Recording-2025-03-03T12:46:26.405Z

Money Supply and Exchange Rates

• The relationship between money supply and prices:

  • An increase in the money supply leads to higher demand.

  • Prices do not adjust immediately; long run adjustments occur gradually.

  • Initial exchange rate increases occur alongside prices but are influenced by sticky prices.

  • Exchange rates mirror price movements.

• Interest rates in reaction to money supply:

  • Interest rates decrease due to increased money supply.

  • Gradual return to original levels as the economy adjusts.

Importance of Nobel Prize Ideas

• The significance of a Nobel Prize-winning idea:

  • Represents impactful and transformative concepts in economics.

  • Rewards the transition from academic obscurity to global recognition.

  • E.g. the model explaining exchange rate volatility.

Historical Context: Exchange Rate Volatility

• Reference to the oil shock in the late 1970s:

  • Initially locked exchange rates (pound-dollar, pound-Deutsche Mark) were expected to stabilize trade.

  • Actual outcome was much higher exchange rate volatility than anticipated.

  • Flexible exchange rates proved to manage economic shocks but created uncertainty.

  • Dornbusch's model provided clarity on these movements.

Model Development: Long-Run Exchange Rate Models

• Framework introduction:

  • Focus on long-run models of exchange rates.

  • Importance of building accurate models that address underlying economic phenomena.

Keynesian-New Classical Synthesis

• Understanding price stickiness in the Keynesian framework:

  • Goods traders operate within a system of prices that may not adjust quickly.

  • David Ricardo's theory of comparative advantage:

    • Example: Britain gains from cloth production versus Portugal's wine production.

Law of One Price and Practical Application

• Concept of the Law of One Price:

  • Observation that identical goods should have the same price in different locations when currency is adjusted.

  • Example using hamburgers across US and Canadian markets, demonstrating pricing consistency.

Relative Purchasing Power Parity (PPP)

• Introduction to Relative PPP:

  • Examines changes in exchange rates and their relation to price changes between two time periods.

  • Equation: change in exchange rates over time (from t-1 to t) relates to differences in inflation rates.

  • This reflects how certain factors remain constant over time, allowing for a focus on variables that change.

Monetary Approach to Exchange Rates

• Transitioning to the monetary approach to exchange rates:

  • The new model will incorporate the relationship between money supply, interest rates, and exchange rates.