A monetary model is a way of describing the monetary side of the economy: the interaction between people’s spending and the supply of money the government creates. Policymakers use these models to understand the effects their choices will have on the economy. These models are particularly relevant in predicting the fluctuations of exchange rates as a result of monetary policy.
Monetary policy is one tool governments have at their disposal. Another is fiscal policy, which uses government spending in various sectors to encourage growth in the economy. When the government uses monetary policy, it targets either a certain level of money supply or a certain interest rate. Policymakers use a monetary model to estimate the effect a change in monetary policy will have on other economic variables.
There are two main types of monetary models that policymakers use to model the behavior of exchange rates. One is the flexible monetary model, which assumes that prices react instantly to changes in monetary policy. In a flexible model, purchasing power parity is assumed, which means a certain amount of currency will buy the same amount of goods as will any amount of currency it can be exchanged for. This means that when prices adjust in response to new policies, exchange rates change as well.
The other kind of monetary model is a sticky price model. According to this type of model, when changes to national monetary policy are announced, prices do not respond right away. This is a reasonable expectation because shopkeepers are relatively slow to react to investment news, and they often hold prices at a fairly stable level to avoid alienating customers. Exchange rates, however, adjust quickly because they are determined by investment behavior, and investors are sensitive to policy changes. Thus, under this type of model, changes to the money supply affect people’s real income levels.
Like all models, monetary models are simplified ways of representing actual behavior. To be effective, a model must be complicated enough to give useful results. It must be simple enough, however, to be understandable. The more complex a model is, the closer it is to the real world, but the cause of observed effects is more difficult to determine in more complicated systems.
Using the predictions of a monetary model, the government can adjust its monetary policy to achieve its objectives using various methods. One common method is carried out by the circulation desk of a country’s central bank, which controls the money supply. The desk staff, at the direction of policymakers, can buy or sell bonds to contract or expand the money supply. The government can also change the interest rate at which it lends money to banks, which acts as a benchmark rate for other lending.