The benchmark model is presented in Section 2.1, and the expectations formations are formulated and discussed in Section 2.2.
Benchmark model
Basically, the model is a twocountry model with a money market equilibrium condition, an international asset market equilibrium condition, a price adjustment mechanism since goods prices are assumed to be sticky, and market expectations that are formed by the relative weights given to the chartists’and fundamentalists’exchange rate expectations. The formal structure of the model is presented below, where Greek letters denote positive structural parameters.
The money market is in equilibrium when
(1)
where m, p, y and i are (the logarithm of) the relative money supply[4], (the logarithm of) the relative price level, (the logarithm of) the relative real income, and the relative nominal interest rate, respectively.
Moreover, m and y are exogenously given[5]. Thus, according to (1), real money demand depends positively on real domestic income and negatively on nominal domestic interest rate. The money market is assumed to be permanently in equilibrium, i.e., disturbances are immediately intercepted by a perfectly flexible domestic interest rate.
The international asset market is in equilibrium when
(2)
where s is (the logarithm of) the spot exchange rate, which is de…ned as the domestic price of the foreign currency. Moreover, the superscript e denotes expectations.
The equilibrium condition in (2), also known as uncovered interest rate parity, is based on the assumption that domestic and foreign assets are perfect substitutes, which only can be the case if there is perfect capital mobility. Since the latter is assumed, only the slightest di¤erence in expected yields would draw the entire capital into the asset that o¤ers the highest expected yield.
Thus, the international asset market can only be in equilibrium if domestic and foreign assets o¤er the same expected yield. According to (2), a positive (negative) relative nominal interest rate means that the exchange rate is expected to depreciate (appreciate). The equilibrium condition is maintained by the assumption of a perfectly ‡exible exchange rate. The price adjustment mechanism is
(3)
where 0 ≤ β ≤1 and s - p is (the logarithm of) the real spot exchange rate. According to (3), goods prices are assumed to be sticky. Thus, goods prices respond to market disequilibria, but not fast enough to eliminate the disequilibria instantly. Two extremes are obtained by setting β = 0, which is the case of completely rigid goods prices, and by setting β = 1, which is the case of perfectly flexible goods prices.
4 That is, the di¤erence between the domestic and foreign money supplies. The other macroeconomic variables in the model are de…ned in a similar way.
5 In the simulations of the model in Section 3.5, m will follow a stochastic process.
By Mikael Bask and Carina Selander
Next: Expectations formations
Summary: Index