Question

Explain the monetary approach to exchange rate determination using the equations that
characterize this approach, stating its general prediction. What are its specific predictions
about the long-run effects on the exchange rate of changes in money supplies, interest rates,
and output levels?

Answer 1

Basis lecture 3 of Prof. Alan Isaac

Exchange rates are of two types : Fixed and Floating.

In fixed exchange rate system , a country's government self determines the exchange rate and its policy. Monetary policy is absolutely ineffective. So, here we are concerned about only floating exchange rate, and discussing effects of monetary policy on floating exchange rate - how monetary approach affects exchange rate determination.

Monetary policy is being given the central role in exchange rate determination.This approach focuses on both domestic and foreign money supply. This approach has two major ingredients

1. Exogeneity of real exchange rate i.e inflation at home or abroad does not effect how much foreign good costs in terms of domestic goods.
2. Classical model of price determination which says price level is proportional to money supply, so that monetary policy is the key determinant of inflation rate.

Monetary approach to exhange rate determination appears more realistic in long-run outcomes.

Exogenous real exchange rate

Exogenous depicts external cause; real exchange rate gives the rate at which domestic goods must be given up to obtain foreign good.

Let P be domestic consumer price index and P* be foreign consumer price index. Assumption is both P and P* are monetary cost of a fixed consumption bucket. The below picture (1) depicts real exchange rate Q. The monetary approach assumes Q is exogenous.

Given the real exchange rate, the nominal exchange rate and relative price level have a determinate relation given by image (2).

S is exchange rate. For any given Q, equation in picture 2 requires that exchange rate movements offset price level movements so that the rate at which goods actually exchange for each other remains unchanged.

Purchasing power parity- ppp

Most presentations of the monetary approach to flexible exchange rates assume that the real exchange rate is not only exogenous but that it is invariant. This is called the purchasing power parity assumption. Constancy of the real exchange rate implies that the exchange rate is proportional to the relative price level. If domestic inflation leads to a doubling of the domestic prices, while foreign inflation is zero. Then a doubling of the exchange rate will leave the real exchange rate unchanged.

The classical model of price determination

Here the money supply determines the price level. In this model, monetary policy has no effect on real economic activity. So here we treat real real income and real interest rate exogenous. There are 4 assumptions of this model -

1. Real money demand(L) is a stable function of real income(Y) and nominal interest rate(i).
2. the money market is in continuous equilibrium, (so real money supply equals to real money demand)
3. real interest rate(r) and nominal money supply(H) are exogenous
4. P moves to clear money market

The classical theory states that nominal money supply and real money demand determine price level. Algebrically image (3).

Basic predictions of classical model :

1. Given the interest rate, an exogenous increase in the money supply raises the price level so as to leave the real money supply unchanged
2. Changes in money demand also affect the price level, of course.