Transcript Chapter 12 - Academic Csuohio

14
EXCHANGE RATES I:
THE MONETARY
APPROACH IN THE
LONG RUN
1
Exchange Rates and
Prices in the Long Run
2
Money, Prices, and
Exchange Rates in the
Long Run
3
The Monetary
Approach
4
Money, Interest, and
Prices in the Long Run
5
Monetary Regimes and
Exchange Rate
Regimes
6
Conclusions
Introduction to Exchange Rates and Prices
• Consider some hypothetical data on prices and exchange
rates in the U.S. and U.K.:
 Prices of U.S. and U.K. CPI baskets
 1970 PUK=£100
 1970 PUS=$175
1990
1990
PUK=£110
PUS=$175
1990
E£/$=0.63
 Exchange rates (£/$)
 1970 E£/$=0.57
 Prices of baskets in common currency (U.S. $)
 UK
 US
1970 $175 (= £100/ 0.57)
1990 $175 (= £110/ 0.63)
$175 in both years
• Is it coincidence that the exchange rate and price levels
adjusted in this way?
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Introduction to Exchange Rates and Prices
• The ideas of arbitrage
 Chapter 13: applied there to currencies and interest rates
 Chapter 14: applied here to the goods market
• The prices of goods and services in different
countries are related to the exchange rate.
 When the relative prices of goods changes, the exchange rate
adjusts to reflect this change (but this may take time).
• The monetary approach to exchange rates is the
result.
 A long run theory linking money, exchange rates, prices, and
interest rates.
• The foundation of this theory is the fundamental
arbitrage principle known as the law of one price.
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The Law of One Price
• Key assumption – frictionless trade




No transaction costs
No barriers to trade
Identical goods in each location
No barriers to price adjustment
• General idea:
 Prices must be equal in all locations for any good when
expressed in a common currency.
 Otherwise, there would be a profit opportunity from
buying low and selling high.
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The Law of One Price
• Consider a single good, g, in 2 different markets.
• The law of one price (LOOP) states that the
price of the good in each market must be the
same.
• This is a microeconomic concept, applied to a
single good, g.
• Relative price ratio for g:
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The Law of One Price
• If LOOP holds then (for each good g):
This means the price of good g is the same in Europe
and in the U.S.
• What if LOOP doesn’t hold?
 Goods less expensive in U.S.
 Goods less expensive in Europe
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Purchasing Power Parity
• Macroeconomic counterpart to LOOP.
 If LOOP holds for every good in CPI basket, then the
prices of the entire baskets must be the same in each
locations.
• The purchasing power parity (PPP) theory
states that these overall price levels in each
market must be the same.
• Relative price level ratio:
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The Real Exchange Rate
• The relative price level ratio q is an important concept.
It is called the real exchange rate
• Remember the key difference to avoid confusion.
 Nominal exchange rate E is the ratio at which currencies trade.
 Real exchange rate q is ratio at which goods baskets trade.
• However, the real exchange rate has some terminology in
common with the nominal exchange rate…
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Real Appreciation and Depreciation
• Changes in the real exchange rate:
 If the real exchange rate rises
 more home goods needed in exchange for foreign goods
 intuitively called a real depreciation.
 If the real exchange rate falls
 fewer home goods needed in exchange for foreign goods
 Intuitively called a real appreciation.
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Overvaluation and Undervaluation
• Absolute PPP holds if and only if the real exchange rate
equals 1:
• What if absolute PPP does not hold?
 If the real exchange rate is above one (by x %)
 foreign (European) goods are relatively expensive
 foreign currency (euro) is said to be overvalued (by x %).
• why? euros are x% dearer than they would have to be to satisfy
PPP.
 If the real exchange rate is below one (by x %)
 foreign (European) goods are relatively cheap
 foreign currency (euro) is said to be undervalued (by x%).
• why? euros are x% cheaper than they would have to be to satisfy
PPP.
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Absolute PPP, Prices, and
the Nominal Exchange Rate
• We can now see that PPP supplies a reference
level for the exchange rate.
 Rearrange the PPP equation:
 PPP implies that the exchange rate at which two
currencies trade is equal to the relative price levels of the
two countries.
 PPP theory can be used to predict exchange rate
movements – these simply reflect relative prices, so all
we need to do is predict prices.
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Relative PPP, Inflation, and
Exchange Rate Depreciation
• The absolute PPP equation:
• If this is true in levels of exchange rates and
prices, then it is also true in rates of change.
 The rate of change in the exchange rate is the rate of
depreciation in the home currency (U.S. $):
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Relative PPP, Inflation, and
Exchange Rate Depreciation
• The rate of change in relative prices (PUS/PE) is the
home-foreign inflation differential:
• Result is
Relative PPP:
 Relative PPP implies that the rate of depreciation of the nominal
exchange rate equals the inflation differential.
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Relative PPP, Inflation, and
Exchange Rate Depreciation
• Relative PPP is derived from Absolute PPP
 If Absolute PPP holds then Relative PPP must hold
also.
• But the converse need not be true: one could
imagine a case where a basket always costs a
fixed amount more, say, 10% in common currency
terms in one country than the other:
 In this case Absolute PPP fails, but Relative PPP holds.
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Where Are We Now?
• The PPP theory, whether in absolute of relative
form, suggests that price levels in different
countries and exchange rates are tightly linked,
either in levels or in rates of change.
• Stop and ask some questions:
 Where do price levels come from?
 Do the data support the theory of purchasing power
parity?
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Empirical Evidence on PPP
• According to relative PPP, the percentage change in the
exchange rate should equal the inflation differential.
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Empirical Evidence on PPP
• According to absolute PPP, relative prices should
converge over time.
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How Slow is Convergence to PPP?
• Two measures:
 Speed of convergence: how quickly deviations from
PPP disappear over time (estimated to be 15% per
year).
 Half-life: how long it takes for half of the deviations from
PPP to disappear (estimated to be about four years).
• These estimates are useful for forecasting how
long exchange rate adjustments will take.
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Forecasting Real Exchange Rates
SIDE BAR
• If a currency is undervalued or overvalued, then
the real exchange rate is not equal to one at all
times.
 We can allow for this by letting q change in the
formulas we have derived.
 From the definition of q:
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Forecasting Real Exchange Rates
SIDE BAR
• If q=1 is constant (PPP) then the 1st term on the right is
zero.
• To forecast the change in E you just need to forecast the inflation
differential, as before.
• If q deviates from 1, and we can measure it, then we can
use the convergence speed to estimate how quickly q
will rise/fall towards 1.
• This estimate of the rate of change of q can then be factored in,
in addition to the inflation differential, to allow for an estimate of
nominal depreciation.
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Forecasting Real Exchange Rates
SIDE BAR
• Example
 You find that US inflation is 3%, Eurozone inflation is 2%.
 Based on the inflation differential you predict a 1% rate of
depreciation of the US dollar, or E to rise by 1%.
 Then you also discover that the US dollar is 10% overvalued
against the euro (q=0.90), relative to a PPP value of 1.
 You expect 15% of that deviation of –0.1 to vanish in one year,
so you expect q to rise (real depreciation) by 1.5%.
 Adding the inflation differential, you now expect E to rise by
2.5%.
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What Explains Deviations from PPP?
• Transaction costs
 Recent estimates suggest transportation costs may add about 20%
to the cost of goods moving internationally.
 Tariffs (and other policy barriers) may add another 10%, with
variation across goods and across countries.
 Further costs arise due to the time taken to ship goods.
• Nontraded goods
 Some goods are inherently nontradable;
 Most goods fall somewhere in between freely tradable and purely
nontradable.
 For example: a cup of coffee in a café. It includes some highly-traded
components (coffee beans, sugar) and some nontraded components
(the labor input of the barista).
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What Explains Deviations from PPP?
• Imperfect competition and legal obstacles
 Many goods are differentiated products, often with brand names,
copyrights, and legal protection.
 Firms can engage in price discrimination across countries, using
legal protection to prevent arbitrage
 E.g., if you try to import large quantities of a pharmaceuticals, and
resell them, you may hear from the firm’s lawyers.
• Price stickiness
 One of the most common assumptions of macroeconomics is that
prices are “sticky” prices in the short run.
 PPP assumes that arbitrage can force prices to adjust, but
adjustment will be slowed down by price stickiness.
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The Big Mac Index
HEADLINES
• For over 20 years The Economist newspaper has used
PPP to evaluate whether currencies are undervalued or
overvalued.
 Recall, home currency is x% overvalued/undervalued when the
home basket costs x% more/less than the foreign basket.
• The test is really based on Law of One Price because it
relies on a basket with one good.
 Invented (1986) by economics editor Pam Woodall. She asked
correspondents around the world to visit McDonalds and get
prices of a Big Mac, then compute price relative to the U.S.
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The Big Mac Index
HEADLINES
Big Mac
q
1 
“Big M ac index ” =
Big Mac
E $/local currencyPlocal
Big Mac
US
P
1
 The % deviation (+/–) from the US price measures the
over/under
 valuation of the local currency based on
the burger basket.
 Updated every year:
http://www.economist.com/markets/Bigmac/
 In 2004 they tried the same exercise with another
global, uniform product: the Starbucks tall latte.
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The Big Mac Index
HEADLINES
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PPP as a Theory of the Exchange Rate
• In levels we have Absolute PPP:
• In rates of change we have Relative PPP
• Now we need to ask: where do the price levels (and
inflation rates) come from?
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What Is Money?
• Money is an object that serves three functions:
 Store of value
 Money is an asset that can be used to buy goods in the future.
 Financial assets (stocks and bonds) and property are other
stores of value that are not money.
 Unit of account
 How prices are expressed.
 A unit of account is used to measure value of different items.
 Medium of exchange
 Money is generally accepted as a means of payment for goods.
 Money is the most liquid form of payment: an asset that is
easily converted into goods and services
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Measurement of Money
• Different measures of money
 Monetary base = Currency
 Currency in circulation plus currency in banking system
 M1 = Currency in circulation + demand deposits
 Demand deposits are checking accounts payable on demand
by the bank customer.
 M2 = M1 + other less liquid assets
 Other less liquid assets include savings accounts, small time
deposits, and money market mutual funds.
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M0, M1, and M2 in the United States (2007)
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The Supply of Money
• We will focus on M1, the predominant type of
money that we use for transactions.
• We will assume that the nominal money supply M
= M1 is controlled by the central bank.
 In fact, the central bank directly controls only part of M,
namely the monetary base (M0).
 However, central banks can indirectly control M1 by
using interest rate policies and other tools (such as
reserve requirements) to influence the total amount of
bank deposits created (M1 – M0).
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The Demand for Money: A Simple Model
• We assume that the demand for nominal money
is driven by the need to use money to undertake
transactions.
• In the simplest model, the quantity theory: the
amount of transactions assumed to be proportional to
the dollar value of nominal income PY (where real
income is Y).
M
d
demand
for money ($)

PY
nominal income ($)

L
a constant
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The Demand for Money: A Simple Model
• Rearrange to get an expression for the demand for real
money balances (nominal value of money demand
deflated by the price level P):
d
M

P
L
a constant

Y
real income
demand
for real
money
• The demand for real money balances is a constant
multiple of the real income level Y.

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Equilibrium in the Money Market
• The demand for money balances must equal the supply
(denoted M):
M  L PY
• Rewriting this expression, the demand for real money
balances must equal the real money supply:

M
 LY
P
• In the long run, prices are flexible. Prices adjust to equal
real money demand and real money supply.
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The Monetary Approach:
A Simple Model of Prices
• Solving for the price level in each country:
• Fundamental equations of the monetary model of the
price level
 These expressions say that the price level P is determined
by the ratio of nominal money supplied M to nominal money
demanded (LY).
 Prices rise if there is “more money chasing fewer goods”
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The Monetary Approach:
A Simple Model of Prices
• Building blocks:
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The Monetary Approach:
A Simple Model of the Exchange Rate
• Recall that PPP shows us the relationship between the
price level and exchange rates.
 PPP says E equals the ratio of the price levels.
 Substituting for prices using the money market equilibrium
conditions we get the Fundamental equation of the
monetary model of the exchange rate
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The Monetary Approach:
Money, Growth, and Depreciation
• The monetary theory can be also expressed in terms of
rates of change.
 Let growth rate of money supply M be m :
 Let growth rate of real income Y be g :
 These expressions apply to growth rates in Europe too.
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The Monetary Approach:
Money, Growth, and Depreciation
• The levels equation
• The same equation in growth rates (L is assumed to be
constant for the moment):
• Important result: inflation equals the excess of money
growth over real output growth.
• Same for Europe:
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The Monetary Approach:
Money, Growth, and Depreciation
• Where does that get us?
 To some clear and testable predictions.
 Combining these expressions with Relative PPP we can
obtain expressions relating the rate of depreciation, the
inflation differential, and money and output growth rates.
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Exchange Rate Forecasts Using the Simple Model
• Assumptions in a simple policy experiment
 Both countries
 Constant money growth rate m , fixed level of output Y
 Foreign
 Money growth m is zero, inflation p is zero
• Consider two cases:
 Case 1: Home money growth m is zero, inflation p is zero. Home
implements a one-time x% increase in M.
 Case 2: Home money growth m is positive, inflation p is positive.
Home increases its rate of money growth m by D m
• What happens to key economic variables
according to the monetary approach in each
case?
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Exchange Rate Forecasts Using the Simple Model
• Case 1: One-time x% increase in money supply M




Real money balances remain unchanged (Y fixed).
The home price level P increases by x%.
The exchange rate E increases by x%.
Result: a one-time jump of x % in all nominal variables.
• Case 2: Home increases rate of money growth m
by D m
 We discuss this case first using a diagram…
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Exchange Rate Forecasts Using the Simple Model
Case 2: Home increases its rate of money growth m by Dm
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Exchange Rate Forecasts Using the Simple Model
• Case 2: Home increases rate of money growth m
by D m
• Before the change:
 M, P and E were all growing at rate m
• After the change:
 Real money balances M/P remain unchanged (Y fixed).
 The home inflation rate increases by D m
 The rate of exchange rate depreciation increases by
D m percentage points.
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Evidence for the Monetary Approach
• Two tests:
• Test 1: Any change in the money growth rate
differential should be reflected one-for-one with
a change in the inflation differential.
• Test 2: Differentials in money growth rates
should reflect changes in the exchange rate.
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Evidence for the Monetary Approach
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Evidence for the Monetary Approach
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Evidence for the Monetary Approach
• There are two possible reasons why these
relationships many not hold exactly in the data.
 First, real income growth may change over time,
reflecting another source of inflation differentials.
 Second, we assumed the money demand parameter L
was constant. We relax this assumption in the
following section to incorporate interest rates into the
model.
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Evidence from Hyperinflations
• Hyperinflation occurs when the monthly inflation rate
equals 50% or more over a sustained period.
 Relative PPP predicts the large inflation differentials should
lead to equally large depreciations in the currency.
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Evidence from Hyperinflations
• In our simple model L is constant and real money
balances M/P remain constant (assuming Y fixed).
• Not true in reality, especially in hyperinflations (where
M/P falls much more than output). Why?
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The Demand for Money: The General Model
• Simple model: quantity theory assumes L is a
constant
 For a given level of real output Y, the level of real
money balances M/P is assume constant
• Why might people adjust their level of money
balances?
 The more general theory assumes that L isn’t constant,
and depends inversely on the opportunity cost of
holding money.
 What is the opportunity cost of holding money?
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The Demand for Money: The General Model
• Assume an individual decides how much money she
wants to hold, based on the costs and benefits of holding
money, relative to an alternative asset.
 Benefits of holding money
 Individuals hold money to conduct everyday transactions.
 From the quantity theory of money used in the simple model,
assume this is proportionate to nominal income PY.
 As PY increases, transactions increase, so the quantity of
money balances demanded will decrease.
 Costs of holding money
 Compared with other assets, money earns no interest.
 The opportunity cost is i, the nominal interest rate.
 As i increases, the opportunity cost of holding money rises, so
the quantity of money balances demanded will decrease.
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The Demand for Money: The General Model
• Moving from the individual or household level up
to the aggregate or macroeconomic level, we can
infer that the aggregate money demand will
behave similarly:
 All else equal, a rise in national dollar income (nominal
income) will cause a proportional increase in
transactions and, hence, in aggregate money demand.
 All else equal, a rise in the nominal interest rate will
cause the aggregate demand for money to fall.
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The Demand for Money: The General Model
• Mathematically:
 Nominal money demand
 Therefore, the real money demand function is
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The Demand for Money: The General Model
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Long-Run Equilibrium in the Money Market
• Money market equilibrium is determined by the
intersection of real money supply and real money demand:
• This equilibrium condition implies that changes in the
nominal interest rate play a role in the fundamental
equations we developed in the simple model above.
• But… what determines i?
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Inflation and Interest Rates in the Long Run
• Recall: We are building a long run theory
 Much is unchanged in the general model as compared to the
simple model.
 Same key assumptions:
 price flexibility
 PPP determines the behavior of exchange rates
 monetary model for the determination of prices
• Modification:
 The addition of the term L(i) in the monetary model is only
useful if we have a theory of where the interest rate comes
from in the long run.
 What can we do? Take PPP and UIP and see what they
imply in the long run…
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Inflation and Interest Rates in the Long Run
• Combine two expressions that are equal:
 Relative PPP (and take expectations)
 UIP (approximation)
 Right hand sides must be equal.
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The Fisher Effect
• Relative PPP and UIP imply:
 This is known as the Fisher effect.
 An increase in the inflation rate in one country leads to
a one-for-one increase in the nominal interest rate in
that country.
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Real Interest Parity
• This expression can be rewritten as:
 This is known as real interest parity.
 Real interest parity implies that (expected) real interest
rates should be equal across countries:
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Real Interest Parity
• According to real interest parity, we can define an
expected world interest rate r* for all countries:
• Nominal interest rates in the home and foreign countries
are therefore given by r* plus expected inflation in each
country:
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Evidence on Fisher Effect
• The Fisher effect: nominal interest rate differentials should
move one-for-one with inflation differentials.
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Evidence on Real Interest Parity
• RIP: real interest rates should equalize in the long run.
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The Fundamental Equation of the General Model
• Same as the basic (quantity theory) model except that the
constant L is replaced by a decreasing function L(i):




Not much changes:
E is still a ratio of price levels (PPP)
P is ratio of money supply M to real money demand L(i)Y
Thus: The basic model is adequate for analysis if interest
rates i are stable in the long run.
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Exchange Rate Forecasts Using the General Model
• Revisit Policy Predictions, Case 2 to see what’s new:
• Assumptions
 Both countries
 Constant money growth rate m , fixed level of output Y
 Foreign
 Money growth m is zero, inflation p is zero
 Home
 Money growth m is positive, inflation p is positive
• Home increases its rate of money growth m by D m
 What happens to key variables in the long run (flexible price)
case, when we use the general model and L = L(i)
 NB: Assume inflation and interest rate are constant before and
after the policy change. We can verify assumption later as a
consistency check.
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Exchange Rate Forecasts Using the General Model
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Exchange Rate Forecasts Using the General Model
• Results of an increase in the money growth rate:
 The home inflation rate increases by D m
 The nominal interest rate increases by D m
 A one-time decrease in real money balances M/P
because of the increase in the nominal interest rate.
 A one-time increase in P and E.
 The rate of exchange rate depreciation increases by D m
percentage points after E jumps up.
• The importance of expectations
 If people know that a change in money growth is coming
in the future, they will adjust their expectations of the
inflation rate and exchange rates accordingly.
 Even if a change is not implemented, expectation of a
change has consequences for the variables in the model.
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Monetary Regimes and Exchange Rate Regimes
• Policy makers are concerned with costs of
inflation
 Inflation is unpopular and has macroeconomic costs
 These costs are severe when inflation rates are high.
 This is why inflation targets are desirable.
• The monetary approach shows how policymakers
can choose among different nominal anchors to
achieve their inflation goal.
 The monetary regime they choose specifies what are the
rules, objectives, policies followed by the central bank.
 The exchange rate regime is part of the monetary regime,
and must be consistent with it; is the exchange rate fixed or
floating?
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The Long Run: Nominal Anchor via E
• Exchange rate target
 Can be applied not just to pegs (E=constant), but also to
crawls and managed float regimes.
• Tradeoffs
 Pro: Simple and transparent.
 Con: Possibility of “imported inflation” from other country.
 With a fixed exchange rate, relative PPP means the home
country inflation equals the foreign country inflation rate.
 Choice of which country to fix to is crucial.
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The Long Run: Nominal Anchor via M
• Money supply target
• Tradeoffs
 Pro: Mechanical. There is little decision-making for central
bankers.
 Con: Can only achieve target rate of inflation if real income
growth is known.
 Example: M growth 4%, Y growth 2% means inflation of 2%
 What if Y growth is 1%? 3%?
 Problem: nobody knows future real income growth, not even
central bankers.
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The Long Run: Nominal Anchor via i
• Inflation target plus interest rate policy
• Tradeoffs
 Pro: Flexibility for central bankers.
 In the short run the central bank has the freedom to let i
fluctuate temporarily, but in long run promises to set i on
average at a “neutral level” dictated in the above equation by
the inflation target plus the world real interest rate.
 Con: Neither simple, nor transparent
 Requires credibility, if central bankers are to assure people that
expected rates of inflation and depreciation are firm.
 As we see in the next chapter, serious instability results if
people think the central bank has made a permanent change in
its policy and the anchor is lost.
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The Choice of a Nominal Anchor
• There are two important considerations in
choosing a monetary regime.
• Choosing more than one target (or weighting) can
work sometimes, but it may be problematic.
 Different regimes may call for different policy
responses, causing confusion.
 Success in anchoring inflation may be affected by a
more vague and discretionary policy framework.
• A country with a nominal anchor sacrifices
monetary policy autonomy in the long run.
 Hitting the target will only be possible if the central bank
picks the right levels of M or E or i.
 Unpopular choices at times.
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