)) plots the PPP line. How-
ever, with the exchange rate pegged at Q0, the economy must at all times be restricted
to points that lie along the vertical line. Since, as before, equilibrium requires that the
domestic price level be at purchasing power parity, it follows that the system must
start off at A, at the intersection of the PPP line with the fixed exchange rate line. Put
formally, we must have:
P = Q0 O* (5.10)
where the bars over the right-hand side variables remind us that both S and P* are
fixed exogenously.
The economy is in full equilibrium initially, because the PPP price level defined in
Equation 5.10 is precisely the one consistent with the (endogenous) money stock and
hence with equality of aggregate supply and demand at the point a in Figure 5.5(b).
Now suppose the initial equilibrium illustrated by points A, a and H is disturbed
by a monetary expansion.
With the expansion of domestic credit, the 45° line in the money supply diagram
Figure 5.5(c) shifts upward by the amount of the expansion, so that, with the foreign
exchange reserves still at their previous level (of FX0 ), the money stock has now
swelled to M s1, as we can see at the point J.
Following the line across from J, we see that the new money stock implies a price
level of P1 (at b), thanks to an upward shift in the aggregate demand schedule. From
the PPP line in Figure 5.5(a), it is clear that the higher price level has made the
domestic economy uncompetitive, since, given unchanged foreign prices and the
fixed exchange rate, it amounts to a real appreciation. At C, there is an incentive for
domestic entrepreneurs to import from abroad and none for foreigners to buy locally
produced goods.
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156 Chapter 5 · Flexible prices: the monetary model

The obvious outcome must be a deficit on the balance of payments4 as the

economy responds to the changed terms of trade. The situation is unsustainable. It
would cause an immediate depreciation if the authorities permitted one. However,
by assumption, they avoid that outcome by using the foreign exchange reserves to
buy the domestic currency or, to put it differently, to finance the ongoing payments
deficit. The result is that the reserves start to fall.
Each successive reduction in the reserves tends to reduce the money supply, push-
ing the economy along the arrowed paths in the three quadrants, so that the system
moves from J to K, from b back to a and from C down to A. The process ends with
competitiveness restored and the balance of payments deficit reduced to zero, back
at A on the PPP line, with the price level restored to its old level of P0 (at the
point a). The reinstatement of the original equilibrium is possible because the money
supply has contracted, to the point where it is once more at its initial level, M 0s .
To understand why we get this result, recall from Equation 4.7 that our demand
for money, given PPP, must equal:
M d = kPy = k(QO*)J (5.11)
The final term is the demand for money. Notice that all its components are exogen-
ously given variables. It follows that, under our assumptions, nothing the domestic
monetary authority does can affect the demand for money. If the market is to clear,
then it follows equally that the money supply must automatically find its way back
to its pre-expansion level.
Equating demand and supply:
M d = kQO*J = M s = FX + DC (5.12)
so that, solving for FX gives us:
FX = kQO*J − DC (5.13)
Equation 5.13 tells us that the foreign currency reserves, FX, must be exactly equal
to the gap between the given demand for domestic money and the supply generated
by the local banking system, through the process of domestic credit expansion. It fol-
lows that the more sparing the domestic authorities are in their credit creation, the
greater will be the shortfall that has to be made up by the reserves.
In terms of changes, we can state that:

Proposition 5.4. Under fixed exchange rates in the monetary model, starting from
a position of equilibrium, domestic credit creation will be neutralized, other things
being equal, by a fall in the reserves as a result of a temporary balance of pay-
ments deficit. Conversely, domestic credit contraction will cause a temporary
balance of payments surplus and a consequent offsetting rise in the reserves.

Notice that, as always in the monetary model, the mechanism involved here could
be expressed purely in terms of the excess demand for money.
The right-hand side of Equation 5.13 is the excess demand for money balances.
It is this excess demand that is satisfied by the supply of international currency.
An increase in domestic credit from an initial equilibrium generates an excess supply
of money balances in the local market. As in the closed economy context (see
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5.2 The simple monetary model of a fixed exchange rate 157

Section 4.1.2), the effect is to cause domestic residents to run down their excess money
balances by spending. With real income fixed, however, the consequent inflation
makes foreign products relatively cheaper and the home country’s exports more
expensive. The external deficit is a by-product of the private sector’s attempt to sub-
stitute goods for excess money balances. As reserves flow out, the foreign component
of the money stock falls along with domestic prices until equilibrium is reinstated.
Notice that since it is stocks of money that count in this model, the flow of reserves
in or out of a country can only be a temporary phenomenon, as the money stock
adjusts over time to the demand. In other words, balance of payments deficits or sur-
pluses are viewed as inherently transient by-products of the adjustment mechanism.
Once that process is complete and the money market is back in equilibrium, the
deficit or surplus will have evaporated.
If the money supply, price level and balance of payments all return to their previ-
ous level, what has changed in the new equilibrium?
Compare the points K and H in Figure 5.5(c). Although the money supply is
unchanged at K, its composition has altered as a result of the cumulative impact of
the balance of payments deficit that persisted throughout the period of adjustment.
The new money supply is made up as follows:
M 0s = FX1 + DC 1 (5.14)
In other words, the net outcome is that the money stock now consists of more
domestic credit and less foreign exchange than previously. What has occurred is a
kind of debasement of the currency – a dilution of the international asset backing of
the domestic money supply. Obviously, the process has a well-defined limit – at the
point when the reserves have fallen to zero and the entire money stock is composed
of domestic credit.

Sterilization of reserve changes

Notice that the process described here amounts to a type of automatic stabilization.
In fact, this is broadly the mechanism relied on to guarantee the stability both of the
pre-World War I Gold Standard and the Bretton Woods system (see Section 1.5.1).
With a fixed exchange rate, flows of reserves act automatically to adjust the money
stock so as to reinstate equilibrium. Government monetary policy is not only imposs-
ible, it is also unnecessary.
In particular, viewed from this standpoint, balance of payments deficits (or sur-
pluses), far from requiring remedial macroeconomic policy, are actually the channels
through which disequilibria are spontaneously rectified.
Nonetheless, a government that wishes for whatever reason to resist these stabil-
izing forces might in principle be able to do so, temporarily at least. To see how this
can be achieved, go back to the situation facing domestic policymakers at the start
of what has been called here the adjustment phase, in the aftermath of the initial
destabilizing domestic credit expansion, when the economy is at points C, b and J
respectively in Figures 5.5(a) to (c).
At that juncture, the UK is running a balance of payments deficit and is therefore
losing reserves (as first seen in Equation 4.11). In other words, the UK money stock
is falling because, in the identity:
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158 Chapter 5 · Flexible prices: the monetary model

∆FX + ∆DC ≡ ∆M s
the first term is negative. Since the second term is constant (the once and for all
increase is assumed to have already taken place), the money supply is falling. Hence,
it is only a matter of time until the cumulative effect of the continuing deficits reduces
the money supply to its pre-disturbance level.
Now suppose the authorities decided to try to prevent the money stock falling by
further expanding domestic credit. It would appear that, in so doing, they could pre-
empt the fall in the money supply. If they increased credit enough to offset the fall in
the foreign currency reserves in each period, it looks as though they could neutralize
the deficits completely.
The following piece of jargon is commonly used:

Sterilization is the process of neutralizing the effect of a balance of

payments deficit (surplus) by creating (retiring) enough domestic
credit to offset the fall in the foreign exchange reserves.

There has been a great deal of debate, among both researchers and policymakers,
about how far sterilization is actually feasible. Even its most enthusiastic advocates
would not claim it can work for very long. Whether it can work at all in today’s cur-
rency markets is extremely dubious.5
To see why its usefulness is likely to be limited, we need to follow through the
implication of the second stage increase in domestic credit. Obviously, the effect of
an increase in domestic credit starting from the situation at J in Figure 5.5(c) will be
to move the money supply line even further up the vertical axis. The result will be to
further dilute the foreign currency backing of the UK money stock.
Neither is that all. We have already established that, as long as the money stock is
above its equilibrium level, the UK will be haemorrhaging reserves. Clearly, any-
thing that prolongs that situation will reduce the reserves below what they otherwise
would be in the absence of any attempt at sterilization.
It follows that sterilization is likely to prove a treadmill. Each expansion of
domestic credit will prolong the reserve loss and hence generate the need for further
credit creation. At each stage, the domestic credit component of the money stock gets
larger and the reserve component smaller.
In theory, at least, there will come a stage when the reserves are exhausted and the
game will be over. In reality, the limit to this process is likely to come some time
before the country’s reserves are actually exhausted, simply because currency markets
will anticipate the evil day and thereby hasten its arrival by rushing to sell pounds at
the current exchange rate while they still can,6 as we shall see in Chapter 17.

5.2.2 Income increase under fixed exchange rates

As far as changes in real income and the world price level are concerned, the analysis
involves a straightforward application of the results from the floating rate case.
With the price level unchanged, an increase in real income amounts to a rise in the
demand for real money balances, other things being equal. Starting from a position
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5.2 The simple monetary model of a fixed exchange rate 159

of equilibrium, then, the impact will cause domestic residents to spend less, so as to
raise their balances to a level commensurate with their new, higher volume of trans-
actions. In doing so, they force the price level down, which with a fixed exchange rate
makes the home country’s output overcompetitive on world markets, leading to a
balance of payments surplus and consequent rise in the reserves. This process will
come to an end only when the domestic money stock has grown sufficiently to match
the new, larger demand.
So, as the reader may confirm by redrawing Figure 5.5 and shifting the aggregate
supply line to the right, we can state the following:

Proposition 5.5. Under fixed exchange rates in the monetary model, starting from
a position of equilibrium, the result of a rise in (the domestic country’s) real
income will be to cause an increase in the reserves as a result of a temporary
balance of payments surplus, other things being equal. In the new equilibrium, the
domestic money stock will have risen and the home price level will have returned
to its PPP level.

Again, note the contrast with the DIY model (Section 1.4).

5.2.3 Foreign price increase under fixed exchange rates

As for a rise in the world price level, the effect under a fixed exchange rate is directly
to increase the home country’s competitiveness, causing a payments surplus and
consequent rise in the reserves. (In terms of Figure 5.5, the impact effect is to cause
the PPP line to become steeper.) This in turn brings about a rise in the money stock,
pushing up the home country price level until it reaches parity with that of the
outside world, at which point PPP and external balance are restored. So, for
completeness:

Proposition 5.6. Under fixed exchange rates in the monetary model, starting from
a position of equilibrium, the result of a rise in the rest of the world’s price level
will be to cause an increase in the reserves as the result of a temporary balance of
payments surplus, other things being equal. In the new equilibrium, the domestic
money stock will be greater and the home price level will have risen to its PPP
level.

Note the implication: a country that pegs its exchange rate has ultimately to
accept the world price level. In the common jargon of the 1960s and 1970s, it is
forced to import inflation from the rest of the world. The fact that it cannot control
its own money supply means it cannot choose its price level or inflation rate inde-
pendently of developments beyond its borders.
Hence, an important conclusion of the monetary model is that, subject to one
qualification we shall deal with in a moment, a country cannot follow an independent
monetary policy under fixed exchange rates – neither, as a consequence, can it choose
a price level or inflation rate different from that of the rest of the world.
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160 Chapter 5 · Flexible prices: the monetary model

To see the qualification that needs to be added to this statement, ask yourself the
following question: what determines the world price level, P*? What causes world
inflation – at any rate, in this simple model?
The answer must be that world prices rise when the world’s money stock increases
faster than world demand. Also, world money supply and demand are simply the
sum of the supply and demand in all of the countries in the world. It follows that,
when we analyse the effect of, say, an increase in the home country’s money stock,
we can only treat the world price level as exogenous if the additional money creation is
of negligible significance to the world as a whole. In other words, we have to be able
safely to ignore the impact of the home country’s money supply increase on the rest
of the world’s money markets and hence on world prices. Obviously, this assumption
only makes sense if the domestic country is small enough in economic terms relat-
ive to the world economy for us to be able to ignore the repercussions of its policy
measures on the world economy.7

5.2.4 Devaluation under fixed exchange rates

Before leaving the analysis of fixed exchange rates, there is one special case that
merits attention, because it provides a particularly clear insight into the nature of
the monetary model.
No fixed exchange rate is fixed forever. Sooner or later the authorities find them-
selves forced to move the rate to a new level, higher or lower. That is why a fixed
exchange rate regime is sometimes referred to as an adjustable peg. What happens
when the peg is adjusted?
Figure 5.6 shows the effect of a devaluation, an announced, once-and-for-all
rise in the price of foreign currency. It must be emphasized that the analysis is only
applicable to a devaluation that is an isolated event, and perceived as such, not one
that generates the expectation of further devaluation (or revaluation) to come.
Following the pedagogic convention in economics, we start the analysis from a
position of equilibrium, which is somewhat unrealistic in this case because countries
usually alter a fixed exchange rate only when absolutely necessary to correct an
obvious disequilibrium. Nonetheless, it is easy to see how the conclusions could be
modified to deal with an initial balance of payments deficit.
The economy starts off in equilibrium at points A, a and G in the three diagrams
in Figure 5.6, with, as before, an exchange rate of Q0 , a price level under PPP of P0 ,
and a money supply of M s0 , made up of domestic credit in the quantity DC 0 and
reserves of FX0.
The home country then devalues, raising the price of foreign currency to Q1.
The overnight impact effect is to move the economy instantaneously to a point
like C. In other words, with a given foreign price level and, as yet, with no time for
domestic prices to change (suppose the devaluation took place over a weekend, as
became the fashion in the European Monetary System) the home country is now
overcompetitive. Had it started off from a position of being uncompetitive (that is,
above the PPP line), the impact effect would have been to move it to the right, mak-
ing it more competitive than previously, which would, presumably, have been the
object of the whole exercise in the first place.
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5.2 The simple monetary model of a fixed exchange rate 161

Figure 5.6 Devaluation under fixed rates (M s0 = P0 = 1)

The interim verdict has to be: so far, so good. With both domestic and foreign
prices unchanged, it is the real as well as the nominal exchange rate that has been
devalued. Foreign goods now cost more, while domestic goods are unchanged in
price. The result must be a tendency for home country consumers to buy more
domestically produced output than previously and fewer imports. Conversely, for-
eigners find the home country’s products more attractively priced, on average, than
prior to the devaluation.
Starting from equilibrium, the outcome has to be a balance of payments surplus.
If we had started, more realistically, from a position of deficit, we would only have
been able to assert that the result would be a less unfavourable foreign balance.
The story of what happens during the next stage, as the economy adjusts to the
devaluation, can be told in several different ways, each focusing on the adjustment
process in a different sector, all leading inexorably to the same conclusion.
First, consider what is happening to the money supply when the economy is
‘bounced’ over to C.8 With its balance of payments in surplus, the country must
be accumulating reserves – hence the arrows on the path from G to H in the money
supply diagram (Figure 5.6(c) ). Since the volume of domestic credit is unchanged,
the money supply must be growing, shifting the aggregate demand schedule upwards.
In terms of the money market, with real income and output constant, and hence an
unchanged demand, the price level must be bid up as agents attempt to reduce their
excess real balances by buying additional goods. As the price level rises, of course,
the competitive advantage and consequent external surplus is eroded, until the new
equilibrium is reached at B in Figure 5.6(a).
In terms of the goods market, if output is pegged at y0, the increased demand by
domestic residents (for cheaper import substitutes) and by foreigners (for the home
country’s exports) cannot be satisfied. The excess demand must simply generate an
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162 Chapter 5 · Flexible prices: the monetary model

inflation, which persists until enough of the additional demand has been priced out
of the market in order to restore equilibrium.
The version of this process that gained wide acceptance in the early 1970s, par-
ticularly in the UK, emphasized the reaction of labour markets to devaluation. It
was argued that a key role would be played by wage inflation, induced either by a
cost–push process as workers reacted to the higher price of imports by demanding
compensating wage rises or by a demand–pull mechanism, as employers bid up the
wage rate in an attempt to satisfy the excess demand for goods by recruiting more
labour.
Whichever of these processes is the dominant one, there can be no doubt about
the conclusion. Ultimately, the economy ends up at B, with PPP restored and the real
exchange rate back where it was before, thanks to domestic inflation.
What has changed, if anything, compared to the pre-devaluation situation?
Obviously, the higher price level is supported or sustained by a larger money stock,
M 1s , made up of the same level of domestic credit plus a larger stock of foreign cur-
rency reserves – the accumulation of the intervening weeks, months or possibly years
of balance of payments surplus. So:

Proposition 5.7. Under fixed exchange rates in the monetary model the result of a
once-and-for-all devaluation will be a temporary improvement in the competitive-
ness of the home country and, consequently, a balance of payments surplus, lead-
ing in turn to a rise in its foreign currency reserves. However, the ensuing inflation
will, as time passes, erode the country’s price advantage, until the economy finds
itself back where it started, with a higher price level, greater reserves and a larger
nominal money stock, but the same real money supply.

From a policy point of view, the good news is that, if the monetary model’s
message is to be believed, devaluation works. It does indeed generate a balance of
payments surplus or at least reduce the deficit of a country that starts off in disequi-
librium. Devaluation replenishes the reserves or slows down the rate of reserve loss
for a deficit country.
The bad news, on the other hand, is that its beneficial effect is temporary. It
cannot permanently affect competitiveness. It causes inflation, thereby ultimately
neutralizing the benefits that it is supposed to confer. How long the adjustment takes
is an empirical question, to which the answer would probably vary from country to
country and case to case.
In any case, there may well be a delay before the balance of payments effect of a
devaluation appears. It is often argued that the immediate impact of a devaluation is
to worsen rather than improve the situation. The logic is as follows.
If trade flows are usually invoiced in the currency of the exporting nation, a
devaluation of the pound will reduce the average dollar price of UK exports, but have
no effect on the (dollar) price of our imports. Furthermore, if the very short-run
elasticities of demand for exports and imports are negligible (because of inertia in
consumer tastes, difficulty in switching production and so on), the immediate outcome
will be unchanged trade volumes priced less favourably for the home country. Each
unit of exports will now earn fewer dollars, while each import still costs the same.
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5.3 Interest rates in the monetary model 163

The result will be a deterioration in the UK balance of payments, which will only be
rectified with the passage of time, as trade volumes react to the new relative price.
If this analysis is correct, devaluation will be followed by an initial increase in the
current account deficit, reversing itself gradually, until it surpasses its former pos-
ition and carries on improving, the so-called J-curve effect.
While the J curve is often regarded as a problem, it is obvious from what has just
been said that it relates exclusively to the current account.9 So, if the objective of
devaluation is to improve the current account, the possibility of a J-curve effect may
be a worry. Conceivably, the cost pressures generated in the domestic economy by
the devaluation could be felt even before the supposed benefits appear. If, however,
the aim of devaluation is to replenish the reserves, there is no obvious reason why the
benefits should await an improvement in the current account.

5.3 Interest rates in the monetary model

Until now, we have made use of a particularly simple form of the demand for money,
the Cambridge quantity equation. In Chapter 4 (Section 4.1.2), however, it was
argued that a plausible view of the demand for money would include a role for
interest rates, as a key determinant of the opportunity cost. We now proceed to
examine the implications of incorporating interest rates into our simple model of
exchange rates (see Figure 5.7).
Our first approach will be naive, or rather myopic, because we shall temporarily
ignore the important conclusions we reached in Chapter 3.
Look back at the formulation of the demand for money in Equation 4.9. As we
have already seen, it implies that the demand for real balances will be lower, at any
given level of income, the higher are interest rates. In other words, at any price level,

Figure 5.7 Interest rate increase under floating exchange rates

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164 Chapter 5 · Flexible prices: the monetary model

the nominal demand will be smaller at a higher interest rate r1 than at a lower interest
rate, r0.
It follows that, with an unchanged money stock, the effect of a rise in UK interest
rates is to create a temporary excess supply of money and excess demand for goods.
Hence, in Figure 5.7(b) the aggregate demand schedule shifts to the right10 at the
initial price level, P0 , generating immediate excess demand equal to ( y d1 − y0 ), and
consequent inflation. As the price level rises, the economy moves up its new aggre-
gate demand curve from c to b.
Translating the argument into money market terms, at the point c the higher
opportunity cost induces agents to economize on real balances by attempting to
spend more. In the process, they drive up prices until the real money stock has been
reduced sufficiently to reinstate equilibrium at the new, higher interest rate. When
equilibrium is reached, at the new price level, P1, nominal income has increased so as
to generate a transactions demand great enough to offset the impact of the higher
opportunity cost.
Switching attention to Figure 5.7(a), if the exchange rate is floating, the higher
interest rate must be associated with a higher value of S, in other words a more
expensive dollar and a cheaper pound. Furthermore, it is easy to see that a similar
logic would apply to a change in the foreign interest rate. Hence, as before, since
increased US interest rates mean a cheaper dollar, other things being equal, and
higher UK interest rates imply a cheaper pound, the net effect on the exchange rate
depends on relative interest rates.11 We appear to have arrived at another general
proposition:

Proposition 5.8. According to the monetary model, with given nominal money
stocks and real incomes, a rise in domestic interest rates relative to those in the
foreign country will be associated with a depreciation in the domestic currency.

Again, note the contrast with the DIY model.

However, this proposition is not as simple as it seems. Look back, if necessary, at
the conclusions we reached in Chapter 3. In particular, recall the discussion of what
determines the interest differential between two countries: under interest rate parity,
we came to the conclusion it would reflect the expected rate of currency depreciation.
What Proposition 5.8 says then, is that if something occurs that causes agents to
expect the exchange rate to depreciate more rapidly, the domestic country’s interest
rates rise and the exchange rate does indeed depreciate – immediately. In other
words, in an international context, we can view the opportunity cost of holding a
currency as the rate of change in its international value, that is to say its command
over goods in world markets.
A caveat is in order, however. Consider for a moment the question of what deter-
mines the market’s expectations with regard to currency movements. Answering this
question fully will take up a large slice of the remainder of the book (see Chapters 12
and 13). For the moment, we will be content to sketch a vague outline of the kind of
factors likely to play a part in influencing market perceptions.
It is highly likely, we assert, that currency speculators will base their predictions
of future exchange rate movements on their forecasts of what is going to happen to
those variables that they believe are the ultimate determinants of long-run exchange
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5.4 The monetary model as an explanation of the facts 165

rates. In other words, they first forecast the ‘fundamentals’, then form their expecta-
tions as to the exchange rate accordingly.
What this implies, of course, is that interest rate changes are not exogenous events,
they don’t just happen, they are themselves very much the outcome of changes in
expectations.
But now ask yourself another question: what kind of factors are these ‘funda-
mentals’ likely to be?
It is very probable that the fundamentals will turn out to include, among others,
the very variables that figured in the simple monetary model we sketched in Section
5.1 – relative money stocks and income. Changes in the market’s anticipations with
regard to these fundamentals will trigger reassessments of the future outlook for
exchange rates and this, in turn, will cause instantaneous fluctuations in the demand
for the different currencies and hence in their international values. So we may
well have a situation where an event that is seen as foreshadowing a change in the
domestic money stock for example, brings about an immediate adjustment in the
interest rate and a simultaneous movement in the exchange rate.
This type of ‘bootstrap’ situation is one that will be familiar to anyone who has
ever observed the behaviour of a typical financial market when the price of an asset,
whether foreign currency, share or bond or commodity, is expected to rise at some
point in the future, the rise occurs not in the future, but right now. The very fact it is
expected to rise pushes it up immediately.
This type of feedback mechanism will be examined at length later in the book (see
Chapter 13). For the moment, all we can do is to note that the association between
interest rates and exchange rates is complicated by the fact that, unlike money and
income, interest rates cannot seriously be regarded as exogenous variables. Our con-
clusions in this case, therefore, ought to be viewed as provisional.

5.4 The monetary model as an explanation of the facts

Before going on to look at the question of how well the monetary model explains the
facts, it is worth pausing for a moment to try to guess the answer, because we already
have a clue from Section 2.5. Remember that we concluded then that, for all the
plausibility of the PPP hypothesis, it came nowhere near to explaining the wide
fluctuations in exchange rates in the last decade or so. Since the PPP hypothesis is
one of the two central building blocks of the simple monetary model, need we bother
to go any further? Surely, if the foundations are rotten, there is no need to go on and
look at the rest of the edifice?
This is certainly a persuasive argument. At the very least, it is hard to be anything
other than extremely pessimistic about the prospects for using the monetary model
to explain the facts. Nonetheless, it is worth proceeding – just about. It is still possible
(although unlikely) that the monetary model might work for the following reason.
Suppose the reason for the apparent failure of PPP to explain the facts is that the
tests use the wrong price index. Suppose furthermore that the ‘true’ price index (the
one that actually measures the prices that agents face) is unobservable. As long as
that same unobservable price index figures in the demand for money, we could end
up finding that the monetary model fitted quite well in spite of the failure of PPP.12
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166 Chapter 5 · Flexible prices: the monetary model

Figure 5.8 UK money, income and exchange rate, 1975–99 (1995 = 100)

If this seems a forlorn hope, the reader can comfort himself with the thought that
sooner or later, in a book of this nature, we would have to take a look at the broad
outline of what has happened to relative money stocks and incomes in recent years.
Now is as good a time as any.
Figures 5.8 to 5.10 illustrate graphically the recent history of the UK, West
Germany and Japan in this regard. In each case, the variables plotted are domestic
M1 and GDP, relative to the USA, and the exchange rate, in home currency per
dollar. All have been scaled so that 1995 = 100.13
The first thing to notice is that all three exchange rates are considerably more
volatile than money stocks and incomes and this is a conclusion that would have
been even more forcefully illustrated in the monthly or weekly data, had we pre-
sented them.
For the UK, for example, while relative money stock had a range of 55% and rel-
ative GDP only 17% (as measured by maximum over minimum), the value of the
pound fluctuated by more than 80%. For Germany and Japan, the disparity is even
more marked. In both countries, relative money stocks varied by 50% and GDP by
just over 20%, while exchange rates moved up and down across a range as wide as
140% in the case of the DM and just under 400% in the case of the yen. If anything,
this understates the extent of the disproportion, which would be even more obvious
if we examined monthly, weekly or daily data. At these higher frequencies, we would
find the comparatively slow, trend changes in income, and even the somewhat more
volatile money stock statistics, completely swamped by the sharp day-to-day, week-
to-week movements in exchange rates.
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5.4 The monetary model as an explanation of the facts 167

250
German M1/USM1
230 German GDP/US GDP
DM per $
210

190

170

150

130

110

90

70

50
75 976 977 978 979 980 981 982 983 984 985 986 987 988 989 990 991 992 993 994 995 996 997 998 999
19 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
Year
Figure 5.9 German money, income and exchange rate, 1975–99 (1995 = 100)

500

Japanese M1/USM1
450 Japanese GDP/US GDP
Yen per $
400

350

300

250

200

150

100

50
75 976 977 978 979 980 981 982 983 984 985 986 987 988 989 990 991 992 993 994 995 996 997 998 999
19 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
Year
Figure 5.10 Japanese money, income and exchange rate, 1975–99 (1995 = 100)
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168 Chapter 5 · Flexible prices: the monetary model

Next, look at the trends in the data (where there are any). There was a spectacu-
lar rise in UK M1 relative to that of the USA in the late 1970s, followed by a long
fall through most of the Thatcher years of the 1980s, yet in those 15 years the
exchange rate went through two distinct cycles for which there is no apparent ex-
planation here. More recently, the UK money stock has again risen sharply, yet the
exchange rate against the dollar has been more stable than at any time since the start
of the floating rate era in 1972.
Japan and Germany are in some respects even more problematic. Both the yen
and the DM enjoyed a long-term appreciation throughout the first 20 years of the
period, broken only by the dollar’s rise in the early 1980s. Yet neither currency’s
strength was justified by monetary or real factors. In fact the changes in the two
countries’ relative income were so small as to be within the likely margin of error
for aggregate data like these, while monetary growth differentials could justify
appreciation of no more than 30% for Japan and 20% for Germany at the absolute
maximum.
The evidence presented here is not, on the whole, very encouraging. All that
can be said in favour of the monetary model (and it is not something to be dismissed
altogether) is that it does appear to explain the facts over the very long run, at least
in broad outline. This is particularly true of fixed rate periods.
For example, until the 1980s, the West German economy consistently enjoyed
more rapid growth than either the UK or USA. It also stuck to a monetary policy
that was markedly less expansionary than most other industrialized countries. As pre-
dicted by the models we have examined in this chapter, the outcome was a balance
of payments surplus and reserve accumulation, as well as long-term appreciation of
the Deutschmark, whether in forced realignments, when a fixed rate regime was in
force, or more gradually, when floating.
Conversely, for most of the post-World War II period until the late 1970s, the UK
suffered from relatively slow economic growth, while its policymakers permitted a
rapid expansion in the UK’s money stock – or at least in its domestic credit com-
ponent. Again, the result was as predicted – declining reserves and a depreciating
currency.
At the same time, Japanese growth averaged several percentage points more than
that of the UK or USA, while its money supply expanded at a moderate rate, caus-
ing mounting balance of payments surpluses and an appreciating international value
for the yen.
Perhaps unsurprisingly, the more marked are the divergences between rates of
monetary growth (and hence inflation), the better the monetary model fits the facts.
If we were to examine a currency under conditions of hyperinflation (inflation at
rates of, say, 100% per annum and above), we would find its rate of depreciation
against any of the hard currencies more or less equal to the difference in rates of
monetary growth. However, as was noted at the end of Chapter 2, this is simply a
reflection of the fact that in these pathological cases PPP has to be broadly main-
tained, at least to within limits that are narrow compared to the gap between
inflation rates.
However, economists are not in the habit of drawing conclusions on the basis of
this kind of cursory examination of a small amount of data. There is a wealth of
additional evidence that could be used to cast light on the viability of the monetary
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Summary 169

model as an explanation of exchange rate changes and there are sophisticated statis-
tical and econometric techniques that could be brought to bear on the detailed data.
Researchers have, in fact, left no stone unturned in searching for evidence on the
validity or otherwise of the monetary model. They have examined annual, quarterly
and monthly data.14 They have looked at trade-weighted as well as bilateral exchange
rates. They have used narrow measures of money (M0 and M1) and broad measures
(M3 and so on). They have extended and complicated the simple model to take
account of adjustment delays (‘lags’) of all types and they have used state-of-the-art
econometric techniques to test the theory.
By and large, their conclusions have been similar to ours. For example, in a series
of influential publications, Meese and Rogoff found little support for the monetary
model15 in the period since 1973. Studies of individual exchange rates, particularly
the pound/dollar and the Deutschmark/dollar, but also of a number of other hard
and soft currencies lead to similar conclusions.
Even where a clear pattern associating monetary growth with depreciation can be
found, the relationship is rarely anything like the strict proportionality predicted by
Proposition 5.1. It is often even harder to find a link between a country’s national
income and the value of its currency (Proposition 5.2), although in some cases this
may be the result of the use of inadequate proxy measures in place of GDP.
Worst of all, such relationships that do appear tend to be unstable, with appar-
ently satisfactory results over one period either reversing themselves or disappearing
altogether in the next period.

5.5 Conclusions
The monetary model combines the quantity theory of the demand for money with
purchasing power parity to generate unambiguous conclusions about the effect of
changes in exogenous variables on a floating exchange rate, or on the balance of
payments, as the case may be. It remains an important benchmark with which to
compare other models – not least because as we shall see in Chapters 6–9 its pre-
dictions accord in most cases with their long-run equilibrium results. Moreover, the
analysis in Chapters 13, 16 and 17 takes the monetary model as its starting point.
Unfortunately, as an explanation of the facts, the monetary model must be
regarded as grossly inadequate in anything but the very long run, which is hardly sur-
prising given the failure of PPP. If a model that assumes perfect flexibility of prices
cannot explain the facts, we direct our attention in Chapter 6 to one that starts from
the assertion that the price level is constant.

Summary
n The monetary model of a floating exchange rate predicts that the domestic cur-
rency will depreciate when any of the following occurs:
– the domestic (foreign country) money stock increases (decreases)
– domestic (foreign) national income falls (rises)
– the foreign price level falls.
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170 Chapter 5 · Flexible prices: the monetary model

The depreciation will be proportionate to any increase in the relative money

stock.
n The monetary model of a fixed exchange rate predicts that the balance of pay-
ments will deteriorate and the home country will lose reserves when any of the
following occurs:
– the home country’s domestically generated money stock (that is, domestic
credit) increases
– domestic (foreign) national income falls (rises)
– the foreign price level falls.
n Devaluation of a fixed exchange rate results in a period of balance of payments
surpluses, which comes to an end when the home country’s reserves have risen
sufficiently to restore the value of the real money stock to its pre-devaluation level.
Once this has happened, the real exchange rate is back at its former level (that is,
PPP is reinstated) and the temporary competitive advantage enjoyed by the home
country as a result of the devaluation has been completely eliminated by inflation.
n Since higher interest rates mean a smaller demand for money, other things being
equal, they also imply a higher price level and therefore a lower value for the home
country’s currency. However, this conclusion must be qualified by our finding in
Chapter 3 that interest rates, far from being an exogenous variable, are likely to
reflect the market’s expected rate of currency depreciation or appreciation. A
firmer conclusion must await the analysis of how market expectations are deter-
mined in Chapters 12 and 13 of this book.
n Since PPP does not fit the facts of the 1970s and 1980s very well it is not surpris-
ing that the monetary model turns out to be able to explain the facts only very
weakly and even then only over the long run. A cursory examination of annual
data for the UK, West Germany and Japan since 1975 is not encouraging and this
is broadly the conclusion reached by most researchers in detailed scientific studies
of the data.

Reading guide
On the monetary model, the starting point (well worth reading) is Hume (1741). The simplest
modern statement of its basic propositions is in Johnson (1977). Other influential work was by
Mussa (1976) and Bilson (1979). The analysis of devaluation is due to Dornbusch (1973).
Influential empirical work has been carried out by Frenkel (1976) and Frankel (1979),
among others. The last (empirical) word on the monetary model appears to have been said by
Meese and Rogoff (1983), which also contains a useful bibliography.
On exchange rates under hyperinflationary conditions, see Frenkel (1977).
Web page: www.pearsoned.co.uk/copeland.

Notes
1 In the language of microeconomics, the aggregate demand curve has unitary elasticity in this
special case. It is in fact a rectangular hyperbola.
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Notes 171

Note that in the present case, the LM curve is vertical, since the demand for money is
unaffected by the interest rate. It follows that we are only concerned with the extent to which it
shifts horizontally when the real money stock changes. We are also able to ignore the interest
rate because the IS curve is implicitly flat, with saving and investment being equated by the
interest rate alone, independently of income.
2 Of course, in this simple model the inflation rate is the only variable left for the government of
either country to choose.
3 We ignore another complication here which is that, in practice, countries running so-called fixed
exchange rates invariably allow some measure of freedom for the rate to move up or down from
its central parity (see Section 1.2). The consequences of this will be the subject of Chapter 16.
4 The monetary model is normally seen as dealing with the balance of payments rather than the
balance of trade alone. In the present context, the distinction hardly matters.
5 The issue is clouded by all kinds of other problems, for example the apparent instability of the
demand for money in the UK and USA, interest differentials (see Section 5.1.3) and risk pre-
miums (Chapter 14), and many others.
6 The sterilization mechanism is also likely to prove self-defeating because of its impact on interest
rates.
7 It is an awkward question, of course, to decide how small is small enough for present purposes.
On the one hand, the USA, the EU or Japan are obviously far too large to be able to ignore the
feedback effects of their policies on the world economy. On the other hand, the vast majority of
countries in the world are clearly small relative to world money markets. But what about
medium sized economies such as the UK, Canada, for example? The answer is not obvious.
Those readers who are familiar with elementary price theory will recognize a similarity here
with the simple model of the perfectly competitive firm. Remember the paradox there was that
market price was unaffected by the typical small firm’s output decisions. Although the perfectly
competitive firm acting alone cannot influence market price, the small firms in aggregate deter-
mine the price by their independently taken decisions. By the same token, we assume here the
small country cannot on its own have an impact on the world economy, but the monetary policy
of small countries in aggregate (together with the large countries) determines the world price level.
8 We ignore the second-order effect on the money stock of the rise in the sterling value of the UK
reserves when the pound is devalued.
9 In fact, it dates back to arguments about whether devaluation could improve the current
account even in the long run. Thus, economists afflicted by ‘elasticity pessimism’ in the 1950s
believed that the J-curve was all tail and no upswing.
10 In IS–LM terms, the upward shift in the horizontal IS curve cuts the unchanged LM curve fur-
ther to the northeast.
11 A formal demonstration of this fact would be a little messier and more complicated than was
the case in Section 5.6 with relative money stocks and incomes. The reason is to be found in our
formulation of the demand for money that is linear in natural numbers. Fortunately, there is
more or less universal support among researchers for a log linear formulation. In this case, it
turns out that exchange rates depend on relative values of all variables, provided that income
and interest elasticities are the same in each each country.
12 The possibility referred to here would also imply that demand for money studies using the
standard price index were misspecified and should be expected to fit poorly. In fact, they fit
reasonably well – certainly far better than PPP models (see the reading guide).
13 The pictures would look very similar if we defined money as M3 (M1 plus time deposits) and,
although recalculating on a different base year would change the pictures superficially, it would
not alter the general nature of our conclusions. There are, in any case, no sound reasons for
preferring one definition of money to another in the present context or any overwhelming
arguments in favour of any particular base year.
14 Higher frequency data exist only for the US money stock and for financial variables (exchange
rates and interest rates). Even then, there are no monthly data on national income, so most
researchers have used the index of industrial production as a proxy.
15 Although they also reached similarly negative conclusions with respect to all the other models
they tested. It should be repeated that researchers have usually tested versions of the monetary
model that were a good deal more complicated than the one presented in this chapter.