Question

How does an increase in inflation affect the nominal exchange rate

How consistent is the Keynesian consumption function with the random walk hypothesis

Use Tobin's q theory and the neoclassical theory of investment to explain why investment rises so rapidly once the economy has passed the trough of a business cycle

Answer 1

In the last few months we have seen some major changes in Canada’s economic landscape. Canada’s inflation rate fell from 2 percent in November to 1.5 percent in December, and is expected to fall further in the next few months. For the first half of 2014, one Canadian dollar bought around $0.91 USD – now it buys around $0.80 USD, representing a drop of just over 12 percent in the currency’s value. As Canada’s inflation rate fell, so did the value of its currency – at least when compared to the US dollar. While the loonie depreciated greatly against the US dollar, it held its ground against the British Pound, the Euro, and the Australian dollar, among others.

The link between inflation rate and currency exchange

Exchanges rates and inflation are closely related and can influence one another. A weak Canadian dollar helps businesses and industries that rely on exports for a large portion of their income. As the currency drops, the cost to their foreign consumers falls and they are likely to buy more. This in turn translates to higher profits, production, employment, and output. When output goes up, inflation goes up. In theory, the higher demand for Canadian goods will lead to higher demand for the loonie, which will bring the exchange rate back into equilibrium.

More intervention is needed in order for the inflation rate to have an impact on the exchange rate. When inflation is high, central bankers will often increase interest rates in order to slow the economy down, and bring inflation back into an acceptable range. Whenever interest rates go up, it becomes more attractive for foreign investors to move funds into the country for deposit and to buy bonds. To do so, they need to purchase countries currency. If the increased demand for the currency is large enough, it would then trigger an appreciation in the currency exchange rate. In short: high inflation often brings higher interest rates, which could then cause a stronger currency.

Low inflation on the other hand will often induce central bankers to drop interest rates in hopes of jump starting economic growth and bringing inflation back up. Foreign investors now view the country as less attractive to invest in and will move funds into other jurisdictions to get better returns. When they do so, they have have to sell the local currency in order to buy another countries currency, which puts downward pressure on the currency being sold and makes it depreciate.

What Is the Consumption Function?

The consumption function, or Keynesian consumption function, is an economic formula that represents the functional relationship between total consumption and gross national income. It was introduced by British economist John Maynard Keynes, who argued the function could be used to track and predict total aggregate consumption expenditures

Understanding the Consumption Function

The classic consumption function suggests consumer spending is wholly determined by income and the changes in income. If true, aggregate savings should increase proportionally as gross domestic product (GDP) grows over time. The idea is to create a mathematical relationship between disposable income and consumer spending, but only on aggregate levels.

The stability of the consumption function, based in part on Keynes' Psychological Law of Consumption, especially when contrasted with the volatility of investment, is a cornerstone of Keynesian macroeconomic theory. Most post-Keynesians admit the consumption function is not stable in the long run since consumption patterns change as income rises

Assumptions and Implications

Much of the Keynesian doctrine centers around the frequency with which a given population spends or saves new income. The multiplier, the consumption function, and the marginal propensity to consume are each crucial to Keynes’ focus on spending and aggregate demand.

The consumption function is assumed stable and static; all expenditures are passively determined by the level of national income. The same is not true of savings, which Keynes called “investment,” not to be confused with government spending, another concept Keynes often defined as investment.

For the model to be valid, the consumption function and independent investment must remain constant long enough for national income to reach equilibrium. At equilibrium, business expectations and consumer expectations match up. One potential problem is that the consumption function cannot handle changes in the distribution of income and wealth. When these change, so too might autonomous consumption and the marginal propensity to consume