Economics 236/336 Fall 2024 - 2025

American University of Beirut

Department of Economics
Economics 236/336

Week 4 Tutorial - Solutions

Exchange Rates I: The Monetary Approach in the Long Run

1. Consider two countries: Japan and South Korea. In 1996 Japan experienced relatively slow output growth
(1%), while South Korea had relatively robust output growth (6%). Suppose the Bank of Japan allowed
the money supply to grow by 2% each year, while the Bank of Korea chose to maintain relatively high
money growth of 15% per year.

For the following questions, use the simple monetary model (where L is constant). You will find it easiest
to treat South Korea as the home country and Japan as the foreign country.

(a) What is the inflation rate in South Korea? In Japan?

πK = µK − gK = 15% − 6% = 9%
πJ = µJ − gJ = 2% − 1% = 1%

(b) What is the expected rate of depreciation in the Korean won relative to the Japanese yen?

e
%∆Ewon/yen = πK − πJ = 9% − 1% = 8%. You can check this by using the following expression
e
from the monetary model: %∆Ewon/yen = (µK − gK ) − (µJ − gJ ).

(c) Suppose the Bank of Korea decreases the money growth rate from 15% to 12%. If nothing in Japan
changes, what is the new inflation rate in South Korea?

N EW
πK = µK − gK = 12% − 6% = 6%

(d) Using time series diagrams, illustrate how this decrease in the money growth rate affects the money
supply MK , South Koreas interest rate, prices PK , real money supply, and Ewon/yen over time. (Plot
each variable on the vertical axis and time on the horizontal axis.)

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(e) Suppose the Bank of Korea wants to maintain an exchange rate peg with the Japanese yen. What
money growth rate would the Bank of Korea have to choose to keep the value of the won fixed relative
to the yen?

To keep the exchange rate constant, the Bank of Korea must lower its money growth rate. We can
figure out exactly which money growth rate will keep the exchange rate fixed by using the fundamental
equation for the simple monetary model (used above in [b]):
e
%∆Ewon/yen = (µK − gK ) − (µJ − gJ )
e
The objective is to set %∆Ewon/yen = 0:

(µK − gK ) = (µJ − gJ )

Plug in the values given in the question and solve for µK :

(µK − 6%) = (2% − 1%) ⇒ µK = 7%

Therefore, if the Bank of Korea sets its money growth rate to 7%, its exchange rate with Japan will
remain unchanged.

(f) Suppose the Bank of Korea sought to implement policy that would cause the Korean won to appre-
ciate relative to the Japanese yen. What ranges of the money growth rate (assuming positive values)
would allow the Bank of Korea to achieve this objective?

e
Using the same reasoning as previously, the objective is for the won to appreciate: %∆Ewon/yen < 0.
This can be achieved if the Bank of Korea allows the money supply to grow by less than 7% each year.
The diagrams on the previous page show how this would affect the variables in the model over time.

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2. This question uses the general monetary model, where L is no longer assumed constant, and money demand
is inversely related to the nominal interest rate. Consider the same scenario described at the beginning of
the previous question. In addition, the bank deposits in Japan pay a 3% interest rate, iyen = 3%.

(a) Compute the interest rate paid on South Korean won deposits.

Assuming that the relative PPP holds, the exchange rate depreciation equals the inflation differ-
ential, which in turn by UIP implies the Fisher effectthat is: iwon − iyen = πK − πJ . Solve for
iwon = (6% − 1%) + 3% = 8%.

(b) Using the definition of the real interest rate (nominal interest rate adjusted for inflation), show that
the real interest rate in South Korea is equal to the real interest rate in Japan. (Note that the
inflation rates you computed in the previous question will be the same in this question.)

ryen = iyen − πJ = 3% − 1% = 2%
rwom = iwon − πK = 8% − 6% = 2%

(c) Suppose the Bank of Korea increases the money growth rate from 12% to 15% and the inflation rate
rises proportionately (one for one) with this decrease. If the nominal interest rate in Japan remains
unchanged, what happens to the interest rate paid on Korean won deposits?

We know that the inflation rate in Korea will increase to 9%. We also know that the real interest
rate will remain unchanged. Therefore: iwon = rwon + πK = 2% + 9% = 11%.

(d) Using time series diagrams, illustrate how this increase in the money growth rate affects the money
supply MK ; South Koreas interest rate; prices PK ; real money supply; and Ewon/yen over time. (Plot
each variable on the vertical axis and time on the horizontal axis.)

As the interest rate rises due to expected inflation (Fisher effect), there is a fall in L(i) which must be
equilibrated by a fall in the real money supply. Since the money supply does not change, equilibrium
requires a rise in the price level. Then, by PPP, the exchange rate depreciates.

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3. Both advanced economies and developing countries have experienced a decrease in inflation since the
1980s. This question considers how the choice of policy regime has influenced such global disinflation.
Use the monetary model to answer this question.

(a) Consider a period when the Swiss Central Bank targeted its money growth rate to achieve policy
objectives. Suppose Switzerland has output growth of 2% and money growth of 3% each year. What
is Switzerlands inflation rate in this case? Describe how the Swiss Central Bank could achieve an
inflation rate of 2% in the long run through the use of a nominal anchor.

From the monetary approach: πS = µS − gS = 3% − 2% = 1%. If the Swiss Central Bank

wants to achieve an inflation target of 2%, it would need to increase its money growth rate to 4%:
µS = πS + gS = 2% + 2% = 4%.

(b) Consider a period when the Reserve Bank of New Zealand used an interest rate target. Suppose the
Reserve Bank of New Zealand maintains a 5% interest rate target and the world real interest rate
is 1.5%. What is the New Zealand inflation rate in the long run? In 1997 New Zealand adopted a
policy agreement that required the bank to maintain an inflation rate no higher than 2.5%. What
interest rate targets would achieve this objective?

From the Fisher effect:πN Z = iN Z$ − r∗ = 5% − 1.5% = 3.5%. The Reserve Bank of New Zealand
needs to set the interest rate target equal to 4% or lower: iN Z$ = r∗ + πN Z = 1.5% + 2.5% = 4%.

(c) Consider a period when, prior to euro entry, the central bank of Lithuania maintained an exchange
rate band relative to the euroat the time this was a prerequisite for joining the Eurozone. The rules
said that Lithuania had to keep its exchange rate within ± 15% of the central parity of 3.4528 litas
per euro. Compute the exchange rate values corresponding to the upper and lower edges of this

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band. Suppose PPP holds. Assuming Eurozone inflation was 2% per year and inflation in Lithuania
was 6%, compute the PPP-implied rate of depreciation of the lita. Could Lithuania maintain the
band requirement? For how long? Does your answer depend on where in the band the exchange rate
currently sits? A primary objective of the European Central Bank is price stability (low inflation)
in the current and future Eurozone. Is an exchange rate band a necessary or sufficient condition for
the attainment of this objective?

e
From relative PPP: πL = %∆Elita/e −πE . Plug in the inflation rates for the Eurozone and Lithuania,
e
and find the implied rate of depreciation in Lithuanian currency: %∆Elita/e = 6%−2% = 4% < 15%.
Thus, the Lithuanian currency is depreciating relative to the euro. If the Lithuanian currency were
to depreciate by 4% each year, it would be outside the exchange rate band after just less than four
years. We can see that the exchange rate band is not sufficient to ensure low inflation. The Eurozone
would need to impose a stricter range, or a hard peg, to ensure that Lithuanias inflation rate is equal
to (or less than) that of the Eurozone.