Handout 5 The Monetary Model (Flexible Prices)

Question 1

A Money supply increase (floating exchange rates)

Answer 1

• The monetary stock increases from MSo to `MS1 while all other exogenous variables (y and P*) do not change
• At the old price level P0, there is an excess supply of money (MS0 > Md=kY).
  -The excess supply of money implies that there is an excess demand of goods and services.
  -Given the assumption of fixed output, the excess demand of goods and services will drive up prices.
• Since domestic prices increase, the domestic economy becomes less competitive, so for PPP to hold the domestic currency has to depreciate.
• Depreciation of the domestic currency is proportional to the increase in the domestic price.
  In the monetary model, an increase in money supply leads to a depreciation of domestic currency.

Question 2

An income increase (floating exchange rates)

Answer 2

• Real income increases from y0 to y1 while all other exogenous variables (M0S and P*) do not change.
• At the old price level Po there is an excess demand of money (MS0 < Md=kY)
• The excess demand of money implies that there is an excess supply of goods and services.
• The excess supply of goods and services will decrease prices.
• Since domestic prices decrease, the domestic economy becomes more competitive, so for PPP to hold, the domestic currency has to appreciate.

In the monetary model, an increase in real income leads to an appreciation of domestic currency.

Question 3

A foreign price increase (floating exchange rates)

Answer 3

The foreign price level increases from P0 to P1 while all other exogenous variables (M0S and y ) do not change.

• the slope of the PPP given by P1* increases.
• At the previous nominal exchange rate, the domestic economy becomes over competitive, so the domestic currency has to appreciate.
• In the monetary model, a rise in the foreign price level leads to an appreciation of domestic currency and no other change in the domestic economy.

Question 4

A foreign price increase (fixed exchange rates)

Answer 4

The foreign price increases from P0 to P1 while all other exogenous variables do not change.

• The slope of the PPP line, given by P1*, increases;
• for given domestic prices, the country becomes more competitive;
• The excess demand for domestic goods generates a balance of payments surplus
• Foreign exchange reserves FX increase so money supply increases as well
• The increase in money supply increases the domestic price level to its PPP level
• A country which pegs it exchange rate ultimately has to accept the world price level ( it imports inflation from the rest of the world). In other words, the country cannot follow an independent monetary policy, nor can it choose a price level or inflation rate different from that of the rest of the world.

Question 5

Devaluation under fixed exchange rates

Answer 5

• At the previous price level, the country is now more competitive
• The excess demand for domestic goods generates a balance of payments surplus
• Foreign exchange reserves FX increase so money supply increases as well
• The Increase in money supply increases the domestic price level to its PPP level.
  Note: the effect of the devaluation on the balance of payments may be delayed depending on the short-run elasticities of the demand for exports and imports.

Question 6

What are the assumptions of the Monetary Model under floating exchange rate?

Answer 6

• AS curve is vertical -> implies P’s are perfectly flexible.
• The demand for money is given by the cambridge quantity equation: M^d = kPy
  Equilibrium: M^d = M^s. (M^s=M^d=kY)
• Purchasing Power Parity must hold at all times. When expressed in a common currency, domestic and foreign price levels should be identical. P = eP. In the open economy equilibrium PPP has to hold which argues that:
  e= M^s/ kPy

Question 7

What are the predictions of the monetary model in a floating exchange rate regime?

Answer 7

e= Ms/kP*y

An increase in y leads to e decreasing (appreciation).
An increase in Ms leads to e increasing (depreciation).
An increase in P* leads to an e decreasing. (appreciation).

Question 8

What change in the assumptions are found when we move towards a monetary model with a fixed exchange rate?

Answer 8

Under a fixed exchange rate regime, the central bank buys and sells domestic currency in order to keep the nominal exchange rate fixed. The money supply is now given by:

Ms = FX +DC