77 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
Money and the Exchange Rate in the Long Run
Inflation and Exchange Rate Dynamics
Short-Run Price Rigidity versus Long-Run Price Flexibility
Box: Money Supply Growth and Hyperinflation in Bolivia
Permanent Money Supply Changes and the Exchange Rate
Exchange Rate Overshooting
Case Study: Can Higher Inflation Lead to Currency Appreciation? The Implications of Inflation Targeting
Summary
.2 Chapter Overview
This chapter combines the foreign-exchange market model of the previous chapter with an analysis of the
demand for and supply of money to provide a more complete analysis of exchange rate determination in
the short run. The chapter also introduces the concept of the long-run neutrality of money which allows an
examination of exchange rate dynamics. These elements are brought together at the end of the chapter in a
model of exchange rate overshooting.
The chapter begins by reviewing the roles played by money. Money supply is determined by the central bank;
for a given price level, the central bank’s choice of a nominal money supply determines the real money
supply. An aggregate demand function for real money balances is motivated and presented. Money-market
equilibrium—the equality of real money demand and the supply of real money balances—determines the
equilibrium interest rate.
A familiar diagram portraying money-market equilibrium is combined with the interest rate parity
diagram presented in the previous chapter to give a simple model of monetary influences on exchange
rate determination. The domestic interest rate, determined in the domestic money market, affects the
exchange rate through the interest parity mechanism. Thus, an increase in domestic money supply leads to
a fall in the domestic interest rate. The home currency depreciates until its expected future appreciation is
large enough to equate expected returns on interest-bearing assets denominated in domestic currency and
in foreign currency. A contraction in the money supply leads to an exchange rate appreciation through a
similar argument. Throughout this part of the chapter the expected future exchange rate is still regarded
as fixed.
The analysis is then extended to incorporate the dynamics of long-run adjustment to monetary changes.
The long run is defined as the equilibrium that would be maintained after all wages and prices fully
adjusted to their market-clearing levels. Thus, the long-run analysis is based on the long-run neutrality
of money: All else being equal, a permanent increase in the money supply affects only the general price
level—and not interest rates, relative prices, or real output—in the long run. Money prices, including,
importantly, the money prices of foreign currencies, move in the long run in proportion to any change in
the money supply’s level. Thus, an increase in the money supply, for example, ultimately results in a
proportional exchange rate depreciation.
The combination of these long-run effects with the short-run static model allows consideration of exchange
rate dynamics. In particular, the long-run results are suggestive of how long-run exchange rate expectations
change after permanent money-supply changes. One dynamic result which emerges from this model is
exchange rate overshooting in response to a change in the money supply. For example, a permanent
money-supply expansion leads to expectations of a proportional long-run currency depreciation.
Foreign-exchange market equilibrium requires an initial depreciation of the currency large enough to
equate expected returns on foreign and domestic bonds. But because the domestic interest rate falls in the
short run, the currency must actually depreciate beyond (and thus overshoot) its new expected long-run
level in the short run to maintain interest parity. As domestic prices rise and M/P falls, the interest rate
returns to its previous level and the exchange rate falls (appreciates) back to its long-run level, higher than
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