Exchange Rate and Stock Market Dynamics in a Two-Country Model

This chapter considers macroeconomic real-financial market interactions in a two country framework with money, bonds, equities and a foreign exchange market with a flexible exchange rate. The model uses conventional dynamic multiplier dynamics in its real part as in Blanchard (1981), augmented by either a simple LM curve or later on a simple Taylor interest rate policy rule, but enriched by a broad spectrum of financial assets, based in their dynamic interaction on the assumption of perfect substitute and perfect foresight throughout. Contrary to Blanchard’s (1981) original contribution on stock market dynamics, we however aim to analyze and solve a revised form of the model, in order to avoid the heroical assumption of the jump-variable technique (JVT) of the rational expectations school. In approaching such an objective, the model will first be considered in conventional form, starting from the Dornbusch (1976) overshooting exchange rate model, and will then be integrated with the Blanchard (1981) stock market approach in a two-country setup as in Turnovsky (1986). This will lead us to a dynamic model with five laws of motion and a variety of interacting feedback chains and their (in)stability implications.