International Macroeconomics & Exchange Rates – Core Review

🏦 1. Money, Interest Rates, and the Exchange Rate

Why money matters:

• People don’t just want a number of currency units; they want what money can buy (purchasing power). That’s why economists focus on real money demand, not just nominal.

What affects real money demand?

• Interest rate (↓ demand): Holding money means giving up interest income. If interest rates are high, people prefer interest-bearing assets.

• Real income/output (↑ demand): The more economic activity (more buying/selling), the more money people need for transactions.

Money Market Equilibrium:

• Occurs when real money supply = real money demand.

• If the central bank increases the money supply, people hold more money than they want → they use excess money to buy bonds → bond prices rise → interest rates fall.

Why interest rates matter:

• Lower interest rates make the domestic currency less attractive to foreign investors.

• So, currency depreciates as demand shifts away.

Graph Reference:
📊 Figure 15-7 – Money Market/Exchange Rate Linkages

⏳ 2. Short-Run vs. Long-Run Effects of Monetary Policy

Short Run:

• Prices and wages are sticky: Contracts, menu costs, and expectations mean firms don’t change prices immediately.

• So, an increase in the money supply lowers interest rates and causes exchange rate movements even though prices don’t yet reflect this.

Long Run:

• Prices fully adjust.

• A permanent increase in the money supply causes:

  • Proportional rise in price levels (inflation).

  • Proportional currency depreciation to maintain purchasing power parity.

  • No change in real output or real interest rate in the long run.

Graph Reference:
📊 Figure 15-10 – Money Growth and Inflation in Latin America

⚠ 3. Exchange Rate Overshooting (Dornbusch’s Model)

What it is:

• When a shock (like a permanent increase in the money supply) causes the exchange rate to jump more in the short run than it will in the long run.

Why it happens:

• Sticky prices mean the real money supply increases in the short run → interest rates drop → capital flows out → currency depreciates.

• Investors know prices will rise later → they expect the currency to appreciate in the future.

• For this expectation to hold, the currency must depreciate “too much” now → that’s overshooting.

Why it matters:

• Explains high exchange rate volatility, even under rational expectations.

Graph Reference:
📊 Figure 15-9 – Overshooting Pattern (E jumps above long-run E)

💵 4. Purchasing Power Parity (PPP)

Absolute PPP:

• Exchange rate between two countries = ratio of their price levels.

• If a basket of goods costs $100 in the US and €80 in the Eurozone, PPP says the exchange rate should be $1.25/€.

Relative PPP:

• Changes in exchange rates = difference in inflation rates.

• If US inflation = 4% and EU = 2%, the dollar should depreciate 2% per year.

Limits of PPP:

• Doesn’t always hold due to:

  • Trade barriers

  • Transportation costs

  • Non-tradable goods (e.g. haircuts, rent)

  • Market power (pricing to market)

Real-World Application:
📊 Big Mac Index (Table) – Shows implied PPP exchange rates by country

🧮 5. Monetary Approach to Exchange Rates

Key assumptions:

• Based on PPP holding in the long run.

• Exchange rates reflect money supply/demand and inflation expectations.

Implication:

• Higher money growth → higher inflation → currency depreciation.

• Interest rates reflect inflation expectations (Fisher effect).

Key takeaway:

• In the long run, monetary policy determines exchange rates through its impact on inflation.

📈 6. Real Exchange Rate

Definition:

• Price of foreign goods in terms of domestic goods.

Formula:

• Real Exchange Rate = (Nominal Exchange Rate × Foreign Price Level) / Domestic Price Level

Interpretation:

• ↑ Real exchange rate = foreign goods are more expensive → real depreciation.

• ↓ Real exchange rate = foreign goods are cheaper → real appreciation.

Factors influencing it:

• Supply & demand for goods

• Shocks to productivity or preferences

• Trade balances

🏛 7. Fixed vs. Floating Exchange Rate Regimes

Fixed Exchange Rate:

• Central bank intervenes to keep the exchange rate constant.

• Must adjust money supply (buy/sell currency).

• Loses monetary independence.

• Fiscal policy becomes more effective.

Floating Exchange Rate:

• No intervention; market determines the rate.

• Central bank keeps control of monetary policy.

• Exchange rates can be more volatile.

Sterilized Intervention:

• Central bank intervenes in FX market but offsets the impact on the money supply.

• Example: Buys foreign currency → increases base money → sells bonds to reduce money again.

💥 8. Currency Crises & Balance of Payments

How a crisis happens:

• Fixed exchange rate becomes unsustainable (e.g., reserves fall).

• Investors anticipate devaluation, withdraw capital.

• Triggers self-fulfilling crisis (Thailand 1997, Argentina 2001).

Balance of Payments Pressure:

• Trade deficit → reserve depletion → pressure to devalue.

• Confidence loss can create massive capital flight.

💰 9. Reserve Systems & Gold Standard

Gold Standard:

• Currency backed by gold.

• Limits monetary expansion (no printing beyond gold reserves).

• Eliminated flexibility to respond to crises.

Reserve Currency System:

• Example: USD as reserve currency.

• Other countries fix to USD, which has full monetary control.

• Creates asymmetry and potential imbalances.

🇪🇺 10. Optimum Currency Areas (OCA)

Key question:
When should countries share a currency?

Benefits (GG curve):

• Reduced transaction costs

• Exchange rate stability

• Trade & investment growth

Costs (LL curve):

• Loss of independent monetary policy

• Inability to adjust to asymmetric shocks

Ideal conditions:

• High labor mobility

• Fiscal transfers

• Similar business cycles

Eurozone Case:
Mixed evidence—strong trade ties but limited labor mobility.

Graph References:
📊 GG and LL curves – Show trade-offs of joining a currency union

🧠 Key Takeaways for Exams