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  • 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 =PUSPEU

    Relative PPP4E$/euroE$/euro

    = US 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

  • Absolute and relative PPP

    Absolute

    E$/euro =PUSPEU

    Relative PPP4E$/euroE$/euro

    = US 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

  • Absolute and relative PPP

    Absolute

    E$/euro =PUSPEU

    Relative PPP4E$/euroE$/euro

    = US 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

  • Absolute and relative PPP

    Absolute

    E$/euro =PUSPEU

    Relative PPP4E$/euroE$/euro

    = US 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 individualsincome.

    Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.

    A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.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 todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): M

    Money market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.

    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 individualsincome.Assume that the aggregate money demand will behave similarly.A rise in national dollar income (nominal income)

    will cause a proportional increase in transactions andin aggregate money demand.

    A simple model in which the demand for money is proportional todollar income is known as the quantity theory of money

    Md = L PY

    Supply of Money by the central bank (Federal reserve system): MMoney market equilibrium Md = M determines price level

    P =ML Y

    In the long run, we assume prices are flexible and will adjust to putthe money market in equilibrium.Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 3 / 20

  • Exchange rate

    US price level

    PUS =MUS

    LUS Y US

    EU price level

    PEU =MEU

    LUS Y EU

    Exchange rate

    E$/euro =PUSPEU

    =MUS

    LUS Y US

    MEULUS Y EU

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

  • Exchange rate

    US price level

    PUS =MUS

    LUS Y US

    EU price level

    PEU =MEU

    LUS Y EU

    Exchange rate

    E$/euro =PUSPEU

    =MUS

    LUS Y US

    MEULUS Y EU

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

  • Exchange rate

    US price level

    PUS =MUS

    LUS Y US

    EU price level

    PEU =MEU

    LUS Y EU

    Exchange rate

    E$/euro =PUSPEU

    =MUS

    LUS Y US

    MEULUS Y EU

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 4 / 20

  • Money, output, and inflation

    In the equation P = ML Y , L is a constant.

    If M Changes by % and Y changes by g%, by how much % does Pchange?

    Inflation

    =4PP

    =4MM

    4YYg

    4LL0

    Thus, = g

    Question 1:5 3 = 2%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

  • Money, output, and inflation

    In the equation P = ML Y , L is a constant.

    If M Changes by % and Y changes by g%, by how much % does Pchange?

    Inflation

    =4PP

    =4MM

    4YYg

    4LL0

    Thus, = g

    Question 1:5 3 = 2%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

  • Money, output, and inflation

    In the equation P = ML Y , L is a constant.

    If M Changes by % and Y changes by g%, by how much % does Pchange?

    Inflation

    =4PP

    =4MM

    4YYg

    4LL0

    Thus, = g

    Question 1:5 3 = 2%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

  • Money, output, and inflation

    In the equation P = ML Y , L is a constant.

    If M Changes by % and Y changes by g%, by how much % does Pchange?

    Inflation

    =4PP

    =4MM

    4YYg

    4LL0

    Thus, = g

    Question 1:5 3 = 2%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 5 / 20

  • Money, output, and inflation

    In the equation P = ML Y , L is a constant.

    If M Changes by % and Y changes by g%, by how much % does Pchange?

    Inflation

    =4PP

    =4MM

    4YYg

    4LL0

    Thus, = g

    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

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Money, output, and inflation, and exchange rates

    We already showed that

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Money, output, and inflation, and exchange rates

    We already showed that

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Money, output, and inflation, and exchange rates

    We already showed that

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidly

    If the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Money, output, and inflation, and exchange rates

    We already showed that

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidly

    Question 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Money, output, and inflation, and exchange rates

    We already showed that

    =4PP

    = g

    Exchange rate from PPP

    E$/euro =PUSPEU

    In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x y)%. Using their symbolic notation, it means

    4E$/euroE$/euro

    =4PUSPUS

    4PEUPEU

    = US EU= (US gUS ) (EU gEU )

    All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:US = 1.5; EU = 1; gUS = 3; gEU = 1

    (1.5 1) (3 1) = 1.5%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 6 / 20

  • Forecasting exchange rates in levels

    Money market equilibrium

    PUS =MUS

    LUS YUS

    Question 3: PUS rises by 5%. No change in PEU . E$/euro =PUSPEU

    alsorises by 5%

    Question 4: PUS declines by a factor of 1.05. Falls from Pold toPold/1.05

    11.05 11

    = 0.048%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 7 / 20

  • Forecasting exchange rates in levels

    Money market equilibrium

    PUS =MUS

    LUS YUS

    Question 3: PUS rises by 5%. No change in PEU . E$/euro =PUSPEU

    alsorises by 5%

    Question 4: PUS declines by a factor of 1.05. Falls from Pold toPold/1.05

    11.05 11

    = 0.048%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 7 / 20

  • Forecasting exchange rates in levels

    Money market equilibrium

    PUS =MUS

    LUS YUS

    Question 3: PUS rises by 5%. No change in PEU . E$/euro =PUSPEU

    alsorises by 5%

    Question 4: PUS declines by a factor of 1.05. Falls from Pold toPold/1.05

    11.05 11

    = 0.048%

    Rajesh Singh () Econ 457 Spring 2018 Feb 6, 2018 7 / 20

    Explanations

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