Monetary Approach to Exchange Rates

Transcription

1 Monetary Approach to Exchange Rates Rajesh Singh Feb 6, 2018 Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

2 Absolute and relative PPP Absolute E $/euro = P US Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

3 Absolute and relative PPP Absolute Relative PPP E $/euro E $/euro E $/euro = P US = π US π EU Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

4 Absolute and relative PPP Absolute Relative PPP E $/euro E $/euro E $/euro = P US = π US π EU The question is: How are price levels determined? Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

5 Absolute and relative PPP Absolute Relative PPP E $/euro E $/euro E $/euro = P US = π US π EU The question is: How are price levels determined? We need a theory of price level Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

6 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

7 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

8 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

9 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

10 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

11 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. A simple model in which the demand for money is proportional to dollar income is known as the quantity theory of money M d = L PY Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

12 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. A simple model in which the demand for money is proportional to dollar income is known as the quantity theory of money M d = L PY Supply of Money by the central bank (Federal reserve system): M Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

13 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. A simple model in which the demand for money is proportional to dollar income is known as the quantity theory of money M d = L PY Supply of Money by the central bank (Federal reserve system): M Money market equilibrium M d = M determines price level P = M L Y Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

14 Money, output, and inflation The need to conduct transactions is in proportion to an individual s income. Assume that the aggregate money demand will behave similarly. A rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand. A simple model in which the demand for money is proportional to dollar income is known as the quantity theory of money M d = L PY Supply of Money by the central bank (Federal reserve system): M Money market equilibrium M d = M determines price level P = M L Y In the long run, we assume prices are flexible and will adjust to put the money market in equilibrium. Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

15 Exchange rate US price level P US = MUS L US Y US Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

16 Exchange rate US price level EU price level P US = = MUS L US Y US MEU L US Y EU Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

17 Exchange rate US price level EU price level Exchange rate P US = = MUS L US Y US MEU L US Y EU E $/euro = P US = M US L US Y US M EU L US Y EU Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

18 Money, output, and inflation In the equation P = M L Y, L is a constant. Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

19 Money, output, and inflation In the equation P = M L Y, L is a constant. If M Changes by µ% and Y changes by g%, by how much % does P change? Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

20 Money, output, and inflation In the equation P = M L Y, L is a constant. If M Changes by µ% and Y changes by g%, by how much % does P change? Inflation π = P P = M M }{{} µ Y Y }{{} g L L }{{} 0 Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

21 Money, output, and inflation In the equation P = M L Y, L is a constant. If M Changes by µ% and Y changes by g%, by how much % does P change? Inflation Thus, π = P P = M M }{{} µ Y Y π = µ g }{{} g L L }{{} 0 Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

22 Money, output, and inflation In the equation P = M L Y, L is a constant. If M Changes by µ% and Y changes by g%, by how much % does P change? Inflation Thus, π = P P = M M }{{} µ Y Y π = µ g }{{} g L L }{{} 0 Question 1: 5 3 = 2% Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

23 Money, output, and inflation, and exchange rates We already showed that π = P P = µ g Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

24 Money, output, and inflation, and exchange rates We already showed that Exchange rate from PPP π = P P = µ g E $/euro = P US Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

25 Money, output, and inflation, and exchange rates We already showed that Exchange rate from PPP π = P P = µ g E $/euro = P US In P US changes by x% and changes by y%, we say that E $/euro changes by (x y) %. Using their symbolic notation, it means E $/euro E $/euro = P US P US = π US π EU = (µ US g US ) (µ EU g EU ) Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

26 Money, output, and inflation, and exchange rates We already showed that Exchange rate from PPP π = P P = µ g E $/euro = P US In P US changes by x% and changes by y%, we say that E $/euro changes by (x y) %. Using their symbolic notation, it means E $/euro E $/euro = P US P US = π US π EU = (µ US g US ) (µ EU g EU ) All else equal, if the United States runs a looser monetary policy measured by a faster money growth rate, the dollar will depreciate more rapidly Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

27 Money, output, and inflation, and exchange rates We already showed that Exchange rate from PPP π = P P = µ g E $/euro = P US In P US changes by x% and changes by y%, we say that E $/euro changes by (x y) %. Using their symbolic notation, it means E $/euro E $/euro = P US P US = π US π EU = (µ US g US ) (µ EU g EU ) All else equal, if the United States runs a looser monetary policy measured by a faster money growth rate, the dollar will depreciate more rapidly IfRajesh the Singh U.S. () economy growsecon faster 457 Spring in the 2018 long run, the dollar Feb 6, will / 20

28 Money, output, and inflation, and exchange rates We already showed that Exchange rate from PPP π = P P = µ g E $/euro = P US In P US changes by x% and changes by y%, we say that E $/euro changes by (x y) %. Using their symbolic notation, it means E $/euro E $/euro = P US P US = π US π EU = (µ US g US ) (µ EU g EU ) All else equal, if the United States runs a looser monetary policy measured by a faster money growth rate, the dollar will depreciate more rapidly IfRajesh the Singh U.S. () economy growsecon faster 457 Spring in the 2018 long run, the dollar Feb 6, will / 20

29 Forecasting exchange rates in levels Money market equilibrium P US = M US L US Y US Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

30 Forecasting exchange rates in levels Money market equilibrium P US = M US L US Y US Question 3: P US rises by 5%. No change in. E $/euro = P US rises by 5% also Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20

31 Forecasting exchange rates in levels Money market equilibrium P US = M US L US Y US Question 3: P US rises by 5%. No change in. E $/euro = P US rises by 5% Question 4: P US declines by a factor of Falls from P old to P old / = 0.048% 1 also Rajesh Singh () Econ 457 Spring 2018 Feb 6, / 20