DP355 | Exchange Rate Determination with Bank-Financed Investment

Publication Date

01/11/1989

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Abstract

This paper analyses the effects of monetary shocks in the determination of exchange rates in economies where banks play a central role in providing finance for domestic investment and in international capital transactions. This is a situation that prevails in many countries, both developed and developing. For such countries the standard models of exchange rate determination are not strictly appropriate. As there are six state variables, a rational expectations simulation model is constructed and is used to carry out the dynamic analysis. In addition to the exchange rate there are two other jump variables in the model: Tobin's q and the shadow price of bank debt, which depends on expectations of future interest rates. It is shown that financing investment through intermediation helps to stabilize the economy following a domestic monetary shock but makes the economy more vulnerable to a foreign monetary shock.