INTERNATIONAL FINANCE LESSON 5

real money balances Graphical Illustration Interest rate i1=10% Money supply M1s/P Equilibrium interest rate  Now lets make everything disappear… Money demand L(i,y) real money balances Graphical Illustration  i1=10% …and reappear but rotated clockwise by 90 degrees Interest rate Money supply M1s/P real money balances Equilibrium interest rate Money demand L(i,y) Graphical Illustration return on $ assets  $/€ Expected return on € assets e1=1.00 i1=10% Now lets add the foreign exchange market graph Interest rate Money supply M1s/P real money balances Equilibrium interest rate Money demand L(i,y) Graphical Illustration $/€ Expected e2=1.05 return on € assets Equilibrium return on exchange rate↑ $ assets  e1=1.00 i2=5% i1=10% Now suppose the government raises money supply Interest rate Money supply M1s/P real money balances Equilibrium interest rate ↓ Equilibrium interest rate Money demand L(i,y) Money supply M2s/P Are Our Assumptions Reasonable?  We have assumed that    Exchange rate expectations are given Prices are given It is perhaps reasonable to assume that prices are fixed in the short-run, but prices will most likely change in the long-run In that case is it reasonable to assume that exchange rate expectations will be unchanged The Long-Run    In the long-run money is neutral; an x% change in money supply will cause an x% change in prices, but no change in output Thus in the long-run prices will adjust not the interest rate to bring the money market back into equilibrium To see this consider our money market equilibrium condition Ms = PL(i,y) If Ms changes by x% but so does P then money market equilibrium is restored Exchange Rate Expectations    If in the long run prices adjust not the interest rate, what are the implications for the exchange rate? The implication would be that in the long-run monetary policy has no impact on the exchange rate However one thing that we have not considered is: what happens to exchange rate expectations Purchasing Power Parity   In order to understand how these expectations will change, we need some sort of understanding of what determines the exchange rate over a longer horizon Something we will study next lecture is called purchasing power parity This says that the domestic price level, and therefore monetary policy, influences the long-run behavior of the exchange rate Implications of PPP  PPP tells us that if the price level rises, the exchange rate will depreciate   To see this consider the implications of a currency reform Suppose the Argentine government replaced its current peso with new pesos, worth twice as much as the old peso, what will happen to the peso/$ exchange rate? It will decrease by 50%, that is the peso will appreciate by 100%, while prices in Argentina, in terms of the new peso, will decline by 50% ... demand L(i,y) Graphical Illustration $/€ Expected e2=1. 05 return on € assets Equilibrium return on exchange rate↑ $ assets  e1=1.00 i2 =5% i1=10% Now suppose the government raises money supply... peso/$ exchange rate? It will decrease by 50 %, that is the peso will appreciate by 100%, while prices in Argentina, in terms of the new peso, will decline by 50 % Monetary Policy and Long-Run Expectations... be lower Illustration of Long-Run Scenario Hence the equilibrium exchange rate rises $/€ e2=1. 05 e1=1.00 i1=10% But expectations change Interest rate Money supply M1s/P real money balances In