Econ 141 Fall 2013. Slide Set 4 Simple and general models of the monetary approach to the exchange rate. Money and Exchange Rates – Simple Model.
Slide Set 4
Simple and general models of the monetary approach to the exchange rate.
or, equivalently, the real money supply equals real money demand:
in rates of change
and then use our equations for inflation to substitute and get
Intuition behind the fundamental equation,
Suppose that U.S. and European real income growth rates both equal zero (gUS= gEUR = 0), and that the European price level is constant, so that European inflation is zero.
1. Because prices are flexible and GDP, YUS, is constant, the price level rises by 10% and real money balances MUS/PUS are constant.
2. PPP implies that the exchange rate E rises by 10% because the price level for the U.S. rises relative to the price level for Europe. The dollar depreciates by 10%.
1. GDP growth is zero, so the growth rate of real balances M/P is zero.
2. The price level P and money supply M must grow at the same rate, μ. Inflation in the U.S. equals μ .
3. The rate of depreciation of the exchange rate is determined by relative PPP as
4. If the European inflation rate is zero, the dollar depreciates at a rate of μ against the euro:
At time T, the United States will raise the rate of money supply growth to a higher rate, μ + Δμ
At T, real balances must continue to stay constant (U.S. and European GDP growth rates are zero). U.S. inflation rises at time T from to
The rate of depreciation of the dollar against the euro also rises from to
The monetary approach to prices and exchange rates suggests that, all else equal:
Increases in the relative rate of inflation should correspond to equal increases in the rate of depreciation for the home currency,
Increases in the relative money supply growth rates should correspond to equal increases in relative inflation and, hence, the rate of exchange rate depreciation for the home country.
but Zimbabwe legalized foreign currency use and dollarized.
Dividing by P, we can derive the demand for real money balances
This graph shows the differences between the real interest rate and the U.S. real interest rate using monthly data for 1970 through 2012. These are calculated by subtracting average core CPI inflation for the past year from the current 3-month nominal rate.
These are the real interest rates for the U.S., U.K. and Germany used in the previous graph. (The differences between U.S. and U.K. rates reflects differences in inflation rates.)
An increase in the money supply growth rate for the general model of money demand
tells us that the rate of depreciation of the dollar also rises by Δμ.
shows that E$/€ depreciates suddenly at T.
In this example, the growth rate of the U.S. money is raised from μ to μ+Δμ
The nominal anchor
Relative PPP says that home inflation equals the rate of depreciation plus foreign inflation.
A simple exchange rate rule is to set the rate of depreciation equal to a constant.
Choosing the desired long-run rate of depreciation implies that foreign (US) inflation rate anchors home (Brazilian) monetary policy.
Choosing a target rate of inflation sets the desired rate of depreciation given foreign (U.S.) inflation.
It allows the money supply growth rate to vary with real income growth.
The Fisher effect tells us how inflation depends on the international real rate of interest.
This chart shows the global disinflation