ABSTRACT
This chapter develops a simple equilibrium model of exchange rate determination that permits a discussion of the international transmission of disturbances. It aims to analyze and solve a simple small-country model that will permit a discussion of the role of the exchange rate in immunizing the domestic economy from foreign disturbances. The chapter extends the analysis to deal with the effects of a monetary policy that seeks to insulate the domestic economy from fluctuations in the world price. It considers the underlying real and monetary sources of fluctuations in the world price, while retaining a modified version of the small-country assumption. It is shown that only the unanticipated portion of foreign monetary movements matter for domestic employment determination, and that such shock would lead to a positive statistical association between domestic and foreign output movements. The chapter concludes with some general comments on the propagation of cyclical movements under flexible exchange rates.
