A Model of Exchange Rate Determination under Currency Substitution and Rational Expectations

This paper analyzes a two-sector model of exchange rate determination for a mall open economy with flexible prices. Residents are assumed to hold both domestic and foreign currency and to have rational expectations. The model satisfies the homogeneity postulate but it is shown that an increase in the rate of expansions of money supply leads to an instantaneous deterioration of the real exchange rate. In the long run, however, the latter moves back to its previous level.