The Monetary Model of Exchange Rate Determination

Monetary models of exchange rate determination were developed after the collapse of the fixed exchange rate system in the early 70’s. They are descendants of the Mundell-Fleming type of models. Several versions have been put forward giving rise to three main types of models. These are the flexible price monetary model due to Frenkel (1976) and Bilson (1978), the sticky price / real interest rate differential of Dornbusch (1976) and Frankel (1979) and the sticky price-asset monetary model of Hooper and Morton (1982). The modeling strategy is similar in all cases. Ad hoc aggregate macroeconomic relationships are used to obtain a semi-reduced form equation that specifies the level of the exchange rate as a linear function of fundamentals1.