Monetary Approach to Exchange Rates Rajesh Singh Feb 6, 2018 Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 1 / 20
Absolute and relative PPP Absolute E $/euro = P US Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 2 / 20
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, 2018 2 / 20
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, 2018 2 / 20
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, 2018 2 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
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, 2018 3 / 20
Exchange rate US price level P US = MUS L US Y US Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20
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, 2018 4 / 20
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, 2018 4 / 20
Money, output, and inflation In the equation P = M L Y, L is a constant. Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 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? Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 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, 2018 5 / 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 Thus, π = P P = M M }{{} µ Y Y π = µ g }{{} g L L }{{} 0 Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 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 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, 2018 5 / 20
Money, output, and inflation, and exchange rates We already showed that π = P P = µ g Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20
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, 2018 6 / 20
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, 2018 6 / 20
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, 2018 6 / 20
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 2018 6 / 20
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 2018 6 / 20
Forecasting exchange rates in levels Money market equilibrium P US = M US L US Y US Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 7 / 20
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, 2018 7 / 20
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 1.05. Falls from P old to P old /1.05 1 1.05 1 = 0.048% 1 also Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 7 / 20