As shown in Chapter 1, most emerging-market and developing economies maintain some type of officially determined exchange rate regime. Accordingly, the benchmark model of Part 2 was built on the assumption of a fixed exchange rate. However, as also shown in Chapter 1, a substantial number of emerging-market economies – and a few developing economies as well – operate exchange rate regimes that are best described as managed or free floats. To examine how the economy behaves in the short run under this alternative exchange rate regime, in this chapter we will revisit the benchmark model of Part 2 and investigate how it would need to be modified to describe an economy with floating exchange rates. This extension will not only allow us to study the macroeconomics of some important emerging economies but will also give us a frame of reference for analyzing optimal exchange rate regimes in Chapter 18.

The structure of this chapter is as follows: the first section spells out the analytical framework that we will use to study a floating exchange rate economy. Section II takes the first step in analyzing such an economy by examining how the equilibrium nominal exchange rate is determined when the central bank does not intervene in the foreign exchange market. Section III assembles the complete short-run model under floating rates, building on the groundwork laid out in the two preceding sections.