Towards a New Monetary Theory of Exchange Rate Determination

57 Pages Posted: 30 Aug 2019

See all articles by Ambrogio Cesa-Bianchi

Ambrogio Cesa-Bianchi

Bank of England

Michael Kumhof

CEPR

Andrej Sokol

Bank of England

Gregory Thwaites

London School of Economics & Political Science (LSE) - London School of Economics

Date Written: August 30, 2019

Abstract

We study exchange rate determination in a 2-country model where domestic banks create each economy’s supply of domestic and foreign currency. The model combines the UIP-based and monetary theories of exchange rate determination, but the latter with a focus on private rather than public money creation. The model features an endogenous monetary spread or excess return in the UIP condition. This spread experiences sizeable changes when shocks affect the relative supplies (of bank loans) or demands (for bank deposits) of the two currencies. Under such shocks, monetary effects dominate traditional UIP effects in the determination of exchange rates and allocations, and this becomes stronger as domestic and foreign currencies become more imperfect substitutes. With these shocks, the model successfully addresses the UIP puzzle, and it is also consistent with the Meese-Rogoff and PPP puzzles.

Keywords: bank lending, money creation, money demand, endogenous money, uncovered interest parity, exchange rate determination, international capital flows, gross capital flows

JEL Classification: E44, E51, F41, F44

Suggested Citation

Cesa-Bianchi, Ambrogio and Kumhof, Michael and Sokol, Andrej and Thwaites, Gregory, Towards a New Monetary Theory of Exchange Rate Determination (August 30, 2019). Bank of England Working Paper No. 817, August 2019, Available at SSRN: https://ssrn.com/abstract=3445454 or http://dx.doi.org/10.2139/ssrn.3445454

Ambrogio Cesa-Bianchi (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

HOME PAGE: http://https://sites.google.com/site/ambropo/

Michael Kumhof

CEPR ( email )

London
United Kingdom

Andrej Sokol

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Gregory Thwaites

London School of Economics & Political Science (LSE) - London School of Economics ( email )

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