The flexible price monetary model

Question 1

Other factors this model includes

Answer 1

• PPP: concerned with goods arbitrage and not capital
movements
• Expectations: crucial determinant of capital
movements.
• If a currency is expected to depreciate, agents will
switch to another currency that is expected to
appreciate

Question 2

2 reasons For UIP to hold

Answer 2

UIP: ES= r(uk)-r (us)
• 1. there has to be perfect capital mobility:
investors can change the composition of their
international investments portfolio

• 2. Investors have to regard US and UK bonds
as equally risky

• If 2 conditions above meet, UK and US bonds
are perfect substitutes and UIP will hold in a
continuous basis

Question 3

3 assumption of the flexible price monetary model

Answer 3

• Assumptions:
• PPP holds continuously
• Prices are perfectly flexible
• UIP condition holds

Question 4

S=(m-m)-n(y-y)+omega(r-r*)

Effect of increase in domestic money supply m

Answer 4

• increase in domestic money supply (m-m*):
equivalent depreciation of the domestic
currency
• Increase in foreign money supply: equivalent
appreciation of the currency

Question 5

S=(m-m)-n(y-y)+omega(r-r*)
Rise in domestic national income (constant money stock and
interest rates)

Answer 5

-increase in transactions demand for money:
prices fall and real cash balances increase: appreciation of the
domestic currency to maintain PPP.

Question 6

S=(m-m)-n(y-y)+omega(r-r*)

Increase in domestic interest rate

Answer 6

Increase in domestic interest rate leads to a depreciation of the
domestic currency.
• Explanation:
• I) reduction in the demand for real balances

• II) increase in domestic price inflation expectations : decreased
demand for cash balances and increased demand for goods:
rise in domestic prices: depreciation of the domestic currency