Chapter 5 B&W - Money, Prices and Exchange Rates in the Long Run

What does the money neutrality principle state?

Increases/decreases in the monetary supply do not affect real variables such as real GDP and unemployment, only the price level

What are the two implications of money neutrality?

• In the long run monetary policy is ineffective in terms of competitiveness

• The real exchange rate is constant in the long-run and is independent of monetary factors

What is the demand for money?

M = kPY where k is proportion of income held as cash, P is price level and Y is real GDP i.e. PY = nominal GDP

What is the purchasing power or real value of money?

M/P = kY

What happens if the central bank doubles money supply overnight and hands out banknotes to everyone?

• People will demand more goods and services

• Producers may supply more goods but it’s difficult to increase supply as fast as demand

• In the long run, the prices will have to be increased i.e. inflation

What is inflation?

The growth rate of the price level π = ΔM/M

What happens if you increase the nominal money supply?

The price level increases proportionally

What’s wrong with the money neutrality principle so far?

We expect real GDP to grow in the long run not remain constant…

What is the amended equation?

ΔM/M = π + ΔY/Y i.e. money growth = inflation + gdp growth

What is the real interest rate? What does it imply?

• r = i - π

• a positive inflation rate reduces the cost of borrowing however, we assume that inflation rate = 0 in this situation

What is an appreciation of currency in British terms? And conversely, a depreciation?

• Increase in its value in terms of foreign currencies and S increases

• Decrease in its value in terms of foreign currencies and S decreases

What is the formula for the real exchange rate?

σ = SP/P* or P/(P*/S)

What happens if π = π* ?

If π = π* i.e. P/P* remains unchanged, nominal and real exchange rates should move in tandem

What happens if π > π* ? What happens if π < π* ?

• Domestic prices are rising higher than foreign prices therefore P/P* is increasing therefore σ must appreciate

• Foreign prices are rising higher than domestic prices therefore P/P* is decreasing therefore σ must depreciate

Why would σ appreciate?

• When S appreciates when π = π*

• When S is stable but π > π*

What is the formula for the Δσ/σ ? What does it imply?

• Δσ/σ = ΔS/S + (π - π*)

• A real appreciation is a loss of competitiveness

What are real and nominal effective exchange rates? Why are they used?

• Measures of S and σ that are weighted averages in relation to a basket of other currencies

• Can help when comparing currency with main trading partners

What is the external terms of trade?

Ratio of domestically produced exports to foreign-produced import prices - this indicates how many imports we get in return for our exports

What are the internal terms of trade?

Ratio of non-traded goods to traded goods prices

What does Δσ/σ = ΔS/S + (π - π*) = 0 tell us? What is the principle called?

• σ is constant over the long-run treating foreign inflation as exogenous

• Purchasing power parity (relative)

Explain the logic behind (relative) PPP.

• Domestic monetary policy is more expansionary than foreign monetary policy

• Inflation will be higher at home

• If S remains unchanged, RER appreciates

• Domestic goods + services are more expensive relative to foreign goods (less competitive)

• S depreciates

• In the long-run, country must retain its competitiveness

What is the difference between relative PPP and absolute PPP?

• relative PPP requires σ to be constant

• absolute PPP, otherwise known as the Law of One Price requires P* = SP however absolute PPP is often violated…