Transcript MCF Outline 4

Outline 4: Exchange Rates and Monetary
Economics: How Changes in the Money Supply
Affect Exchange Rates and Forecasting Exchange
Rates in the Short Run
4.1 Introduction
4.2 Quantity Theory of Money
4.3 Monetary Approach to Exchange Rates
4.4 Conclusion
4.1 Introduction
Impact of money supply on GDP is the major
subject of monetary and macroeconomics.
Important Question: Can we manage the economy
(dampen business cycles) by changing the money
supply.
Since FX rates are the prices of one money for
another, these “money models” of the economy
are applied to different countries to predict and
explain future movements in FX rates.
4.2 Quantity Theory of Money (QTM)
The QTM is a simple macro model that explains
the relationship between inflation, money
supply and the level of output (real GDP).
4.2 Quantity Theory of Money
The QTM model is:
PY = MV
Where:
P = price level (e.g., consumer price index)
Y = sometimes denoted as Q is real GDP
M = money supply
V = velocity of money or the number of
times the average dollar is used in a
transaction in a year
4.2 Quantity Theory of Money
Assume that V is a constant and divide both sides
by Y:
M
P
Y
V
If M grows faster than Y, P rises, or if M rises
and Y is constant, prices will rise the same as
M. Now for the foreign country:
*
*
M
*
P  *V
Y
4.2 Quantity Theory of Money
PPP shows that:
P
E *
P
Therefore:
M
V
E  Y*
M
*
V
Y*
4.2 Quantity Theory of Money
QTM shows that, in the long run, relative growth
of M versus Y for two countries determines the
direction of the FX rate.
4.3 Monetary Model of FX Rates
The money market demand equation:
md = p + ay – br
md depends on the price level (p) national income (y) and interest rates (r), where a and b are slopes that
are the same in both countries. All variables are in natural logs or growth rates except for the interest
rate, which is already a percentage. Higher price levels requires higher money balances for
transactions, higher national income creates a higher demand for money for transactions and higher
interest rates lowers demand for money
The money supply, “controlled” by the central bank, is ms.
Since equilibrium always holds in money market, ms always equals md, therefore:
ms = p + ay – br
We denote md and ms as m.
4.3 Monetary Model of FX Rates
The foreign country money market equation is the same
except variables have a “ * “:
m* = p* + ay* – br*,
where m = md = ms.
Since the FX rate is determined by relative md and ms in
both countries for a given income and rate of interest,
subtract foreign equation from domestic:
m – m* = p – p* + a( y – y*) – b(r – r*)
4.3 Monetary Model of FX Rates
Assume that PPP holds continually and E is the dollar price of the foreign
currency:
P
E *
P
or in growth rate form (lower case letters denote growth rate or logs):
e = p – p*
Substitute e for p – p* in money equation and solve for e:
e = (m – m*) – a( y – y*) + b(r – r*)
4.3 Monetary Model of FX Rates
e = (m – m*) – a( y – y*) + b(r – r*)
If m is increased in the US faster than in the foreign
country (m*), holding y and r constant, the $ price
of the foreign currency will rise by the difference
in m growth.
Note that slope on (m – m*) is assumed to be 1.0 by
theory. If slope is greater than 1.0, changes in M
may be a source of instability on E.