INTERNATIONAL FINANCE LESSON 6

The Monetary Approach to the Exchange Rate Antu Panini Murshid Today’s Agenda   The law of one price and purchasing power parity The monetary approach to the exchange rate    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 Why? f Thus Pi = e * Pi Arbitrage for any two countries once again and any good i 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 Example   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/Pf Alternatively the rate of depreciation of one currency relative to another should be equal to the difference in their rates of inflation, i.e %∆e = -f Price Level: Key to Understanding the Exchange Rate   According to the monetary approach, 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 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 real interest rate 3…This is excess demand is eliminated when i rises 5% 4% A rise in  causes the real interest rate to fall SN, supply 2…creating an excess demand for loanable funds I, demand 1,000 1,500 loanable funds Expansionary Monetary Policy in the Money Market Interest rate M1s/P2 Money supply M1s/P    i1=15% Equilibrium interest rate 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) real money balances 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   First the price level rises as a consequence of the rise in the nominal interest rate Second the price level rises because of an excess demand for loanable funds, which in turn causes the interest rate to increase Inflationary Expectations and Financial Assets I II III IV V The increase in the rate of growth of money raises inflationary expectations Investors anticipate a rise in interest rates, which leads to a shift out of bonds an into money The price of bonds falls and the interest rate rises The excess demand for money causes the price of money to fall and the price level to rise In this case the rise in interest rate induces the price level to rise Rise in Investment Demand I II III IV The initial inflationary spurt causes r to fall which creates an excess demand for loanable funds Consequently aggregate demand rises (investment is a component of aggregate demand) This puts upward pressure on P, lowering real money supply and raising i In this case the rise in the price level induces the rise in nominal interest rates Summarizing  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? In the short-run:   ↑ Ms ⇒ ↓ i ⇒ ↑ e > 10% (overshooting) In the long-run:  ↑ P ⇒ ↑ i to initial level, and ↓ e such that overall increase in e is 10% Impact of an Expansionary Monetary Policy  US money supply M(t) Slope = +  M(t0) Slope =  t0 time 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) Impact of an Expansionary Monetary Policy  Nominal interest rate i1+  i1 t0 time As a consequence of the rise in the rate of money expansion, the expected rate of inflation rises from  to + To preserve real interest rate parity the nominal interest rate must rise by  Impact of an Expansionary Monetary Policy Price level  Slope = +  Slope =  t0 time The rise in i creates a disequilibrium in the money market, which is cleared by a jump in the price level Moreover from t0 onward the price level is increasing at a faster rate Impact of an Expansionary Monetary Policy Exchange rate  Finally note that by PPP the exchange rate jumps at t0  And continues rise thereafter at a faster tate Slope = + Slope =  t0 time The Short-Run and the LongRun   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 MS 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 LongRun    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 respond to changes in money growth rates and inflationary expectations ... Empirical Evidence 16 It would appear that over the past 40-years, the Fisher effect worked fairly well 14 12 10 Nominal interest rate Percent Inflation rate -2 1955 1 960 1 965 1970 1975 Year 1980