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International Money and Macroeconomics Solutions

This document provides solutions to tutorial questions for a course on international money and macroeconomics. It examines the effects of a foreign price increase under flexible and fixed exchange rates using a monetary model. It also illustrates how sensitive the exchange rate can be to expectations using an asset approach monetary model where the money supply follows an AR(1) process.

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15 views3 pages

International Money and Macroeconomics Solutions

This document provides solutions to tutorial questions for a course on international money and macroeconomics. It examines the effects of a foreign price increase under flexible and fixed exchange rates using a monetary model. It also illustrates how sensitive the exchange rate can be to expectations using an asset approach monetary model where the money supply follows an AR(1) process.

Uploaded by

pepixt
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

ECON3066 International Money and Macroeconomics

Tutorial 1 Solution
The solutions provided here only serve as brief guidance for students to have a sense of what is
expected in answering the tutorial questions. Students are encouraged to have their own extended
answers.

1. Using the simple monetary model in which the demand for real money balances is a function of
only output, study the effects of a foreign price increase under both flexible and fixed exchange
rates.
Solution guidance: The monetary model contains two main relationships, one is aggregate
demand for money:
Md
= kY,
P
and the other is aggregate supply of money:

F X + DC = M s .

In equilibrium, supply of and demand for money must be equal:

M s = M d = kP Y,

which can be rearranged into


Ms
P = .
kY
To determine the exchange rate, we rely on the assumption of purchasing power parity (PPP):

P Ms
S= = .
P∗ kP ∗ Y
(Potential implications of PPP may be discusses here.) Under floating exchange rate regime, the
exchange rate is determined by the market, and is affected by both domestic financial market
conditions and the foreign price level.
In the above monetary model, a rise in the foreign price level P ∗ , other things being equal,
is associated with an appreciation of the domestic currency - a fall in the price of foreign
exchange rate, S. This is clearly seen by examining figure 4 in lecture 2, where the PPP line
rotates upwards. At the same time, aggregate supply of and demand for money is not affected,
thus there is no other change in the domestic economy. The floating exchange rate acts like a
valve, continually sliding up or down as required to preserve PPP in the face of disturbances
originating in either country’s domestic money markets.
Under the fixed exchange rate, most of the setups laid out above are the same except that now
the domestic price level is determined by the world money market as follows:

P = S̄P ∗ .

An increase in the foreign price level leads to the appreciation pressure on the exchange rate. To
maintain the fixed exchange rate, the domestic monetary authority has to expand the money
stock in order to increase the domestic price level, which in turn depress the exchange rate.
Specifically, the domestic monetary authority has to create credit to match the increased demand
for money. This reminds us of the “policy trilemma” that we have learned in class.

Page 1
ECON3066 International Money and Macroeconomics
Tutorial 1 Solution

2. With reference to the asset approach to the exchange rate, we obtained:

∞
1 X η j−t
st = ( ) Et (mj − φyj + ηi∗j+1 − p∗j ).
1 + η j=t 1 + η

Assuming the money supply process:

mt − mt−1 = ρ(mt−1 − mt−2 ) + t


,
where 0 ≤ ρ ≤ 1 and  is a serially uncorrelated mean-zero shock such that Et−1 (t ) = 0.
Illustrate how sensitive the exchange rate can be to expectations. To simplify, assume that y,
i∗ and p∗ are all zero.
Solution guidance: Make use of the simplification assumptions, we have:
∞
1 X η j−t
st = ( ) Et (mj ).
1 + η j=t 1 + η

Lead the above equation one period forward and take the expectation, we have:
∞
1 X η j−t
Et [st+1 ] = ( ) Et (mj+1 ).
1 + η j=t 1 + η

Take the difference of the exchange rate to get:


∞
1 X η j−t
Et [st+1 ] − st = ( ) Et (mj+1 − mj ).
1 + η j=t 1 + η

Substitute the money supply process into the above equation and make use of the assumption
that Et−1 (t ) = 0, we have:
ρ
Et [st+1 ] − st = (mt − mt−1 ).
1 + η − ηρ
Recall that the demand for money is given by:

mt − pt = −ηit+1 + φyt ,

with PPP and UIRP


pt = st + p∗t ,
it+1 = i∗t+1 + Et (st+1 ) − st ,
together with some algebra, we can derive the following results:

−η(Et (st+1 ) − st ) = mt − p∗t − φyt + ηi∗t+1 − st

Remember that −p∗t − φyt + ηi∗t+1 = 0 by assumption, we have:


1
Et (st+1 ) − st = (mt − st )
−η
ECON3066 International Money and Macroeconomics
Tutorial 1 Solution

Substitute the above equation into the expected exchange rate change to get:
ηρ
st = mt + (mt − mt−1 ).
1 + η − ηρ
This equation shows that an unanticipated shock to mt may have two impacts. It always
raises the exchange rate directly by raising the current nominal money supply. When ρ > 0,
it also raises expectations of future money growth, thereby pushing the exchange rate even
higher. Thus, the simple monetary model provides us with some insight on how instability in
the money supply could lead to proportionally greater variability in the exchange rate.

Common questions

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Purchasing power parity (PPP) plays a central role in determining exchange rates under both regimes. In a floating exchange rate system, PPP dictates that the exchange rate adjusts to offset differences between the domestic and foreign price levels, resulting in exchange rate fluctuations that ensure equal purchasing power. Under a fixed exchange rate regime, PPP necessitates adjustments in the domestic price level through monetary policy operations to keep the exchange rate aligned with a given fixed level. Thus, while PPP influences currency valuation in both systems, the mechanisms for maintaining parity differ: market-driven in floating systems and policy-driven in fixed systems .

To counteract an increase in foreign price levels under a fixed exchange rate system, the domestic monetary authority must expand the domestic money supply. This action is necessary to match the increased demand for money that would arise due to foreign price pressures. By adjusting the money supply to influence the domestic price level, the authority can maintain the fixed exchange rate. This adjustment underscores the importance of domestic monetary actions in a fixed-rate context to uphold the rate in the face of external price changes .

Under a floating exchange rate regime, a rise in the foreign price level P* leads to an appreciation of the domestic currency. This happens because the exchange rate, S, decreases as the price of foreign exchange falls, maintaining purchasing power parity (PPP). The monetary model, with its reliance on the assumption of PPP, shows that even though the foreign price level increases, the equilibrium between domestic money supply and demand remains unaffected .

The exchange rate is highly sensitive to expectations when analyzing the money supply process under a zero mean shock. The exchange rate equation st is influenced by the expected future difference in money supply, given by Et(st+1) - st = Et[0], modified based on the shock's persistence parameter ρ. For ρ > 0, these expectations increase the potential variance of exchange rates due to anticipated future money growth, illustrating the model's implication that exchange rate volatility corresponds to changes in the money supply driven by expectations .

An unanticipated monetary shock, when ρ > 0, has two primary effects on the exchange rate. Firstly, it directly increases the current nominal money supply, which leads to a rise in the exchange rate. Secondly, it increases expectations of future money growth, further enhancing the exchange rate level. These effects emphasize that instability in the money supply process leads to greater variability in the exchange rate, highlighting the sensitivity of exchange rate levels to expectations of future monetary conditions .

The equation Et(st+1) - st = ρ/(1 + η - ηρ)(mt - mt-1) illustrates the expected change in exchange rate due to money supply shocks. It implies that exchange rate volatility is significantly influenced by the extent of persistence (ρ) in money supply changes. The formula shows that, even for identical current supply levels, different expectations about future supply growth lead to pronounced differences in exchange rates, underlining expectations as a crucial determinant of exchange rate fluctuations .

In a fixed exchange rate system, adjusting the domestic money supply is vital due to the need to maintain parity with foreign prices. A change in foreign prices exerts pressure on the fixed exchange rate by creating a disparity between domestic and foreign purchasing power. To counteract this, domestic monetary authorities must modify the money supply to influence the domestic price level, maintaining the fixed rate. This requirement underscores the limitations on independent monetary policy imposed by the fixed exchange rate commitment, demonstrating an inherent dependence on external price stability .

The asset approach model explains the impact of expectations on the nominal exchange rate through the formula st = 1/(1 + η) Σ(η/(1 + η))^j-t Et(mj), where expectations about future money supply mj directly influence the current exchange rate level. Changes in expected future money supply will adjust the current exchange rate based on projected monetary conditions. This emphasizes that nominal exchange rates are highly sensitive to anticipations about future monetary policies and conditions, reflecting the market's forward-looking nature inherent in asset pricing models .

The simple monetary model explains the relationship between money supply growth and exchange rate changes through the dynamics of money demand and PPP. In the equation Et(st+1) = mt + ηρ/(1 + η - ηρ)(mt - mt-1), the exchange rate is directly affected by changes in the money supply, mt. Growth in the money supply, particularly when expected to persist (ρ > 0), leads to increases in exchange rate levels as expectations of future money growth influence current exchange rate movements. Therefore, the model highlights how monetary expansion can lead to exchange rate appreciation, indicating the sensitivity of exchange rates to money supply changes .

The policy trilemma indicates that it is challenging to maintain a fixed exchange rate while also pursuing an independent monetary policy and allowing for free capital movement. In the face of rising foreign prices, the domestic monetary authority must increase the domestic money supply to maintain the fixed exchange rate, which restricts the ability to pursue an independent monetary policy. This action aligns with the policy trilemma's conundrum where only two out of the three goals (fixed exchange rate, monetary independence, and capital mobility) can be achieved simultaneously .

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