Abstract

A Money Supply/Money Demand Model for Flexible Exchange Rates and Central Bank Policy

This article sets out to link up money supply/money demand analysis with the short-term financial market approach of exchange rate theory. This financial market approach, extended by inclusion of the commercial banking sector, offers the possibility to determine the equilibrium values of money supply, interest rate and exchange rate simultaneously in a model and to derive their changes due to central bank policy (monetary policy measures and foreign exchange market interventions). In the case of monetary policy measures such as the adjusted monetary base an occurs coupled with a lowering of the interest rate (i.e. a qualitatively equal result as in the case of the usual money supply/money demand analysis), and a depreciation of the domestic currency. The traditional adjustment processes on the money market have superimposed on them exchange-rate-induced demand and supply changes and their impact on the money supply and interest rate are quantitatively modified. In this connection, it also becomes clear that, given exchange rate flexibility, as opposed to exchange rate stability, an interest rate cut triggered by expansive monetary policy is damped as a rule (providing that there is stabilizing exchange rate speculation). Foreign exchange market interventions, which cannot be given suitable treatment in a traditional money supply/money demand analysis where the foreign exchange market is excluded, are analysed under the assumption that the effects of intervention policy on the adjusted monetary base (e.g. by open-market operations of the central bank with government securities) are sterilized. It proves that even under this assumption, changes in the money supply have to be reckoned with. Moreover, it is found that, for instance, sterilized intervention purchases of foreign exchange bring about, as expected, a depreciation (as long as domestic credit instruments and foreign instruments are not regarded as perfect substitutes), and in addition an interest rate increase occurs as a rule, although an interest rate reduction cannot be precluded a priori