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Chapter 16: Price Levels and the Exchange Rate in the Long Run - Coggle…
Chapter 16: Price Levels and the Exchange Rate in the Long Run
The Behavior of Exchange Rates
In long-run models, all prices adjust to market conditions, influencing both interest rates and exchange rates. These models offer frameworks for understanding how market participants form expectations and how exchange rates evolve over time.
Law of One Price
The law of one price states that identical goods in competitive markets should sell for the same price when there are no transportation costs or trade barriers.
Price differences create opportunities for arbitrage, leading to adjustments in demand, supply, and prices until uniform pricing is achieved across markets.
Purchasing Power Parity (PPP)
PPP applies the law of one price across countries, stating that exchange rates are determined by average price levels.
Absolute PPP holds when exchange rates equal the ratio of average price levels across countries.
Relative PPP focuses on changes: it states that exchange rate movements reflect differences in inflation rates between countries.
Monetary Approach to Exchange Rates
connects the behavior of exchange rates to monetary factors, predicting their adjustments in the long run based on the absolute version of Purchasing Power Parity (PPP).
Exchange Rates Determined by Prices: The monetary approach assumes that prices across countries adjust to equate the supply and demand for real monetary assets. Thus, the exchange rate is ultimately determined by these price levels, which reflect the relative supply and demand for money across countries.
Key Predictions
Interest Rates
An increase in domestic interest rates decreases the demand for real monetary assets and is associated with a rise in domestic prices. This also causes a proportional depreciation of the domestic currency through PPP.
Output Level
An increase in domestic production and income raises the demand for real monetary assets. With a fixed money supply, this causes a decrease in domestic prices, leading to a proportional appreciation of the domestic currency through PPP.
Money Supply
A permanent increase in the domestic money supply leads to a proportional increase in domestic prices. According to PPP, this causes a proportional depreciation of the domestic currency.
Long-Run Adjustments
All three factors—money supply, interest rates, and output—affect the supply or demand for real monetary assets, which in turn causes price adjustments to restore equilibrium. These price changes align with the predictions of PPP, adjusting exchange rates accordingly.
Inflation and Its Impact
A change in the money supply results in a change in the level of average prices.
A constant money supply growth rate leads to a constant inflation rate. This inflation rate influences nominal interest rates but does not affect real income in the long run, since wages and prices adjust proportionally.
However, inflation does affect nominal interest rates, as higher inflation tends to lead to higher nominal interest rates (based on the Fisher equation).
In essence, the Monetary Approach underscores the importance of price adjustments in determining exchange rates, with money supply, interest rates, and output all influencing the long-term equilibrium between currencies, in line with PPP.
The Fisher Effect
describes the relationship between nominal interest rates and inflation rates.
The Fisher Effect illustrates how nominal interest rates and inflation rates are connected in the long run.
A higher inflation rate leads to a higher nominal interest rate to compensate for the expected inflation. When PPP is expected to hold, this leads to an interest rate differential between countries that mirrors their expected inflation differential.
Figure: Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply
Nominal Interest Rate (R$)
The nominal interest rate jumps immediately from R₁ to R₂ = R₁ + Δπ.
This is due to rational expectations and the Fisher effect: markets anticipate higher inflation and adjust interest rates accordingly.
Also supported by Uncovered Interest Parity (UIP): higher expected depreciation requires higher nominal rates.
Price Level (Pᵤₛ)
Prices begin rising more rapidly after t₀ due to increased money supply.
nflation rises to match the new money growth rate (π + Δπ).
Money Supply (Mᵤₛ)
At time t₀, the Federal Reserve raises the money supply growth rate from π to π + Δπ.
The money supply grows at a faster pace going forward.
Exchange Rate (E$/€)
The dollar depreciates both immediately and permanently in line with higher U.S. inflation.
According to PPP, the exchange rate rises to reflect faster U.S. price growth, weakening the dollar.
Key Mechanisms
Real money demand (L(R, Y)) declines due to the rise in nominal interest rates.
To restore money market equilibrium, prices must jump.
To maintain PPP, the exchange rate must also jump (immediate depreciation).
Over time, prices and exchange rates grow at the same higher rate (π + Δπ).