IF lecture 4 - Asset approach in short run and Monetary approach in Long run PDF

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Asset approach in short run and Monetary approach in Long run...

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In the long run the exchange rate is determined by the ratio of the price levels in two countries, What determines those price levels ?  Monetary theory : in the long run, price levels are determined in each country by the relative demand and supply of money What is money ? 1. Money is a store of value because it can be used to buy goods and services in the future. Note : If the opportunity cost of holding money is low, we will hold money more willingly than we hold other assets. 2. Money also gives us a unit of account in which all prices in the economy are quoted. 3. Money is a medium of exchange that allows us to buy and sell goods and services without the need to engage in inefficient barter. The Supply of Money: is controlled in practice by a country’s central But We make the simplifying assumption that the central bank’s indirectly, but accurately, control the level of M1.

Demand for money in a Simple model

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money demand is motivated by the need to conduct transactions in proportion to an individual’s income and we infer that the aggregate money demand will behave similarly (known as the quantity theory of money).

 All else equal, a rise in national dollar income (nominal income) will cause a proportional increase in transactions and in aggregate money demand.

Dividing the previous equation by P, the price level, we can derive the demand for real money balances (a measure of the purchasing power of the stock of money in terms of goods and services).

Note : The demand for real money balances is strictly proportional to real income. equilibrium in the money market :

Md = Ms, (which we assume to be under the control of the central bank) 

Imposing this condition on the last two equations we find that nominal money supply equals nominal money demand: as well as Equilibrium in the Money Market and, equivalently, that real money supply equals real money demand:

M = LxPY Nominal Ms

M/P = LxY Real Ms

A Simple Monetary Model of Prices An expression for the price levels in the U.S. and Europe is:

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Both equations are examples of fundamental equation of the monetary model of the price level. In the long run, we assume prices are flexible and will adjust to put the money market in equilibrium.

Plugging the expression for the price level in the monetary model

➢ Money Growth, Inflation, and Depreciation The U.S. money supply is MUS, and its growth rate is μUS:

The growth rate of real income in the U.S. is gUS:

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Therefore the growth rate of PUS = MUS/LUSYUS = money supply growth rate μUS minus the real income growth rate gUS

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The rate of change of the European price level is calculated similarly: 

Note : When money growth is higher than income growth, we have “more money chasing fewer goods” and this leads to inflation. Combining (3-4) and (3-5), we can now solve for the inflation differential in terms of monetary undamentals and compute the rate of depreciation of the exchange rate:

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.

➢ Interest rates and inflation in the long-run The trouble with the quantity theory we studied earlier is that it assumes that the demand for money is stable which is implausible  general model that allows for money demand to vary with the nominal interest rate  Assumes there is a link between inflation and the nominal interest rate in an open economy

The Demand for Money: The General Model A rise in national dollar income (nominal income) will cause a proportional increase in transactions and, hence, in aggregate money demand

• However , A rise in the nominal interest rate will cause the aggregate demand for money to fall

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

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 Long-Run Equilibrium in the Money Market

 Inflation and Interest Rates in the Long Run

The Fisher Effect

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The nominal interest differential equals the expected inflation differential

All else equal, a rise in the expected inflation rate in a country will lead to an equal rise in its nominal interest rate

➢ Real interest rate parity Rearranging the last equation,

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.

  If PPP and UIP hold, then expected real interest rates are equalized across countries. This powerful condition is called 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

where r* as an exogenous variable Exchange Rates II: The Asset Approach in the Short Run 

Deviations from purchasing power parity (PPP) occur in the short run: the same basket of goods generally does not cost the same everywhere at all times.

Short-run failures of the monetary approach develop an alternative theory to explain exchange rates in the short run: the asset approach to exchange rates

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The asset approach is based on the idea that currencies are assets. The price of the asset in this case is the spot exchange rate, the price of one unit of foreign exchange

 Exchange Rates and Interest Rate in Short Run: UIP and FX Market Equilibrium Risky Arbitrage The uncovered interest parity (UIP) equation is the fundamental equation of the asset approach to exchange rates.

Equilibrium in the FX Market

FX Market Equilibrium: A Numerical Example The returns calculated in Table 4-1 are plotted in this figure. The dollar interest rate is 5%, the euro interest rate is 3%, and the expected future exchange rate is 1.224 $/€. The foreign exchange market is in equilibrium at point 1, where the domestic returns DR and expected foreign returns FR are equal at 5% and the spot exchange rate is 1.20 $/€.

A higher domestic interest rate, i$ = 7%

(a) A

Change in the Home Interest Rate A rise in the dollar interest rate from 5% to 7% increases domestic returns, shifting the DR curve up from DR1 to DR2 . At the initial equilibrium exchange rate of 1.20 $/€ on DR2 , domestic returns are above foreign returns at point 4. Dollar deposits are more attractive and the dollar appreciates from 1.20 $/€ to 1.177 $/€. The new equilibrium is at point 5

A lower foreign interest rate, i€ = 1%

(b) A Change in the Foreign Interest Rate A fall in the euro interest rate from 3% to 1% lowers foreign expected dollar returns, shifting the FR curve down from FR1 to FR2 . At the initial equilibrium exchange rate of 1.20 $/€ on FR2 , foreign returns are below domestic returns at point 6. Dollar deposits are more attractive and the dollar appreciates from 1.20 $/€ to 1.177 $/€. The new equilibrium is at point 7

A lower expected future exchange rate, Ee $/€ = 1.20 $/€

(c) A Change in the Expected Future Exchange Rate A fall in the expected future exchange rate from 1.224 to 1.20 lowers foreign expected dollar returns, shifting the FR curve down from FR1 to FR2 . At the initial equilibrium exchange rate of 1.20 $/€ on FR2 , foreign returns are below domestic returns at point 6. Dollar deposits are more attractive and the dollar appreciates from 1.20 $/€ to 1.177 $/€. The new equilibrium is at point 7.

 Interest Rates in the Short Run: Money Market Equilibrium

 Assumptions : 1) In the short run, the price level is sticky(nominal rigidity); ipredetermined variable, fixed at P = P (the bar indicates a fixed value). 2) In the short run, the nominal interest rate i is fully flexible and adjusts to bring the money market to equilibrium.

1st modeldriven by prices  demand and supply 2nd model driven by interest rate  what drives interest rate...