Question

1. Monetary approaches to the long run exchange rate. Suppose that the current exchange rate between the Canadian dollar and the euro is EC$/ϵ = 2 .

A. Suppose you expect European money supply growth to be a total of 25% larger over the next ten years than in Canada. Using the monetary approach to exchange rates, what is your best guess as to the exchange rate ten years from now? How should the overall inflation rates of the two regions compare over this period of time (who has higher inflation and why)?

B. Suppose that in addition to expecting European money supply growth to be a total of 25% larger than in Canada, you also expect growth in European money demand to be a total of 25% larger than in Canada over the next ten years. (Perhaps you are expecting faster output growth in Europe.) Using the monetary approach to exchange rates, what is your best guess as to the exchange rate ten years from now? How should the overall inflation rates of the two regions compare over this period of time?

Answer 1

Solution(s):

A.

E_C$/€ = P_C$/P_E = 2

Over the next ten years, if the European money supply growth continues to be 25% larger than the Canadian money supply growth then the rise in expected inflation would produce an expected depreciation of the Euro that is larger than the increase in the domestic interest rate in Europe. As a result, the expected return on European assets falls at any exchange rate.

Europe would have a higher rate of inflation as compared to Canada since the growth of money supply is greater in Europe.

B.

Over the next ten years, if the European money supply growth and its demand continues to be 25% larger than the Canadian money supply growth and demand then essentially, the European price level is unaffected. In other words, if the money supply grows at the same rate as real output we maintain the same price level.

It is then possible to maintain the current exchange rate and inflation rates.