A Long-Run exchange rate Model based on ppp Monetary approach to the exchange rate a theory of how exchange rates and monetary factors Interact in the long run a The Fundamental Equation of the monetary Approach Price levels can be expressed in terms of domestic money demand and supplies In the United States US=MUS/L(Rs, Yus (15-3) In europe PE=ME/L (Re, YE (15-4) Copyright C 2003 Pearson Education, Inc Slide 15-11
Copyright © 2003 Pearson Education, Inc. Slide 15-11 ▪ Monetary approach to the exchange rate • A theory of how exchange rates and monetary factors interact in the long run. ▪ The Fundamental Equation of the Monetary Approach • Price levels can be expressed in terms of domestic money demand and supplies: – In the United States: PUS = Ms US/L (R$ , YUS) (15-3) – In Europe: PE = Ms E /L (R€ , YE ) (15-4) A Long-Run Exchange Rate Model Based on PPP
A Long-Run exchange rate Model based on ppp The monetary approach makes a number of specific predictions about the long-run effects on the exchange rate of changes in Money supplies An increase in the U.S. (European) money supply causes a proportional long-run depreciation(appreciation) of the dollar against the euro Interest rates A rise in the interest rate on dollar(euro) denominated assets causes a depreciation (appreciation) of the dollar against the euro Output levels A rise in U.S. (European)output causes an appreciation (depreciation)of the dollar against the euro Copyright C 2003 Pearson Education, Inc Slide 15-12
Copyright © 2003 Pearson Education, Inc. Slide 15-12 • The monetary approach makes a number of specific predictions about the long-run effects on the exchange rate of changes in: – Money supplies – An increase in the U.S. (European) money supply causes a proportional long-run depreciation (appreciation) of the dollar against the euro. – Interest rates – A rise in the interest rate on dollar (euro) denominated assets causes a depreciation (appreciation) of the dollar against the euro. – Output levels – A rise in U.S. (European) output causes an appreciation (depreciation) of the dollar against the euro. A Long-Run Exchange Rate Model Based on PPP
A Long-Run exchange rate Model based on ppp Ongoing Inflation, Interest Parity, and PPP Money supply growth at a constant rate eventually results in ongoing inflation (i.e, continuing rise in the price level) at the same rate Changes in this long-run inflation rate do not affect the ull-employment output level or the long-run relative prices of goods and services The interest rate is not independent of the money supply growth rate in the long run Copyright C 2003 Pearson Education, Inc Slide 15-13
Copyright © 2003 Pearson Education, Inc. Slide 15-13 ▪ Ongoing Inflation, Interest Parity, and PPP • Money supply growth at a constant rate eventually results in ongoing inflation (i.e., continuing rise in the price level) at the same rate. – Changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services. • The interest rate is not independent of the money supply growth rate in the long run. A Long-Run Exchange Rate Model Based on PPP
A Long-Run exchange rate Model based on ppp o The international interest rate difference is the difference between expected national inflation rates Rs-Re-TUS-T (15-5) Copyright C 2003 Pearson Education, Inc Slide 15-14
Copyright © 2003 Pearson Education, Inc. Slide 15-14 • The international interest rate difference is the difference between expected national inflation rates: R$ - R€ = e US - e (15-5) A Long-Run Exchange Rate Model Based on PPP
A Long-Run exchange rate Model based on ppp The fisher effect A rise (fall) in a countrys expected inflation rate will eventually cause an equal rise(fall) in the interest rate that deposits of its currency offer Figure 15-1 illustrates an example, where at time to the Federal Reserve unexpectedly increases the growth rate of the U.S. money supply to a higher level Copyright C 2003 Pearson Education, Inc Slide 15-15
Copyright © 2003 Pearson Education, Inc. Slide 15-15 ▪ The Fisher Effect • A rise (fall) in a country’s expected inflation rate will eventually cause an equal rise (fall) in the interest rate that deposits of its currency offer. – Figure 15-1 illustrates an example, where at time t0 the Federal Reserve unexpectedly increases the growth rate of the U.S. money supply to a higher level. A Long-Run Exchange Rate Model Based on PPP