MONETARY POLICY, EXPECTATIONS AND REAL EXCHANGE RATE DYNAMICS*

Abstract

The theoretical analysis is presented in Section I in which we use a small model of an open economy to explore the response of output, inflation and the exchange rate to a change in monetary policy. Since the results depend critically on the nature of expectations we consider the implications separately of adaptive and rational expectations. In Section II we report the results of our empirical studies of exchange rate determination. We develop a general model of the exchange rate which incorporates the structural and portfolio balance approaches as well as the purchasing power parity approach. We also examine the role of interest rate changes and North Sea oil in determining the level of sterling. In Section III we conclude with a discussion of the policy issues arising from the paper as a whole. We distinguish between real shocks (such as the discovery and exploitation of North Sea oil) and nominal shocks (such as 'balanced' changes in the money supply). The former will have real effects on the economy in the long term; the latter will not. The real effects may include changes in the real money supply. Nominal shocks may also affect the real exchange rate in the short term. We argue that it is wrong to attempt to offset these real effects either in the short term or the long term. If intervention is thought desirable it should not be directed at the exchange rate, which is determined in an efficient market, but at those sectors of the economy-particularly labour markets-which operate inefficiently. I. The model In this section we discuss a general model of the economy and present the