Monetary policy is what determines the exchange rate through affecting demand and supply of domestic currency and in turn influencing flows of tradeables and corresponding flows of currency.
- Assume demand side currency substitution as opposed to supply side currency substitution which occurs under fixed exchange rates where central banks look to maintain fixed exchange rates.
- Monetary currency substitution models contrast to global models in that the former interpret current balance surpluses (deficits) as an excess demand (supply) for foreign currency by domestic residents (where capital account and capital markets are ignored because there are no interest bearing assets in these models). The latter view the relevant money supply as the world money supply within the context of a highly developed and interdependent world capital market. The value of diverse money holdings relates then to the liquidity services money provides.
- Flow approach to currency substitution question and accumulation of foreign currency balances can only come about through a current account surplus
- W=M/e+M* where domestic residents hold their wealth W measured in foreign currency in domestic currency priced in foreign currency at M/e and foreign currency M*.
- Asset demands depend upon the level of wealth and inflation L=L(W, pi) and L*=L*(W, pi*)
- With money markets in equilibrium ratio of home money to foreign money is [M/eM*]=L/L*=l(W, ε) where epsilon = expected depreciation of the home currency
- Currency substitution depends upon the monetary policy pursued by the domestic authorities.
- Unanticipated rise in domestic monetary growth will lead to depreciation of the domestic currency. In turn stimulating foreign demand for domestic tradables leading to a current balance surplus financed by domestic residents accumulating foreign currency balances until the surplus is eliminated by appreciation in the real exchange rate.
- Weakness of this models is that they assume that capital inflow is solely in the form of money - no bonds are permitted in the analysis and thus the model is only applicable to economies with not well-developed financial and capital markets.