Chapter 13
Basic Principles and Assumptions

At the core of the monetary model is the connection between the exchange rate and the BoP equilibrium. BoP stands for Balance of Payments. The balance of payments measures the in- and outflows of payments from exports, imports and capital transfers (usually for investment purposes in home or foreign countries). The exchange rate adjusts so that the value of inflows of foreign currency multiplied by the exchange rate equals the value of outflows. Thus, export surpluses represent an increased demand for the domestic currency and lead to appreciation pressure.

The monetary model was particularly widespread in the 1970s and is the origin of many further developments. However, it also has many shortcomings, in particular, the very simple assumptions it is based on and the undifferentiated structure of the model. For example, it cannot adequately explain many empirical phenomena and the number of theoretical research possibilities is limited. Nevertheless, precisely because of its simplicity, the monetary model is an excellent reference model.

The monetary model is suitable for (mid- to) long-term forecasts, as can be seen from the underlying assumptions.

1. Vertical Supply of Goods
2. Simple Money Demand Equation

   $$M^d=\mathit{kPy}=k-,k>0$$

   (13.1)

3. Purchasing Power Parity

   $$P=S{P}^{\ast }$$

   (13.2)

ad 1) This assumption implies that the model economy is in long-term equilibrium. When examining shocks to growing economies, the model statements remain valid if either the money supply grows at the same rate, and then shocks are analyzed relative to these growth rates (see (2)), or the foreign economy grows at the same rate. These cases are easiest to analyze in the relative form given below.

The money demand equation in the Monetary Model is a quantity equation, like in the AADD model. The here presented form is called the Cambridge equation, in which the cash coefficient $k$ corresponds to the inverse velocity of circulation $\frac{1}{v}$. Changes of $k$ can represent either changed behavior of consumers and companies (e.g. increased propensity to save) or disturbances in the monetary process (banking crisis, stability of the transmission mechanisms in the financial market, etc.).

Purchasing Power Parity (PPP) represents the link to the foreign economy. Here, as well, the "long term" view of the model becomes visible. The PPP is based on the assumption of arbitrage freedom and can be seen as a slow and weak adjustment process due to the inertia of prices and other factors such as non-tradeable goods and transport costs. We also assume that foreign countries are in balance, i.e. $P^{\ast }$ is fixed. In the Monetary Model, the exchange rate is quoted in price - as usual in these models - i.e. $S$ is the price of one unit of foreign currency measured in domestic currency. For example, the exchange rate $S=0,8\frac{\text{€}}{\$}$ means for an European that the price for one US dollar is 0.8€. Therefore, in price quotation, an increase of $S$ means a devaluation of the domestic currency.

ATTENTION: Usually the stock exchange uses the quantity quotation, i.e. exactly the reciprocal value.