Money shocks and deviations from purchasing power parity

This paper applies the island-economy framework of Phelps (1970) to a small open economy under a flexible exchange rate to study the effects of nominal (and real) disturbances on the purchasing power parity relation. Incomplete information about the aggregate state of the economy (and informational differences between agents) implies that a monetary shock that has finite variance can induce deviations from purchasing power parity while also affecting production, consumption and the current account. The real effects of money, however, become smaller as the variance of money gets larger. A type of ‘Lucas slope effect’ of money on deviations from purchasing power parity is obtained.