Question

Define this two questions in a paragraph

C. Explicate the monetary approach to exchange rates. D. Answer the questions on the mini case Flame we presented in class.

Answer 1

Key Ingredients of the Monetary Approach
The monetary approach has two key ingredients: exogeneity of the real exchange rate, and
a simple Classical model of price level determination.1 Exogeneity of the real exchange rate
means that inflation at home or abroad will not affect how much foreign goods cost in terms
of domestic goods. The Classical model of price determination says roughly that the price
level is proportional to the money supply, so that monetary policy is the key determinant of
inflation rates.
Eventually, we will explore both of these constituents in some detail. Suffice it to say
that as short-run descriptions of real economies, both appear quite unrealistic. However as
long-run descriptions, they show somewhat more promise. So the monetary approach to
flexible exchange rates is best seen as a description of long-run outcomes. As a description
of short-run outcomes, it serves as a reference model that highlights some core concerns in
our attempt to understand exchange rate determination.

Exogenous Real Exchange Rates
Let P be the domestic consumer price index and P
∗ be the foreign consumer price index.
For now, we will keep things simple by thinking of each price index as the monetary cost of
a fixed consumption basket. Equation (3.1) defines the real exchange rate,

We call Q the real exchange rate because it tells you the rate at which domestic goods must
be given up to obtain foreign goods. The monetary approach to flexible exchange rates
assumes that Q is exogenous. This exogeneity assumption fits naturally with the Classical
model of price determination, which generally treats real variables as exogenous.
Given the real exchange rate, the nominal exchange rate and the relative price level have.