Towards a new monetary theory of exchange rate determination

Ambrogio Cesa-Bianchi, Michael Kumhof, Andrej Sokol and Gregory Thwaites

No 817, Bank of England working papers from Bank of England

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 (search for similar items in EconPapers)
JEL-codes: E44 E51 F41 F44 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2019-08-30
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:0817

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