International Finance Math Solving

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Lecture 2 Exchange Rates: The

Monetary Approach in the Long Run

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Exchange Rates and Prices in the Long Run: Purchasing

Power Parity and Goods Market Equilibrium

• Arbitrage can occur in international goods markets just as in

international financial markets. The prices of goods in different

countries expressed in a common currency tend to be equalized.

• Applied to a single good, this type of equalization is referred to

as the law of one price.

• Applied to an entire basket of goods, it is called the theory of

purchasing power parity.

• We will develop a simple theory based on an idealized world of

frictionless trade where transaction costs can be neglected.

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

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The Law of One Price

The law of one price (LOOP) states that, in the absence of trade

frictions and under free competition and price flexibility,

identical goods sold in different locations must sell for the same

price when expressed in a common currency.

𝑞𝑈𝑆gΤ𝐸𝑈𝑅 = 𝐸$Τ€ 𝑃𝐸𝑈𝑅g / 𝑃ถ𝑈𝑆g

Relative price of goods g European price U.S. price in Europe versus

U.S. of goods g in $ of good g in $ LOOP holds if this expression

is equal to 1.

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

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The Law of One Price

We can rearrange the equation for price equality to show that the

exchange rate must equal the ratio of the goods’ prices expressed

in the two currencies:

𝐸ถ$Τ€= 𝑃𝑈𝑆𝑔 ൗ 𝑃𝐸𝑈𝑅𝑔

Exchange

rate

Ratio of

goods′prices

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

Purchasing Power Parity

The principle of purchasing power parity (PPP)is the

macroeconomic counterpart to the microeconomic law of one

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price (LOOP). To express PPP algebraically, we can compute the

relative price of the two baskets of goods in each location:

𝑞𝑈𝑆Τ𝐸𝑈𝑅 = 𝐸$Τ€ 𝑃𝐸𝑈𝑅 / 𝑃ต𝑈𝑆

Relative price European price U.S. price of

basket of basket of basket

in Europe expressed expressed versus U.S. in $ in $

• There is no arbitrage when the basket is the same price in both

locations, that is, when qUS/EUR = 1.

• PPP then holds: price levels in two countries are equal when

expressed in a common currency. This is called absolute PPP.

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

The Real Exchange Rate

The real exchange rate is the relative price of the baskets.

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• The U.S. real exchange rate qUS/EUR = E$/€ PEUR / PUS tells us how

many U.S. baskets are needed to purchase one European basket.

• The exchange rate for currencies is a nominal concept. The real

exchange rate is a real concept.

The real exchange rate has terminology similar to the nominal

exchange rate:

• If the real exchange rate rises (more Home goods are needed in

exchange for Foreign goods), Home has experienced a real

depreciation.

• If the real exchange rate falls, Home has experienced a real

appreciation.

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

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Absolute PPP and the Real Exchange Rate

Purchasing power parity (Absolute PPP) requires that the real

exchange rate qUS/EUR is equal to 1.

Absolute PPP, Prices, and the Nominal Exchange Rate

Absolute PPP implies that the exchange rate at which two currencies

trade equals the relative price levels of the two countries:

𝐸ถ$Τ€ = 𝑃𝑈𝑆 Τ 𝑃𝐸𝑈𝑅

Exchange rate Ratio of price levels

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market Equilibrium

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Relative PPP, Inflation, and Exchange Rate Depreciation

We now examine the implications of PPP for the study of

inflation(the rate of change of the price level).

𝐸ถ$Τ€ = 𝑃𝑈𝑆 Τ 𝑃𝐸𝑈𝑅

Exchange rate Ratio of price levels

On the left-hand side, the rate of change of the exchange rate in

Home is the rate of exchange rate depreciation in Home given by

∆𝐸$Τ€,𝑡 𝐸$Τ€,𝑡+1 −𝐸$Τ€,𝑡

=

𝐸$Τ€,𝑡

Rate of depreciation of the

nominal exchange rate

Exchange Rates and Prices in the Long Run:

𝐸 Τ $ € , 𝑡

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Purchasing Power Parity and Goods Market Equilibrium

𝐸ถ$Τ€ = 𝑃𝑈𝑆 Τ 𝑃𝐸𝑈𝑅

Exchange rate Ratio of price levels

On the right, the rate of change of the ratio of price levels equals the

rate of change of the numerator minus that of the denominator:

∆ 𝑃𝑈𝑆Τ𝑃𝐸𝑈𝑅 = ∆𝑃𝑈𝑆,𝑡 – ∆𝑃𝐸𝑈𝑅,𝑡 𝑃𝑈𝑆Τ𝑃𝐸𝑈𝑅 𝑃𝑈𝑆,𝑡 𝑃𝐸𝑈𝑅,𝑡

𝑃𝑈𝑆,𝑡+1−𝑃𝑈𝑆,𝑡 𝑃𝐸𝑈𝑅,𝑡+1−𝑃𝐸𝑈𝑅,𝑡

=−= 𝜋𝑈𝑆,𝑡 − 𝜋𝐸𝑈𝑅,𝑡 𝑃𝑈𝑆,𝑡 𝑃𝐸𝑈𝑅,𝑡

Rate of inflation U.S. Rate of inflation Europe

π𝑈𝑆,𝑡 π𝐸𝑈𝑅,𝑡

Exchange Rates and Prices in the Long Run:

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Purchasing Power Parity and Goods Market Equilibrium

∆𝐸$/€‚t

= 𝜋𝑈𝑆,𝑡 −𝜋𝐸𝑈𝑅,𝑡 𝐸$/€‚t

Inflation differential

Rate of depreciation of the

nominal exchange rate

This way of expressing PPP is called relative PPP, and it implies

that the rate of depreciation of the nominal exchange rate equals

the difference between the inflation rates of two countries.

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APPLICATION

Evidence for PPP in the Long Run and Short Run

Inflation Differentials and the Exchange Rate, 1975 – 2005 This scatterplot shows the relationship

between the rate of exchange rate depreciation against the U.S. dollar and the inflation

differential against the United States over the long run, for a sample of 82 countries. The

correlation between the two variables is strong and bears a close resemblance to the prediction

of PPP that all data points would appear on the 45 - degree line.

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APPLICATION

Evidence for PPP in the Long Run and Short Run

Exchange Rates and Prices in the Long Run:

Exchange Rates and Relative Price Levels Data for the United States and the UK from 1975 to

2010 show that the exchange rate and relative price levels do not always move together in the

short run. Relative price levels tend to change slowly and have a small range of movement;

exchange rates move quickly and experience large fluctuations. Therefore, relative PPP does not

hold in the short run. It is a better guide to the long run, and we can see that the two series do tend

to drift together over the decades.

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Purchasing Power Parity and Goods Market Equilibrium

How Slow Is Convergence to PPP?

• Research shows that price differences—the deviations from

PPP—can be quite persistent.

• Estimates suggest that these deviations may die out at a rate of

about 15% per year. This kind of measure is often called a speed

of convergence.

• Approximately half of any PPP deviation still remains after four

years: Economists refer to this as a four-year half-life.

• Such estimates provide a rule of thumb that is useful as a guide

to forecasting real exchange rates.

Exchange Rates and Prices in the Long Run:

Purchasing Power Parity and Goods Market

Equilibrium

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What Explains Deviations from PPP?

There could be a variety of reasons PPP fails in the short run:

• Transaction costs. These include costs of transportation, tariffs,

duties, etc. On average, they are more than 20% of the price of

goods traded internationally.

• Nontraded goods. Some goods are inherently nontradable (e.g.

hair cuts); they have infinitely high transaction costs.

• Imperfect competition. Differentiated goods create conditions

of imperfect competition because firms have some power to set

the price of their good, allowing firms to charge different prices

not just across brands but also across countries.

• Price stickiness. Prices do not or cannot adjust quickly and

flexibly to changes in market conditions.

Money, Prices, and Exchange Rates in the Long

Run:

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Money Market Equilibrium in a Simple Model

• In the long run the exchange rate is determined by the ratio of

the price levels in two countries. But what determines those

price levels?

• In the long run, price levels are determined in each country by

the relative demand and supply of money.

What Is Money?

1. A store of value because it can be used to buy goods and services

in the future.

2. A unit of account in which all prices in the economy are quoted.

3. A medium of exchange that allows us to buy and sell goods and

services without the need to engage in inefficient barter.

Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

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Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

The Measurement of Money Monetary aggregates for the United States from 2004 to 2015.

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The Supply of Money

• The central bank controls the money supply. It controls

directly the level of M0 by issuing notes, coins and private

bank reserves. It indirectly controls M1 by using monetary

policy.

• We will use M1 as our measure.

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Money, Prices, and Exchange Rates in the Long

Run: Money Market Equilibrium in a Simple Model

The Demand for Money: A Simple Model

• Individuals hold money to pay for goods and services. Money

demand is proportional to income (quantity theory of money).

ต𝑀𝑑 = ณ𝐿 × 𝑃ต𝑌

Demand A Nominal

for money ($) constant income ($)

• Dividing by P, the price level, we derive the demand for real

money balances:

𝑀𝑑

ด𝑃 = ณ𝐿 × 𝑌ณ

A Real

Demand constant income for real money

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Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

Equilibrium in the Money Market

• In equilibrium, money supply equals money demand:

M = 𝐿 P Y

• In real terms:

𝑀

= 𝐿 Y 𝑃

• Price levels in the United States and Europe:

𝑀𝑈𝑆 𝑀𝐸𝑈𝑅

𝑃𝑈𝑆 = 𝐿𝑈𝑆 𝑃𝐸𝑈𝑅 =

𝑌𝑈𝑆 𝐿𝐸𝑈𝑅𝑌𝐸𝑈𝑅

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• In the long run, prices are flexible and adjust to put the money

market in equilibrium.

Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

A Simple Monetary Model of the Exchange Rate

Substitute the expression for the price level in the monetary model

in the equation for absolute PPP:

𝑀𝑈𝑆

𝐸ถ$/€ = 𝑃ถ𝑃𝐸𝑈𝑅𝑈𝑆 = 𝐿𝑈𝑆𝑀𝐸𝑈𝑅𝑌𝑈𝑆 = 𝐿𝑈𝑆𝑌𝑀𝑈𝑆𝑈𝑆ൗ Τ𝐿𝑀𝐸𝑈𝑅𝐸𝑈𝑅𝑌𝐸𝑈𝑅

𝐿𝐸𝑈𝑅𝑌𝐸𝑈𝑅

Exchange Rate Ratio of Relative nominal money supplies

price levels divided by relative real money

demands

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This is the fundamental equation of the monetary approach to

exchange rates.

Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

Money Growth, Inflation, and Depreciation

• Suppose the U.S. money supply increases. The right-hand side

increases (the U.S. nominal money supply increases relative

to Europe), causing the exchange rate to increase (the U.S.

dollar depreciates against the euro).

• Now suppose the U.S. real income level increases. Then the

right-hand side decreases (the U.S. real money demand

increases relative to Europe), causing the exchange rate to

decrease (the U.S. dollar appreciates against the euro). 𝑀𝑈𝑆

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𝐸ถ$/€ = 𝑃ถ𝑃𝐸𝑈𝑅𝑈𝑆 = 𝐿𝑈𝑆𝑀𝐸𝑈𝑅𝑌𝑈𝑆 = 𝐿𝑈𝑆𝑌𝑀𝑈𝑆𝑈𝑆ൗ Τ𝐿𝑀𝐸𝑈𝑅𝐸𝑈𝑅𝑌𝐸𝑈𝑅

𝐿𝐸𝑈𝑅𝑌𝐸𝑈𝑅

Exchange Rate Ratio of price levels Relative nominal money supplies

divided by relative real money demands

Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

Money Growth, Inflation, and Depreciation

𝜇

𝑈𝑆,𝑡 = 𝑀𝑈𝑆,𝑡+1 − 𝑀𝑈𝑆,𝑡

Rate of money supply growth in U.S.

g𝑈𝑆,𝑡 = 𝑌𝑈𝑆,𝑡+𝑌1𝑈𝑆−,𝑡 𝑌𝑈𝑆,𝑡

Rate of real income growth in U.S.

𝑀 𝑈𝑆 , 𝑡

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PUS = MUS / LUS YUS

𝜋𝑈𝑆,𝑡 = 𝜇𝑈𝑆,𝑡 – g𝑈𝑆,𝑡

Similarly, for the Euro Area:

𝜋𝐸𝑈𝑅,𝑡 = 𝜇𝐸𝑈𝑅,𝑡 – g𝐸𝑈𝑅,𝑡

Money, Prices, and Exchange Rates in the Long

Run: Money Market Equilibrium in a Simple Model

Money Growth, Inflation, and Depreciation

When money growth is higher than income growth, we have

“more money chasing fewer goods” and this leads to inflation.

Going back to relative PPP:

∆𝐸$/€‚𝑡 = 𝜋US,t − 𝜋EUR,t = 𝜇US,t − gUS,t − 𝜇EUR,t − gEUR,t

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𝐸$/€‚𝑡

Inflation differential

Rate of depreciation of the nominalexchangerate

= 𝜇US,t − 𝜇EUR,t

Differential in

nominal money supply

growth rates

− gUS,t − gEUR,t

Differential in

real output

growth rates

Money, Prices, and Exchange Rates in the Long Run:

Money Market Equilibrium in a Simple Model

Money Growth, Inflation, and Depreciation

• If the United States runs a looser monetary policy in the long

run, measured by a faster money growth rate, the dollar will

depreciate more rapidly, all else equal.

• If the U.S. economy grows faster in the long run, the dollar

will appreciate more rapidly, all else equal.

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Inflation and money growth: The monetary approach to prices and

exchange rates suggests that increases in the rate of money supply

growth should be the same size as increases in the rate of inflation.

Money growth and the exchange rate: The monetary approach to prices

and exchange rates also suggests that increases in the rate of money supply

growth should be the same size as increases in the rate of exchange rate

depreciation.

The Monetary Approach: Implications and Evidence

Exchange Rate Forecasts Using the Simple Model

• When we use the monetary model for forecasting, we are

answering a hypothetical question: What path would exchange

rates follow if prices were flexible and PPP held?

Forecasting Exchange Rates: An Example

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• Assume that U.S. and European real income growth rates are

identical and equal to zero (0%). Also, the European price level

is constant, and European inflation is zero.

• Based on these assumptions, we examine two cases. Case 1: A

one-time increase in the money supply

Case 2: An increase in the rate of money growth

The Monetary Approach: Implications and Evidence

Exchange Rate Forecasts Using the Simple Model

Forecasting Exchange Rates: An Example

Case 1: A one-time increase in the money supply

a) There is a 10% increase in the money supply M.

b) Real money balances M/P remain constant because real

income is constant (real money demand is constant).

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c) These previous two statements imply that price level P and

money supply M must move in the same proportion, so there

is a 10% increase in the price level P.

d) PPP implies that the exchange rate E and price level P must

move in the same proportion, so there is a 10% increase

(depreciation) in the exchange rate E.

The Monetary Approach: Implications and Evidence

Exchange Rate Forecasts Using the Simple Model

Forecasting Exchange Rates: An Example

Case 2: An increase in the rate of money growth

At time T the United States will raise the rate of money supply

growth to rate of μ + Δμ from a steady fixed rate μ. a) Money

supply M is growing at a constant rate.

b) Real money balances M/P remain constant, as before.

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c) These previous two statements imply that price level P and

money supply M must move in the same proportion, so P is

always a constant multiple of M.

d) PPP implies that the exchange rate E and price level P must

move in the same proportion, so E is always a constant

multiple of P (and hence of M).

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The Monetary Approach: Implications and Evidence

Case 2: An increase in the rate of money growth

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APPLICATION

Evidence for the Monetary Approach

Inflation Rates and Money Growth Rates, 1975 – 2005 This scatterplot shows the

relationship between the rate of inflation and the money supply growth rate over the long

run. The correlation between the two variables is strong and bears a close resemblance to

the theoretical prediction of the monetary model that all data points would appear on the

45 - degree line.

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APPLICATION

Evidence for the Monetary Approach

This scatterplot shows the relationship between the rate of exchange rate depreciation and the

money growth rate differential relative to the United States over the long run. The data show a

strong correlation between the two variables and a close resemblance to the theoretical

prediction of the monetary approach to exchange rates, which would predict that all data points

would appear on the 45 - degree line. 30

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Money, Interest Rates, and Prices in the Long Run: A

General Model

• The quantity theory assumes that the demand for money is

stable.

• We will now explore a more general model that allows for

money demand to vary with the nominal interest rate.

• The nominal interest rate is the opportunity cost of holding

money.

• There are two determinants of money demand:

• A rise in nominal income increases transactions – money

demand increases

• A rise in the nominal interest rate increases the opportunity

cost of holding money – money demand falls

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Money, Interest Rates, and Prices in the Long Run:

A General Model

The Demand for Money: The General Model

• Money demand is proportional to nominal income and is a

decreasing function of the nominal interest rate:

𝑀𝑑 = 𝐿 𝑖$ ⨯ 𝑃ต𝑌

Demand A Nominal

for money ($) decreasing income ($) function

• Dividing by P, we derive the demand for real money balances:

𝑀𝑑

ถ𝑃 = 𝐿 𝑖$ ⨯ 𝑌ณ

Demand decreasingA incomeReal

for real money function

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Money, Interest Rates, and Prices in the Long Run:

A General Model

Panel (a) shows the real money demand function for the United States. The downward slope

implies that the quantity of real money demand rises as the nominal interest rate i $

falls. Panel

( b) shows that an increase in real income from Y 1 US

to Y 2 US

causes real money demand to rise

at all levels of the nominal interest rate i $ .

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Money, Interest Rates, and Prices in the Long Run:

A General Model

Long-Run Equilibrium in the Money Market

𝑀

ต𝑃 = 𝐿 𝑖 𝑌

Real money supply Real money demand

Inflation and Interest Rates in the Long Run

Relative PPP:

∆𝐸𝑒 = 𝜋𝑒 −𝜋𝐸𝑈𝑅𝑒 𝑈𝑆

Expectedinflation

Expected rate of dollar differential depreciation

UIP:

$ / €

𝐸 $ / €

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∆𝐸$𝑒/€ = 𝑖ณ$ − 𝑖ณ€

Net dollar Net euro

Expectedrateofdollar interest rate interest rate

depreciation

Money, Interest Rates, and Prices in the Long Run:

A General Model

The Fisher Effect

• Combining relative PPP and UIP, we get:

𝑖$ −𝑖€ = 𝜋𝑈𝑆𝑒 −𝜋𝐸𝑈𝑅𝑒

Nominal interest rate differential Nominal inflation rate differential

(expected)

• The nominal interest differential equals the expected inflation

differential:

𝐸 $ / €

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• All else equal, a rise in the expected inflation rate in a country

will lead to an equal rise in its nominal interest rate.

• This result is known as the Fisher effect.

Money, Interest Rates, and Prices in the Long Run:

A General Model

Real Interest Parity

• Rearranging the last equation, we find

𝑖$ − 𝜋𝑈𝑆𝑒 = 𝑖€ − 𝜋𝐸𝑈𝑅𝑒

• Subtracting the inflation rate (π) from the nominal interest rate (i)

results in a real interest rate (r), the inflation-adjusted return on

an interest-bearing asset.

𝑟𝑈𝑆𝑒 = 𝑟𝐸𝑈𝑅𝑒

• If PPP and UIP hold, then expected real interest rates are

equalized across countries. This is the real interest parity.

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Money, Interest Rates, and Prices in the Long

Run:

A General Model

Real Interest Parity

• In the long run, all countries will share a common expected real

interest rate, the long-run expected world real interest rate

denoted r*, so

𝑟𝑈𝑆𝑒 = 𝑟𝐸𝑈𝑅𝑒 = 𝑟∗

• We treat r* as an exogenous variable, something outside the

control of a policy maker in any particular country.

• Under these conditions, the Fisher effect is even clearer because,

by definition,

𝑖$ = 𝑟𝑈𝑆𝑒 + 𝜋𝑈𝑆𝑒 = 𝑟∗ + 𝜋𝑈𝑆𝑒

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𝑖€ = 𝑟𝐸𝑈𝑅𝑒 + 𝜋𝐸𝑈𝑅𝑒 = 𝑟∗ + 𝜋𝐸𝑈𝑅𝑒

APPLICATION

Evidence on the Fisher Effect

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APPLICATION

Evidence on the Fisher Effect

These differentials were not zero, so real interest parity did not hold continuously. But the

differentials were on average close to zero, meaning that real interest parity (like PPP) is a general

long - run tendency in the data.

Money, Interest Rates, and Prices in the Long Run:

A General Model

The Fundamental Equation Under the General Model

• This model differs from the simple model (the quantity theory) by

allowing L to vary as a function of the nominal interest rate i.

𝑃𝑈𝑆 =

𝐸ถ$/€ = 𝑃ถ𝐸𝑈𝑅

Exchange Rate Ratio of price levels Relative nominal money suppies

divided by relative real

money demands

𝑀 𝑈𝑆

𝐿 𝑈𝑆 𝑖 $ 𝑌 𝑈𝑆

𝑀 𝐸𝑈𝑅 𝐿 𝐸𝑈𝑅 𝑖 € 𝑌 𝐸𝑈𝑅

= Τ 𝑀 𝑈𝑆 𝑀 𝐸𝑈𝑅

Τ 𝐿 𝑈𝑆 𝑖 $ 𝑌 𝑈𝑆 𝐿 𝐸𝑈𝑅 𝑖 € 𝑌 𝐸𝑈𝑅

47

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Money, Interest Rates, and Prices in the Long Run:

A General Model

Exchange Rate Forecasts Using the General Model

• Suppose that we learn at time T that the United States is raising

the rate of money supply growth from μ to a higher rate μ + Δμ.

• What does the model predict will be the behavior of the

exchange rate, the price level, the interest rate and money

demand?

• We assume that real income levels in the US and Europe are

constant, the European money supply is constant, so the

European price level is constant too.

• To solve the model, we make the provisional assumption that

US inflation rates and interest rates are constant before and

after time T. We focus on the changes that happen at time T.

Money, Interest Rates, and Prices in the Long Run:

A General Model

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Exchange Rate Forecasts Using the General Model

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Money, Interest Rates, and Prices in the Long Run:

A General Model

Exchange Rate Forecasts Using the General Model

• Intuition for these results:

• People learn at time T that money supply will grow faster in

the US. They expect higher inflation in the US and, from

PPP, they expect the dollar to depreciate.

• Holding dollars is less attractive and people will sell dollars

and invest in euros. This creates downward pressure on the

dollar and causes it to depreciate, even though at time T

money growth in the US has not increased yet.

• Even if actual economic conditions today are unchanged,

news about the future affect today’s exchange rate –

expectations matter!

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Monetary Regimes and Exchange Rate Regimes

The Long Run: The Nominal Anchor

• Policymakers aim to keep inflation low in stable. To do that,

they need to have a constraint in the long run. Such constraints

are called nominal anchors.

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• There are three main nominal anchor choices: exchange rate

target, money supply target, and inflation target plus

interest rate policy.

Monetary Regimes and Exchange Rate Regimes

The Long Run: The Nominal Anchor

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• Exchange rate target: depreciation

|

𝐀𝐧𝐜𝐡𝐨𝐫 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞

o Relative PPP says that

home inflation equals the

rate of depreciation plus foreign inflation.

o A simple rule would be to set the rate of depreciation equal to a

constant.

o Under a fixed exchange rate (peg), that constant is equal to zero.

o Under a crawling peg, it is a nonzero constant. o Or the exchange

rate may be able to vary within a band.

Monetary Regimes and Exchange Rate Regimes

The Long Run: The Nominal Anchor

• Exchange rate target:

𝜋ด𝐻

Inflation

= ∆𝐸𝐻/𝐹 𝐸𝐻/𝐹

Rate of

+ 𝜋ด𝐹

Foreign

inflation

54

o The drawback of this policy is that the home country

imports inflation from the foreign country.

o Countries typically peg to a country with a reputation for

price stability (e.g. the US).

o This is a common policy choice: more than half of the

world’s countries have fixed exchange rates.

Monetary Regimes and Exchange Rate Regimes

The Long Run: The Nominal Anchor

• Money supply target:

𝜋ด𝐻 = 𝜇ดH − gด𝐻

Inflation Money supply growth Realoutput growth

|

𝐀𝐧𝐜𝐡𝐨𝐫 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞

55

o A simple rule of this sort is: Set the growth rate of the

money supply equal to a constant, say, 2% a year.

o Again the drawback is the final term in the previous

equation: Real income growth can be unstable. In periods of

high growth, inflation will be below the desired level. In

periods of low growth, inflation will be above the desired

level.

o There are not many examples of countries using money

supply target.

Monetary Regimes and Exchange Rate Regimes

The Long Run: The Nominal Anchor •

Inflation target plus interest rate policy:

𝜋ด𝐻𝑒 = 𝑖ณ𝐻 − ถ𝑟∗

56

Inflation Nominal interest rate World realinterest rate

(expected) |

𝐀𝐧𝐜𝐡𝐨𝐫 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞

o The Fisher effect says that home inflation is the home nominal interest

rate minus the world real interest rate. o If the latter is constant, and

the average home nominal interest rate is stable, inflation can be kept

stable.

o But the Central Bank may want to deviate from the neutral level of

the nominal interest ratein the short run to achieve other objectives

(such as output or employment).

o Inflation targeting is increasingly common – UK, US (since 2012).

International Finance/Lecture 9 Echange rate crises.pdf