A monetary model of the exchange rate and its application to the czech economy

This paper will discuss problems of the floating exchange rate and consists of two parts. In the first theoretical part, a model of exchange rate in the spirit of monetary approach is described, which was developed mainly in the seventies. The explanation is based on the simple model of the exchange rate, which assume absolute capital mobility and flexibility of all prices in the economy. In that simple model, money demand and money supply determine the exchange rate. The level of exchange rate is decided by different developments of money supply in domestic and foreign economies, by a different level of output in domestic and foreign economies and by interest rate differentials between domestic and foreign economies (with respect to differences in inflationary expectations in the respective economies). The second part contains an application of a simple monetary model of the exchange rate to the Czech economy. In the last three years it can be said, that the exchange rate is moved mainly by market factors. Thus, one can apply a monetary model of exchange rate to the Czech economy in that period. A stated empirical analysis indicates the validity of the monetary model of exchange rate in the case of the Czech economy. Unfortunately, time series are too short and the results of empirical analysis have not yet yielded a general validity.

Keywords: exchange rate, money demand, floating, exchange rate determinants, monetary approach, money supply