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$/euro =PUSPEU
Relative PPP4E$/euro
E$/euro= πUS − πEU
The question is: How are price levels determined?
We need a theory of price level
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 2 / 20
Absolute and relative PPP
Absolute
E$/euro =PUSPEU
Relative PPP4E$/euro
E$/euro= πUS − πEU
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$/euro =PUSPEU
Relative PPP4E$/euro
E$/euro= πUS − πEU
The question is: How are price levels determined?
We need a theory of price level
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 2 / 20
Absolute and relative PPP
Absolute
E$/euro =PUSPEU
Relative PPP4E$/euro
E$/euro= πUS − πEU
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’sincome.
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 individual’sincome.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 individual’sincome.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 individual’sincome.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 individual’sincome.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 individual’sincome.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 individual’sincome.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 individual’sincome.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 individual’sincome.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$/euro =PUSPEU
=MUS
LUS Y US
MEU
LUS Y EU
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 4 / 20
Exchange rate
US price level
PUS =MUS
LUS Y US
EU price level
PEU =MEU
LUS Y EU
Exchange rate
E$/euro =PUSPEU
=MUS
LUS Y US
MEU
LUS 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$/euro =PUSPEU
=MUS
LUS Y US
MEU
LUS Y EU
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 4 / 20
Money, output, and inflation
In the equation P = ML Y , L is a constant.
If M Changes by µ% and Y changes by g%, by how much % does Pchange?
Inflation
π =4PP
=4MM︸ ︷︷ ︸µ
− 4YY︸︷︷︸g
− 4LL︸︷︷︸0
Thus,π = µ− g
Question 1:5− 3 = 2%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 5 / 20
Money, output, and inflation
In the equation P = ML Y , L is a constant.
If M Changes by µ% and Y changes by g%, by how much % does Pchange?
Inflation
π =4PP
=4MM︸ ︷︷ ︸µ
− 4YY︸︷︷︸g
− 4LL︸︷︷︸0
Thus,π = µ− g
Question 1:5− 3 = 2%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 5 / 20
Money, output, and inflation
In the equation P = ML Y , L is a constant.
If M Changes by µ% and Y changes by g%, by how much % does Pchange?
Inflation
π =4PP
=4MM︸ ︷︷ ︸µ
− 4YY︸︷︷︸g
− 4LL︸︷︷︸0
Thus,π = µ− g
Question 1:5− 3 = 2%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 5 / 20
Money, output, and inflation
In the equation P = ML Y , L is a constant.
If M Changes by µ% and Y changes by g%, by how much % does Pchange?
Inflation
π =4PP
=4MM︸ ︷︷ ︸µ
− 4YY︸︷︷︸g
− 4LL︸︷︷︸0
Thus,π = µ− g
Question 1:5− 3 = 2%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 5 / 20
Money, output, and inflation
In the equation P = ML Y , L is a constant.
If M Changes by µ% and Y changes by g%, by how much % does Pchange?
Inflation
π =4PP
=4MM︸ ︷︷ ︸µ
− 4YY︸︷︷︸g
− 4LL︸︷︷︸0
Thus,π = µ− g
Question 1:5− 3 = 2%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 5 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )
All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidly
If the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidly
Question 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Money, output, and inflation, and exchange rates
We already showed that
π =4PP
= µ− g
Exchange rate from PPP
E$/euro =PUSPEU
In PUS changes by x% and PEU changes by y%, we say that E$/eurochanges by (x − y)%. Using their symbolic notation, it means
4E$/euro
E$/euro=4PUSPUS
− 4PEUPEU
= πUS − πEU
= (µUS − gUS )− (µEU − gEU )All else equal, if the United States runs a looser monetary policymeasured by a faster money growth rate, the dollar will depreciatemore rapidlyIf the U.S. economy grows faster in the long run, the dollar willappreciate more rapidlyQuestion 2:µUS = 1.5; µEU = 1; gUS = 3; gEU = 1
(1.5− 1)− (3− 1) = −1.5%
Rajesh Singh () Econ 457 — Spring 2018 Feb 6, 2018 6 / 20
Forecasting exchange rates — in levels
Money market equilibrium
PUS =MUS
LUS YUS
Question 3: PUS rises by 5%. No change in PEU . E$/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