International Macroeconomics

- Chapter 3: Exchange rates I: The

monetary approach in long run-

Dr. Yvonne Sperlich,

University of Geneva
Spring semester 2020

Slides based on Feenstra/Taylor, 2015

1
Content of chapter III

• Exchange Rates and Prices in the Long Run

• Money, Prices, and Exchange Rates in the Long Run
• The Monetary Approach
• Money, Interest Rates, and Prices in the Long Run
• Monetary Regimes and Exchange Rate Regimes

2
Goal of this chapter
• The goal of this chapter is to set out the long-run relationships
between money, prices, and exchange rates. The theory we
will develop has two parts:

I. Involves the theory of purchasing power, which links the

exchange rate to price levels in each country in the long
run.
II. Involves how price levels are related to monetary
conditions in each country.

Combining the monetary and the purchasing power theory we

will develop a long-run theory known as the monetary
approach to exchange rates. 3
1. Exchange Rates and Prices in the Long Run: Purchasing Power
Parity and Goods Market Equilibrium

Ex: Suppose price rose of a standardized Canadian basket of

consumer goods from 1970 to 1990: 1970 C$100; 1990 C$392.
Canadian price roses by 292%.
US: Basket of goods cost US$100 in 1970 and 1990 US$336.
Prices rose by 236%
 In 1970 1 C$ was worth almost exactly 1 dollar. Both baskets
cost the same in 1970 expressed in a common currency
(C$100=US$100)
 In 1990, Canadian dollar has depreciated relative to its value
of 1970: C$1.16 was necessary to buy $1.00
 The $336 US basket in 1990 cost actually $336 x 1.16=C$390;
almost the same price as the Canadian basket.
(or expressed in US$: 392/1.16=$338 for Canadian basket) 4
The prices of goods in different countries expressed in a common
currency tend to be equalized.

• Applied to a single good, this idea is referred to as the law of

one price.

• Applied to an entire basket of goods, it is called the theory of

purchasing power parity.

• We will develop a simple theory based on an idealized world of

frictionless trade where transaction costs can be neglected.

• We start with single goods and the law of one price then move
baskets of goods and purchasing power parity.
5
The law of one price (LOOP) states that in the absence of trade
frictions (e.g. transport costs) , under free competition and price
flexibility, identical goods sold in different locations must sell for
the same price when expressed in a common currency.

We can state the law of one price as follows, for the case of any
good g sold in two locations:

where E $/€ is the dollar-euro exchange rate used to convert

euro in dollar prices.
6
qus/€ shows how many units of US goods are needed to
purchase one unit of the same good in Europe.
Three possible outcomes

1. Ratio exceeds 1 => Good costlier in Europe

2. Ratio is less than 1 => Good cheaper in Europe
3. Ratio is 1: qUS/EUR =1 same price in both countries.

7
The law of one price
We can rearrange the equation for price equality

to show that the exchange rate must equal the ratio of the
goods’ prices expressed in the two currencies:

8
Principle of purchasing power parity (PPP) is the
macroeconomic counterpart to the microeconomic law of one
price (LOOP). To express PPP algebraically, we can compute the
relative price of the two baskets of goods in each location:

There is no arbitrage when the basket has the same price in

both locations qUS/EUR = 1. (Other outcomes: Basket
cheaper in US or EU)

PPP holds when price levels in two countries are equal when 9
expressed in a common currency. This is called absolute PPP
Real exchange rate is the relative price of the baskets.
The U.S. real exchange rate qUS/EUR = E$/€ PEUR/PUS tells us how
many U.S. baskets are needed to purchase one European basket.

Difference between real exchange rate and nominal exchange

rate:
The nominal exchange rate is the exchange rate for currencies
The real exchange rate is related to the goods market: how
many US baskets of goods can be exchanged for one European
basket.

If the real exchange rate rises (more Home goods are needed in
exchange for Foreign goods), Home has experienced a real
depreciation.

If the real exchange rate falls, Home has experienced a real 10

appreciation.
The absolute PPP and the real exchange rate
Purchasing power parity states that the real exchange rate is
equal to 1.

• If the real exchange rate qUS/EUR is below 1 by x% then Foreign

goods are relatively cheap. In this case, the Home currency is
said to be strong, the euro is weak, and we say the euro is
undervalued by x%.

• If the real exchange rate qUS/EUR is above 1 by x%, then Foreign

goods are relatively expensive. In this case, the Home currency
is said to be weak, the euro is strong, and we say the euro is
overvalued by x%.

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Ex: European basket costs E$/€PEuR=$550 in dollar terms and a US
basket costs only $500
Real exchange rate=$550/500=1.10
Euro is strong: 10% overvalued against dollar.

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Absolute PPP, prices and nominal exchange rate
We can rearrange the no-arbitrage equation for the equality of
price levels, to allow us to solve for the
exchange rate that would be implied by absolute PPP:
Absolute PPP:

Purchasing power parity implies that the exchange rate at

which two currencies trade equals the relative price levels of the
two countries => clear predication about exchange rate.

Ex. Suppose a basket of goods costs $460 in the US and the

same basket in Europe €400: Predication of exchange rate: 13
$460/€400=$1.15 in euro.
Absolute PPP, prices and nominal exchange rate

According to the PPP Theory In this model, the price levels are
treated as known exogenous variables (in the green boxes). The
model uses these variables to predict the unknown endogenous
variable (in the red box), which is the exchange rate. 14
Relative PPP, Inflation, and Exchange Rate Depreciation

• We now examine the implications of PPP for the study of

inflation (the rate of change of the price level).

• On the left-hand side, the rate of change of the exchange rate

in Home is the rate of exchange rate depreciation in Home
given by

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Relative PPP, Inflation, and Exchange Rate Depreciation
We now examine the implications of PPP for the study of inflation
(the rate of change of the price level)

On the right, the rate of change of the ratio of two price levels
equals the rate of change of the numerator minus that of the
denominator:

16
If equation holds for levels of exchange rates and prices, then it
must also hold for rates of change in these variables. By
combining the last two expressions, we obtain:

This way of expressing PPP is called relative PPP, and it implies

that the rate of depreciation of the nominal exchange rate equals
the difference between the inflation rates of two countries.

Relative PPP predicts a relationship between changes in prices 17

and changes in exchange rates.
Evidences: PPP in long and short run

Scatterplot shows the relationship between the rate of exchange rate depreciation
against the U.S. dollar and the inflation differential against the United States over
the long run, for a sample of 82 countries. The correlation between the two 18
variables is strong and bears a close resemblance to the prediction of PPP that all
data points would appear on the 45-degree line.
Exchange rate and relative price levels do not always move
together in the short run. Relative price levels tend to change
slowly and have a small range of movement; exchange rates move
quickly and experience large fluctuations. Therefore, relative PPP
does not hold in the short run. It is a better guide to the long run,
and we can see that the two series do tend to drift together over
the decades. 19
How slow is convergence to PPP?
Research shows that price differences—the deviations from
PPP—can be quite persistent.

Estimates suggest that these deviations may die out at a rate of

about 15% per year. This kind of measure is often called a speed
of convergence.

Approximately half of any PPP deviation still remains after four

years: economists would refer to this as a four-year half-life.

Such estimates provide a rule of thumb that is useful as a guide

to forecasting real exchange rates.

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Forecasting When the Real Exchange Rate Is Undervalued or
Overvalued
When relative PPP holds, forecasting exchange rate changes is
simple: just compute the inflation differential.
But how do we forecast when PPP doesn’t hold, as is often the
case? Knowing the real exchange rate and the convergence
speed may still allow us to construct a forecast of real and
nominal exchange rates.
The rate of change of the nominal exchange rate equals the rate
of change of the real exchange rate plus home inflation minus
foreign inflation:

21
What Explains Deviations from PPP?

Economists have found a variety of reasons why PPP fails in the

short run:

Transaction costs. Include costs of transportation, tariffs, duties,

and other costs due to shipping and delays associated with
developing distribution networks and satisfying legal and
regulatory requirements in foreign markets. On average, they are
more than 20% of the price of goods traded internationally.

Non-traded goods. Some goods are inherently non-tradable;

they have infinitely high transaction costs. Most goods and
services fall somewhere between tradable and non-tradable

22
Imperfect competition and legal obstacles. Many goods are not
simple undifferentiated commodities, as LOOP and PPP assume.
Differentiated goods create conditions of imperfect competition
because firms have some power to set the price of their good,
allowing firms to charge different prices not just across brands
but also across countries.

Price stickiness. Prices do not or cannot adjust quickly and

flexibly to changes in market conditions.

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The Big Mac Index

For more than 25 years, The Economist

newspaper has engaged in a whimsical attempt
to judge PPP theory based on a well-known,
globally uniform consumer good: the
McDonald’s Big Mac. The over- or
undervaluation of a currency against the U.S.
dollar is gauged by comparing the relative
prices of a burger in a common currency, and
expressing the difference as a percentage
deviation from one:

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The table shows the price of a Big Mac in July 2012 in local currency (column 1) and
converted to U.S. dollars (column 2) using the actual exchange rate (column 4). The
dollar price can then be compared with the average price of a Big Mac in the United
States ($3.22 in column 1, row 1). The difference (column 5) is a measure of the
overvaluation (+) or undervaluation (−) of the local currency against the U.S. dollar. The
exchange rate against the dollar implied by PPP (column 3) is the hypothetical price of
dollars in local currency that would have equalized burger prices, which may be 25
compared with the actual observed exchange rate (column 4).
26
27
2 Money, Prices, and Exchange Rates in the Long Run: Money
Market Equilibrium in a Simple Model

• In the long run the exchange rate is determined by the ratio of

the price levels in two countries. But this prompts a question:
What determines those price levels?

• Monetary theory supplies an answer: in the long run, price

levels are determined in each country by the relative demand
and supply of money.

• This section recaps the essential elements of monetary theory

and shows how they fit into our theory of exchange rates in
the long run.
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Recap: What is money?
Three key functions in an economy:
• Money is a store of value because it can be used to buy goods
and services in the future. If the opportunity cost of holding
money is low, we will hold money more willingly than we hold
other assets.

• Money also gives us a unit of account in which all prices in the

economy are quoted.

• Money is a medium of exchange that allows us to buy and sell

goods and services without the need to engage in inefficient
barter.
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M0 – “base money”
M1 - broader measure of money but excludes the bank’s reserves

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Demand of Money:
We assume money demand is motivated by the need to conduct
transactions in proportion to an individual’s income and we infer
that the aggregate money demand will behave similarly (known
as the quantity theory of money).

All else equal, a rise in national dollar income (nominal income)

will cause a proportional increase in transactions and in
aggregate money demand.
31
Dividing the previous equation by P, the price level, we can
derive the demand for real money balances:

Real money balances are simply a measure of the purchasing

power of the stock of money in terms of goods and services.
The demand for real money balances is strictly proportional
to real income

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Equilibrium in money market

The condition for equilibrium in the money market is simple to

state: the demand for money Md must equal to the supply of
money M, which we assume to be under the control of the
central bank.

Imposing this condition on the last two equations, we find that

nominal money supply equals nominal money demand:

=>

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A simple monetary model of price

An expression for the price levels in the U.S. and Europe is:

These two equations are examples of the fundamental equation

of the monetary model of the price level.

In the long run, we assume prices are flexible and will adjust to put
the money market in equilibrium
34
In these models, the money supply and real income are treated
as known exogenous variables (in the green boxes). The models
use these variables to predict the unknown endogenous variables
(in the red boxes), which are the price levels in each country. 35
We can use the equation for absolute PPP to solve for the
exchange rate:

=Fundamental equation of the monetary approach to

exchange rates

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 Ex.: Suppose the U.S. money supply increases, all else equal. The
right-hand side increases , causing the exchange rate to increase
- the U.S. dollar depreciates against the euro.

In rate of changes:
First term: E / E
$/ € $/ €

Term positive => e.g. 1%, dollar is depreciating

Term negative => e.g. -2%, dollar is appreciating 37

Second Term:  us ,t   eu ,t
Money growth, inflation and depreciation
Third term (L constant)
U.S. money supply is MUS, and its growth rate is μUS:

Growth rate of real income in the U.S. is gUS:

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Therefore, the growth rate of PUS = MUS/LUS x YUS equals the
money supply growth rate μUS minus the real income growth
rate gUS. The growth rate of PUS is the inflation rate πUS. Thus,
we know that:

When money growth is higher than income growth, we have

“more money chasing fewer goods” and this leads to inflation

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Combining the two equations for US and EU, we can now solve
for the inflation differential in terms of monetary fundamentals
and compute the rate of depreciation of the exchange rate:

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The intuition behind this equation is the following:

 If the United States runs a looser monetary policy in the

long run measured by a faster money growth rate, the
dollar will depreciate more rapidly, all else equal.
Ex. EU 5% annual rate of change of money and a 2% rate of change of real
income; inflation 3%. Now the United States 6% rate of change of money
and a 2% rate of change of real income; inflation 4%. Rate of depreciation of
the dollar would be U.S. inflation minus European inflation, 4% minus 3%, or
1% per year.

 If the U.S. economy grows faster in the long run, the dollar
will appreciate more rapidly, all else equal.
Ex. U.S. growth rate of real income in the long run increases from 2% to 5%,
all else equal. U.S. inflation equals the money growth rate of 6% minus the
new real income growth rate of 5%, so inflation is just 1% per year. Now the
rate of dollar depreciation is U.S. inflation minus European inflation, that is,
1% minus 3%, or −2% per year (meaning the U.S. dollar would now 41
appreciate at 2% per year).
3 The Monetary Approach: Implications and Evidence
Exchange rate forecasts: A simple model
• When we use the monetary model for forecasting, we are
answering a hypothetical question: What path would exchange
rates follow from now on if prices were flexible and PPP held?

Possible to use above equation for forecast of future exchange

rates as long as we know how to forecast future money
supplies and real income.
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Forecasting Exchange Rates: An Example
Assume that U.S. and European real income growth rates are
identical and equal to zero (0%). Also, the European price level is
constant, and European inflation is zero.
Based on these assumptions, we examine two cases.
• Case 1: A one-time unanticipated increase in the money supply.
• Case 2: An increase unanticipated in the rate of money growth.

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Forecasting Exchange Rates: An Example
Case 1: A one-time increase in the money supply.

 There is a 10% increase in the money supply M.

 Real money balances M/P remain constant because real
income is constant.
 These last two statements imply that price level P and money
supply M must move in the same proportion, so there is a 10%
increase in the price level P.
 PPP implies that the exchange rate E and price level P must
move in the same proportion, so there is a 10% increase in the
exchange rate E.

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Forecasting Exchange Rates: An Example
Case 2: An increase in the rate of money growth.
At time t the United States will raise the rate of money supply
growth μ + Δμ from a steady fixed rate μ.

Money supply M is growing at a constant rate μ.

Real money balances M/P remain constant, as before.
These last two statements imply that price level P and money
supply M must move in the same proportion, so P is always a
constant multiple of M.
PPP implies that the exchange rate E and price level P must
move in the same proportion, so E is always a constant
multiple of P (and hence of M).

45
Increase in growth rate in simple model

Before time T, money,

prices, and the exchange
rate all grow at rate μ.
Foreign prices are
constant. We suppose at
time T there is an
increase Δμ in the rate of
growth of home money
supply M.

46
In panel (b), the quantity theory assumes that the
level of real money balances remains unchanged.
47
 48

Rate of inflation rises by Δμ Rate of depreciation rises by Δμ

Equation predicts that an x-% difference in money growth rates
should be associated with an x-% difference in inflation rates
(relative to US) and an x-% depreciation of home exchange rate
against $.

49
 Evidences for Monetary approach

Scatterplot shows the relationship between the rate of inflation and

the money supply growth rate. Correlation is strong and bears a close
50
resemblance to the theoretical prediction of the monetary model
Money Growth and the Exchange Rate: The monetary approach
to prices and exchange rates also suggests that, increases in the
rate of money supply growth should be the same size as
increases in the rate of exchange rate depreciation.

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Hyperinflation

The monetary approach assumes long-run PPP, which generally

works poorly in the short run. There is one notable exception to
this general failure of PPP in the short run: hyperinflation.

Economists traditionally define a hyperinflation as a sustained

inflation of more than 50% per month (which means that prices
are doubling every 51 days).

In common usage, some lower-inflation episodes are also called

hyperinflations. An inflation rate of 1,000% per year is a common
rule of thumb (22% per month).

Hyperinflations usually occur when governments face a budget

crisis, are unable to borrow to finance a deficit, and instead
choose to print money 52
First hyperinflation in the 21st century
By 2007 Zimbabwe was almost at an economic standstill, except
for the printing presses churning out the banknotes.

• A creeping inflation—58% in 1999, 76% in 2001, 431% in 2003,

and 302% in 2005—was about to become hyperinflation, and
the long-suffering people faced an accelerating descent into
even deeper chaos.
• By 2007 inflation had risen to 24,000%! Among the five worst
hyperinflations episodes of all time, according to Jeffrey D.
Sachs.
• In 2008, the local currency disappeared from use, replaced by
U.S. dollars and South African rand.

53
Application: PPP during hyperinflation
Scatterplot
shows
relationship
changes in
exchange rates
and changes in
prices levels

The data show a strong correlation between the two variables and a very 54
close resemblance to the theoretical prediction of PPP that all data
points would appear on the 45-degree line.
 Application: Money demand in hyperinflation

M/P=LY , where L fixed: Is this assumption of stable money balance justified?

If yes, there should not be variation in the vertical dimension aside from the fluctuation
of Y. => We see here fluctuation: The higher level of inflation, the lower the level of real
money balances
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4 Money, Interest Rates, and Prices in the Long Run: A General
Model

The trouble with the quantity theory we studied earlier is that it

assumes that the demand for money is stable, and this is
implausible.

We will now explore a more general model that allows for

money demand to vary with the nominal interest rate.

We consider the links between inflation and the nominal

interest rate in an open economy.

But how is the nominal interest rate determined in long-run?

56
Demand for money: General model
All else equal:
 A rise in national income will cause a proportional increase in
transactions and aggregate money demand.
• A rise in the nominal interest rate will cause the aggregate
demand for money to fall.

where L (liquidity ratio) decreasing function of i.

• Dividing by P, we derive the demand for real money balances

57
(a) shows the inverse relationship between demand for real money
balances and nominal interest rate at a given level of real income Y.

(b) shows what happens when Y ↑: Demand for real money balances 58
increases at each level of the nominal interest rate and curve shifts.
Long-Run Equilibrium in the Money Market
Money supply (determined by central bank) equals demand for
real money balances (determined by nominal interest rate & Y)

where P is flexible in long-run.

Last piece to the puzzle: What is the level of i in long-run?

59
Inflation and interest rates in long-run (expected e)

With two relationships, PPP (links prices and exchange rates) and
UIP (links exchange rates and interest rates), we can derive a
striking result concerning interest rates that has profound
implications for our study of open economy macroeconomics. We
use:

and

60
The Fisher Effect
The nominal interest differential equals the expected inflation
differential:

All else equal, a rise in the expected inflation rate in a country will
lead to an equal rise in its nominal interest rate. => known as the
Fisher effect (based on PPP – holds in long-run)).

Ex: Suppose expected inflation rate in US: 4% and in Europe: 2%:

Differential=+2%. If interest rate in Europe is 3% => Interest rate
in US must be equal to 5% (5-3=2). Assume a change in expected
US inflation rate of +1% (all else equal): Expected inflation rate in
US: 5% => US interest rate must rise by 1% to 6%. 61
As inflation rises, the Fisher effect tells us that the nominal
interest rate i must rise by the same amount; the general model
of money demand then tells us that L(i) must fall because it is a
decreasing function of i. Thus, for a given level of real income,
real money balances must fall as inflation rises.

62
Real interest rate parity
Rearranging the last equation, we find

Subtracting the inflation rate (π) from the nominal interest rate
(i), results in a real interest rate (r):

This result states the following: If PPP and UIP hold, then
expected real interest rates are equalized across countries. This
powerful condition is called real interest parity.

Real interest parity implies the following: Arbitrage in goods and

financial markets alone is sufficient, in the long run, to cause the
equalization of real interest rates across countries.
63
Real interest rate parity
In the long run, all countries will share a common expected real
interest rate, the long-run expected world real interest rate
denoted r*, so

We treat r* as an exogenous variable, something outside the

control of a policy maker in any particular country.

Under these conditions, the Fisher effect is even clearer,

because, by definition,

64
Evidences on Fisher effect

Scatterplot shows
the relationship
between the
average annual
nominal interest
rate differential
and the annual
inflation
differential
relative to the
United States over
a ten-year period
for a sample of 62
countries.

Correlation between the two variables is strong 65

 Real Interest Rate Differentials, 1970–1999

Shows actual real interest rate differentials over three decades for the
United Kingdom, Germany, and France relative to the United States. These
differentials were not zero, so real interest parity did not hold
66
continuously. But the differentials were on average close to zero, meaning
that real interest parity (like PPP) is a general long-run tendency in the
data.
Fundamental equation in General Model
This model differs from the simple model (the quantity theory) by
allowing L to vary as a function of the nominal interest rate i.

When nominal interest rates change, the general model has

different implications from the simple model.
Ex.: Reexamine the forecasting problem for an increase in the U.S.
rate of money growth. US is raising the rate of money supply
growth from μ to a higher rate μ + Δμ. Increase from 2% to 3%, so
that Δμ=1%. How will the exchange rat behave in long-run? 67
68
Exchange Rate Forecasts Using the General Model - An Increase in
the Growth Rate of the Money Supply in the Standard Model
???raus????
Before time T, money, prices, and the exchange rate all grow at rate
μ. Foreign prices are constant. In panel (a), we suppose at time T
there is an increase Δμ in the rate of growth of home money supply
M.
This causes an increase Δμ in the rate of inflation; the Fisher effect
means that there will be a Δμ increase in the nominal interest rate;
as a result, as shown in panel (b), real money demand falls with a
discrete jump at T.
If real money balances are to fall when the nominal money supply
expands continuously, then the domestic price level must make a
discrete jump up at time T, as shown in panel (c).
Subsequently, prices grow at the new higher rate of inflation; and
given the stable foreign price level, PPP implies that the exchange
rate follows a similar path to the domestic price level, as shown in
69
panel (d).
5. Monetary regimes and exchange rate regimes: The nominal
anchor
From the nation’s economic policy is the desire to keep inflation
within certain bounds.

To achieve such an objective requires that policy makers be

subject to some kind of constraint in the long run. Such
constraints are called nominal anchors.

Long-run nominal anchoring and short-run flexibility are the

characteristics of the policy framework that economists call the
monetary regime. Objective: Price stability

The three main nominal anchor choices that emerge are

exchange rate target, money supply target, and inflation target 70
plus interest rate policy.
Exchange rate target: Which variable could policy makers use as
anchors to achieve an inflation objective in long-run?

Relative PPP says that home inflation equals the rate of depreciation
plus foreign inflation.

Under fixed exchange rates: Anchor variable zero (peg)

Under a crawl: non-zero constant
Under limited flexibility: band around zero
71
=> Home country imports inflation from abroad under a peg
Money supply target:

 Inflation rate around 2% a year.

 Problem: Real income growth can be unstable.

72
Inflation target plus interest rate policy:

For example, if the world real interest rate is r* = 2.5%, and the
country’s long-run inflation target is 2%, then its long-run nominal
interest rate ought to be on average equal to 4.5% (because 2.5% =
4.5% − 2%). This would be termed the neutral level of the nominal
interest rate.
73
Table illustrates the possible exchange rate regimes that are consistent with various
types of nominal anchors. Countries that are dollarized or in a currency union have a
“superfixed” exchange rate target. Pegs, bands, and crawls also target the exchange
rate. Managed floats have no preset path for the exchange rate, which allows other
targets to be employed. Countries that float freely or independently are judged to
pay no serious attention to exchange rate targets; if they have anchors, they will
involve monetary targets or inflation targets with an interest rate policy. The
countries with “freely falling” exchange rates have no serious target and have high
rates of inflation and depreciation. It should be noted that many countries engage in 74
implicit targeting (e.g., inflation targeting) without announcing an explicit target and
that some countries may use a mix of more than one target.
Application: Nominal Anchors in theory and pratice
An appreciation of the importance of nominal anchors has
transformed monetary policy making and inflation performance
throughout the global economy in recent decades.

In the 1970s and 1980s, most of the world was struggling with
high inflation.

In the 1990s, policies designed to create effective nominal

anchors were put in place in many countries.

Most of those policies have turned out to be credible, too, thanks

to political developments in many countries that have fostered
central-bank independence.
75
Global Disinflation Cross-country data from 1980 to 2012 show the gradual
reduction in the annual rate of inflation around the world. This disinflation process
began in the advanced economies in the early 1980s. The emerging markets and
developing countries suffered from even higher rates of inflation, although these
finally began to fall in the 1990s.
76