Explain the fundamental equation of the monetary approach, International Economics

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Q. Present and explain the Fundamental Equation of the Monetary Approach.

Answer: Suppose E$/E = PUS/PE and that domestic price levels depend on domestic money demands and supplies:

PUS = M^SUS/L(R_$, Y_US) PE = M^SE/L(R_E, Y_E)

So the exchange rate is completely determined in the long run by the relative supplies of those excise and the relative real demands for them. Alters in interest rates and output levels affect the exchange rate only through their influence on money demand.

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