INTERNATIONAL FINANCE LESSON 6

Price Level: Key to Understanding the Exchange Rate the key variable to understanding the long-run behavior of the exchange rate is the price level and the rate of change of the price

The Monetary Approach to the Exchange Rate

Antu Panini Murshid

 Implications of the model

 Real interest rate and the Fisher effect

 Impact of an expansionary monetary

policy

Law of One Price

 The law of one price states that as long as

there are no barriers to trade or

transportation costs, identical goods in two countries must sell for the same price, when their prices are expressed in the same

currency

 Thus Pi = e * Pif

for any two countries

and any good i

Why?

Arbitrage once again

Purchasing Power Parity

 Purchasing power parity is the law of

one price applied to a fixed basket of

commodities

 The law of one price implies that

e=P/Pf, where P is the price of a basket

of commodities in the home country

and Pf is the price of that same basket

of commodities abroad

Implications of Purchasing

Power Parity

 PPP states that the exchange rate between

two currencies is in equilibrium when their purchasing power is the same in each

country, i.e the exchange rate between two countries should equal the ratio of the two countries' price levels

 Thus when one country’s price level is

increasing (decreasing) its exchange rate must also be depreciating (appreciating)

 PPP implies that the real exchange rate

should be equal to one

Relative PPP vs Absolute

PPP

 Absolute PPP was described in the previous

slides

 Relative PPP refers to rates of changes of

price levels, that is, inflation rates This

proposition states that the rate of

appreciation of a currency is equal to the

difference in inflation rates between the

foreign and the home country:

%e =  - f

 If the US inflation rate is 10% and the UK

inflation rate is 5%, the dollar will depreciate against the pound by 5%

 Relative PPP is a useful concept when we

are trying to conceptualize the impact of

changes in rates of monetary growth (or

prices) as opposed to one off changes

Monetary Approach to the

Exchange Rate

 In its simplest form, the monetary approach

to the exchange rate is simply a restatement

of PPP

 Hence according to the monetary approach

to the exchange rate, the exchange rate

should be equal to the ratio of the domestic

and foreign price levels, i.e e = P/P f

 Alternatively the rate of depreciation of one

currency relative to another should be equal

to the difference in their rates of inflation, i.e

Price Level: Key to Understanding

the Exchange Rate

the key variable to understanding the long-run behavior of the exchange rate

is the price level and the rate of

change of the price level

 This differs from the asset market

approach which emphasized the

interest rate

A Long-Run Theory

 The monetary approach to the exchange

rate is a theory on the long-run behavior of the exchange rate, since it assumes that

prices are flexible In the short run prices could very well be rigid and PPP need not apply

 This contrasts with the asset market

approach, which is a theory of the short-run behavior of the exchange rate

Money Supply and Money

Demand

 Given the role of prices, a theory of the

determinants of the exchange rate

must hope to explain movements in the price level

exchange rate focuses on the supply

and demand for money as the key

determinants of the price level

Basic Model

1) M d =P*L(y,i): Liquidity preference

2) M s =M d: Money market equilibrium

3) e=P/P f : PPP

 There is a little bit more to it than this The

money supply is normally written as the

sum of domestic credit and foreign

exchange reserves (we will study this in

greater detail later)

Basic Model

by PPP:

4)

 Recognizing that the foreign price level is

simply the ratio of foreign money supply to money demand we have:

5)

f

P

) i , y ( L

M

e 

) i , y ( L M

) i , y ( L M

e  f f

Implications of the Model

 Let us ignore developments in the foreign

country and focus on the implications of

developments at home, i.e take the foreign

price level, P f, as given then:

dollar depreciates (e↑)

dollar depreciates (e↑)

appreciates (e↓)

Graphical Illustration

 It will be useful to illustrate these

implications of the model graphically, but in order to that first we need to

introduce a new diagram for analyzing money market developments that

emphasizes the price level, not the

interest rate, as the adjustment

mechanism

The Money Market in the

Long-Run

 Consider the

following money market diagram drawn with nominal money balances on the horizontal axis and the price level

on the vertical axis

The Money Market in the

The Money Market in the

Long-Run

 Note that since an

increase in income will raise the demand for nominal money balances the money demand curve will rotate clockwise

The Money Market in the

Long-Run

 An increase in

interest rates will have the opposite effect by lowering the demand for nominal money balances

money supply will

raise the price

level, which will

correspond to

higher values of e

M s 2

P 2

e 2

interest rates will

also raise the

price level, which

Implications of Monetary

Model for the Exchange Rate

M d (i,y)

Price level

contrast will cause

the price level to

fall, which will

Do the Model Predictions

Make Sense?

 The first implication that an increase in money

supply raises the price level and causes the

exchange rate to depreciate is uncontroversial

 Similarly the implication that an increase in output

will cause the exchange rate to appreciate is

reasonable, since increases output would apply downward pressure on prices (think of a rightward shift in the aggregate supply curve)

 However why should an increase in interest rates

cause the exchange rate to depreciate?

The Implications of a Rise in

Interest Rates

 There are two problems with how the model

links interest rates to the exchange rate

remove money market disequilibria, so what is causing the interest rate to change?

interest rates will ultimately lead to a depreciation

of the currency seems inconsistent with our discussion on the short-run behavior of the exchange rate

Understanding Why the

Interest Rate Changes

 In fact the implication that an exchange rate

depreciation will follow an interest rate increase is quite reasonable The key is to understand why the interest rate changes

 It turns out that increases in the interest rate follow

from expansionary monetary policies that raise the rate of inflation, which is consistent with an

exchange rate depreciation

 To see why this is the case, we will need to

introduce the notion of the real interest rate

The Real Interest Rate

 The ex ante real interest rate is defined as:

r = i - e ,

where e is the expected inflation rate

 The ex post or realized real interest rate is

defined as:

r = i - ,

where  is the realized inflation rate

 The real interest rate is determined in

the market for loanable funds

 The supply of loanable funds comes

from savers

 The demand for loanable funds comes

from those who wish to borrow to

make investments

What Determines the Real

Interest Rate?

 The most important factor that determines

the demand for loanable funds is the cost of obtaining a loan—the real interest rate

Since borrowers do not know the inflation

rate before hand the demand for loanable

funds is influenced by the ex ante real

interest rate

implies a lower demand for loanable funds

a higher demand for loanable funds

Determinants of the Demand

for Loanable Funds

Demand Schedule for

1,000 1,500

Technological changes, which affect the MPK, as well as factors influencing the risk characteristics of investments will shift the demand for loanable

funds schedule

 The supply of loanable funds could

also respond to the ex ante real

interest rate, however the evidence

suggests that this relationship is weak

 More important determinants are

demographic shifts that alter private

savings behavior and changes in fiscal expenditure patterns of governments

Determinants of the Supply of

Loanable Funds

Supply Schedule for Loanable

incentives for savers to save

However this effect

savings schedule to shift

Market for Loanable Funds

 Clearly long-run factors that shift the

demand for and supply of loanable funds will affect the real interest rate, however Irving Fisher noted that in general the long-run real interest rate can be regarded as roughly constant or at least exhibiting only weak trends

 The Fisher effect implies that there is a

one-to-one relationship between the inflation rate and the nominal interest rate

Inflation rate

It would appear that over the past 40-years, the

Fisher effect worked fairly well

Expansionary Monetary Policy and the Interest Rate

 According to the Fisher effect an

expansionary monetary policy, which raises the rate of inflation, i.e an

increase in the rate of growth of

money, will also cause the nominal interest rate to rise

Expansionary Monetary Policy in the Market for Loanable Funds

funds

4%

1,500

3…This is excess demand is

eliminated when

i rises

Expansionary Monetary Policy

in the Money Market

 When  increases, for

any given i, r must fall

 The Fisher effect

implies that i must rise

 The resulting

disequilibrium is cleared by the rising price level

i1=10%

Money demand L(i,y)

Equilibrium interest rate

real money balances

Interest rate Money supply M 1 s /P

i1=15%

M 1 s /P 2

Why Does the Price Level

Rise?

 Why exactly does the price level rise?

 There are two ways to think about this

depending on how you want to attribute

causality

the rise in the nominal interest rate

excess demand for loanable funds, which in turn causes the interest rate to increase

Inflationary Expectations and

Financial Assets

I The increase in the rate of growth of money

raises inflationary expectations

II Investors anticipate a rise in interest rates, which

leads to a shift out of bonds an into money

III The price of bonds falls and the interest rate

rises

IV The excess demand for money causes the price

of money to fall and the price level to rise

V In this case the rise in interest rate induces the

price level to rise

Rise in Investment Demand

I. The initial inflationary spurt causes r to fall

which creates an excess demand for

loanable funds

II. Consequently aggregate demand rises

(investment is a component of aggregate demand)

III. This puts upward pressure on P, lowering

real money supply and raising i

IV. In this case the rise in the price level

induces the rise in nominal interest rates

 To summarize the interest rate rises in

the long-run because of increased

inflationary pressures This can result from a change in the rate of growth of money supply, but not from one-off

changes in money, which have no

effect on the interest rate

Real Interest Rate Parity

 We can now bring together what we

have learned about the Fisher effect, interest rate parity and PPP

 Interest rate parity: i - if = E(%∆e)

 PPP: %∆e =  – f

 Real interest rate parity: i - if = E(  – f)

 Note that real interest rate parity is just

another way of stating the Fisher effect

Impact of an Expansionary

Monetary Policy

 First consider the effects of a one-off

10% increase in US money supply?

Impact of an Expansionary

Monetary Policy

 Now consider the

implications of an increase in the rate

of growth of money from  to +

 The increase in

money growth rate

is illustrated in the diagram as a rise in the slope of M(t)

to +

 To preserve real

interest rate parity the nominal interest rate must rise by 

Impact of an Expansionary

Monetary Policy

 The rise in i creates

a disequilibrium in the money market, which is cleared by

a jump in the price level

Impact of an Expansionary

Monetary Policy

 Finally note that

by PPP the exchange rate jumps at t0

The Short-Run and the

Long-Run

 In the short run an increase in Ms produces

a fall in the interest rate to equilibrate the

money market, as prices are rigid ⇒ the only way to maintain interest parity is to expect

an exchange rate appreciation

 In the long run, when prices adjust, an

increase in rate of growth of M S leads to an

increase in expected inflation and the

interest rate (Fisher effect) This in turn

leads to an exchange rate depreciation

(PPP)

The Short-Run and the

Long-Run

 The key difference between the short-run

and the long-run is the speed of adjustment

in prices

 In the short-run prices are sticky and the

interest rate adjusts to bring the money

market to an equilibrium

 In the long-run prices are flexible and

interest rates are insensitive to one-off

changes in money but do respond to

changes in money growth rates and

inflationary expectations