A dynamic IS-LM-X model of exchange rate adjustments and movements

Abstract

This paper contributes to the literature through developing a model of exchange rate adjustments in a dynamic IS-LM-X analytical framework. Our new model, in particular, a) makes the IS-LM model dynamic; b) endogenizes the exchange rate and price variables and; c) extends the dynamic IS and LM components into the external sector in an open economy that evolves over time. The effect of a change in monetary policy on the exchange rate is evaluated and the trajectory towards its new long-run equilibrium level is projected. These are in contrast to the traditional monetary models of exchange rate determination and adjustments that play primarily with the LM component of the IS-LM framework in discrete steps. Effects of interest rate parity and purchasing power parity are then scrutinized, ranging from the short-term to the long-run continuously. The study has profound policy implications, especially in an era of quantitative easing.