The monetary model in Chapter 17 drew attention to important propositions. It reminded us that markets are interdependent—that an excess demand for goods and bonds must be matched by an excess supply of money. It stressed the role of the exchange-rate regime in determining how an open economy maintains monetary equilibrium. It showed why we must distinguish between the short- and long-run effects of policy changes. We saw that a devaluation led at once to a balance-of-payments surplus, but the surplus did not last; by raising reserves and the money supply, it raised absorption, which reduced the surplus.
But the framework of the monetary model is too restrictive. Factor prices are perfectly flexible, leaving output constant at its full-employment level, and this assumption keeps real income constant. Domestic and foreign prices are tied together by purchasing-power parity. Investors are risk-neutral, so open interest parity obtains when there are no obstacles to capital mobility. To focus attention on the money market, the monetary model drastically simplifies behavior in the labor, product, and bond markets.
This chapter presents a richer model. Output does not always stay at its full-employment level; the price level does not depend exclusively on the exchange rate; the domestic interest rate is not tightly tied to the foreign rate.
A PORTFOLIO-BALANCE MODEL
The new model synthesizes much of our earlier work. It borrows its treatment of wage rates, employment, and output from the simple Ricardian trade model in Chapter 3.