If the government adopts a fixed exchange rate regime, or sets the percentage change in
the exchange rate equal to a constant, this will keep the inflation rate constant. The
drawback of this approach is that the home country’s inflation rate changes each time the
foreign country’s inflation rate changes. Therefore, if the foreign country experiences
Money Supply Target The inflation rate depends on the money growth rate and growth
in real income, derived from the quantity theory of money:
Here, the central bank sets the money growth rate equal to a value to achieve the desired
inflation rate. This means the central bank has virtually no discretion to change the
money growth rate in response to changes in output. The drawback of this approach is
that real income growth may be unstable, especially in the short run. If the money growth
rate is kept constant, this may lead to deviations in the inflation target, at least in the short
run.
Inflation Target plus Interest Rate Policy We observe another possible anchor, the
nominal interest rate from the Fisher effect:
π
H = iH − r*
As long as the world real interest rate is constant, there is a direct relationship between
nominal interest rates and inflation in the long run.
The Choice of a Nominal Anchor and Its Implications There are two important
implications we can draw from the regime choices given previously. First, choosing more
than one target is problematic. Often, the regimes will call for different policies. We can
APPLICATION
Nominal Anchors in Theory and Practice
The adoption of targets increased dramatically in the 1990s, replacing regimes that had
no nominal anchor previously. The number of countries using both exchange rate and
inflation targets has increased. Also, several countries use more than one target, through
monitoring a range, rather than an explicit target.
Most of these policies have been credible, owing mainly to political changes that have
6 Conclusions
This chapter uses arbitrage conditions in the goods market and the foreign exchange
market to develop a theory of long-run exchange rate determination known as the
monetary approach. Using the theory of PPP from this chapter, combined with UIP from
Teaching Tips
Teaching Tip 1: The data for the Big Mac PPP test in the Excel workbook for this
chapter can also be used to calculate real exchange rates since qgUS/F = (E$/FORPgFOR)/PgUS,
where FOR is the foreign country. Assign each student a country, and have that student
Teaching Tip 2: Students are always fascinated by hyperinflations. Some of the best
stories come from the German interwar period. Have your students track down tales of
how behavior changed during this period. Here is a couple to get you started.
Teaching Tip 3: When we think of money, we usually think of currency issued by the
central bank or checkable deposits. But there are also private currencies in limited use
around the world. The website of the E. F. Schumacher Society includes a link to issuers
Teaching Tip 4: A paper by Joan Sweeney and Richard James Sweeney discussed the
authors’ experiences as part of a babysitting cooperative in the late 1970s (“Monetary
Theory and the Great Capitol Hill Baby Sitting Co-op Crisis: Comment,” Sweeney, Joan,
IN–CLASS PROBLEMS
1. Suppose that two countries, Brazil and Mexico, produce bananas. Brazil uses the real,
Mexico uses the peso. In Mexico, bananas sell for 10 pesos per pound of bananas.
The exchange rate is 0.5 reals per peso, Ereals/pesos = 0.5. The peso–dollar exchange
rate is Epesos/$ = 10.
a. If LOOP holds, what is the price of bananas in Brazil? What is the price in the
United States?
Answer: The prices implied by LOOP are as follows:
b. Suppose the price of bananas in Brazil is 5.5 reals per pound. At the same time,
the price of bananas in the United States is $1.00 per pound. Based on this
information, where does LOOP hold?
Answer: LOOP holds in the United States but not in Brazil. In the United States,
c. How will banana traders respond to the previous situation? In which markets will
traders buy bananas? Where will they sell them? What will happen to the prices of
bananas in Mexico, Brazil, and the United States?
Answer: Banana traders will buy in Mexico and the United States and sell in
2. For each of the following goods and services, indicate whether you expect LOOP to
hold. Explain briefly why you believe each good or service satisfies the assumptions
necessary for LOOP to hold.
a. Wheat
Answer: LOOP holds. Because wheat is not differentiated and traded in
b. Child care
Answer: LOOP does not hold. In most cases, child care is a nontraded good. It is
c. Automobiles
Answer: LOOP does not hold. Because automobiles are differentiated according
d. Milk
Answer: LOOP does not hold. Because milk is not differentiated, the market is
e. MP3 players
Answer: LOOP does not hold. Because MP3 players are differentiated according
f. Attorney services
Answer: LOOP does not hold. Attorney services are a nontraded service. It is
3. PPP is the macroeconomic counterpart to LOOP. Suppose the assumptions needed for
LOOP hold. Are there situations in which PPP may not hold when LOOP does?
Explain briefly.
Answer: Yes, there are situations in which LOOP holds but PPP does not. Recall that
4. Using the fundamental equations from the simple monetary approach, describe how
each of the following will affect the home and foreign price level, real money
balances, and the exchange rate, EH/F. Also, state whether the home currency
appreciates or depreciates for each.
a. An increase in home money supply
b. An increase in the foreign money supply
Answer: There is an increase in the foreign price level and a decrease in the
c. An increase in home real income
Answer: There is a decrease in the home price level and a decrease in the
d. A decrease in foreign real income
Answer: There is an increase in the foreign price level and a decrease in the
5. Using the fundamental equations from the general monetary approach, describe how
each of the following will affect the home and foreign price level, real money
balances, and the exchange rate, EH/F. Also, state whether the home currency
appreciates or depreciates for each.
a. A decrease in the foreign money supply
Answer: There is a decrease in the foreign price level and an increase in the
b. A decrease in home real income
Answer: There is an increase in the home price level and an increase in the
c. A decrease in the foreign nominal interest rate
Answer: There is an increase in foreign demand for real money balances, leading
6. This question considers long-run policies in Turkey relative to its largest trading
partner: Europe. Assume Turkey’s money growth rate is currently 15% and Turkey’s
output growth is 9%. Europe’s money growth rate is 4% and its output growth is 3%.
For the following questions, use the conditions associated with the simple monetary
model. Treat Turkey as the home country and define the exchange rate as Turkish lira
per euro, EL/€.
a. Calculate the inflation rate in Turkey.
b. Calculate the inflation rate in Europe.
c. Calculate the expected rate of depreciation in the Turkish lira relative to the euro.
d. Suppose the central bank of the Republic of Turkey decreases the money growth
rate from 15% to 11%. If nothing in Europe changes, what is the new inflation
rate in Turkey?
e. Illustrate how the change in (d) affects the following variables: MT, PT, real
money supply, and EL/. over time.
Answer: See the following figures.
f. Suppose the central bank of the Republic of Turkey sought to implement policy
that would cause the Turkish lira to appreciate relative to the euro. What ranges of
the money growth rate (assuming positive values) would allow the central bank to
achieve this objective? What range of values does this imply for Turkey’s
inflation rate?
Answer: Objective: %∆Eelira/€ < 0%
*T − gT) − (
7. This question follows from the analysis of Turkey and Europe in Question 6. Assume
Turkey’s money growth rate is currently 15% and Turkey’s output growth is 9%.
Europe’s money growth rate is 4% and its output growth is 3%. Also, assume the
world real interest rate is 1.75%. For the questions below, use the conditions
associated with the general monetary model. Treat Turkey as the home country and
define the exchange rate as Turkish lira per euro, EL/€.
a. Calculate the nominal interest rate in Turkey and in Europe.
Answer: From the Fisher effect:
ilira =
π
eT + r* = 6% + 1.75% = 7.75%
i€ =
π
eE + r* = 1% + 1.75% = 2.75%
b. Calculate the expected rate of depreciation in the Turkish lira relative to the euro.
c. Suppose the central bank of the Republic of Turkey increases the money growth
rate from 15% to 18%. If nothing in Europe changes, what is the new inflation
rate in Turkey?
d. Illustrate how the change in (c) affects the following variables: MT, PT, real
money supply, iT, and EL/€ over time.
e. Suppose Turkey wants to maintain a fixed exchange rate relative to the euro.
What money growth rate and nominal interest rate would achieve this objective?
Answer: Objective: %∆Eelira/€ = 0%
*T − gT) − (
8. This question considers long-run policies in Mexico relative to Canada. Assume
Mexico’s money growth rate is currently 4% and its inflation rate is 2%. Canada’s
money growth rate is 6% with 3.25% inflation rate. The world real interest rate is
0.75%. For the following questions, use the conditions associated with the general
monetary model. Treat Mexico as the home country and define the exchange rate as
Mexican pesos per Canadian dollar, EM/C$.
a. Calculate the growth rate of real income in each country.
b. Calculate the nominal interest rate in each country.
eM + r* = 2% + 1.75% = 3.75%
iC$ =
π
c. Calculate the expected rate of depreciation in the Mexican peso relative to the
Canadian dollar. Is the peso appreciating or depreciating against the Canadian
dollar?
d. Suppose that Mexico’s central bank wants to maintain a fixed exchange rate
against the Canadian dollar. Assuming that nothing in Canada changes, what must
the central bank do to achieve this long-run objective? What money growth rate
for Mexico’s money supply will make this possible?
Answer: Objective: %∆Eepeso/C$ = 0%
*M − gM) − (
e. Calculate Mexico’s new inflation rate and nominal interest rate after this policy is
implemented.
*M =
*M − gM = 5.25% − 2% = 3.25% =
f. Now suppose that Canada’s inflation rate increases from 3.5% to 5%. If Mexico
wants to maintain the fixed exchange rate, what will happen to its inflation rate?
Answer: If Canada’s inflation rate increases from 3.25% to 5%, then Mexico will
have to increase its money growth rate to maintain the fixed exchange rate.
*M − gM) −
9. Consider data on annual inflation rates across countries over time (refer to Side Bar:
Nominal Anchors in Theory and Practice). How has the experience of advanced
countries differed from that of emerging markets and developing countries? What
might explain the increased use of nominal anchors? Which nominal anchors are most
common?
Answer: Advanced countries have experienced a steady decline in inflation since
10. Both the Federal Reserve in the United States and the European Central Bank monitor
growth in the money supply over time, but use nominal interest rates to implement
policy. Provide an example of a situation in which these two approaches to targeting
require different central bank responses. Provide an example in which these two
approaches are compatible. [Hint: Recall that prices are sticky in the short run, so
expected inflation and actual inflation may differ].
Answer: These two approaches will be incompatible if the central bank wishes to
target the nominal anchor in response to an unexpected change in real income growth.
11. Consider a country that has experienced a hyperinflation. In general, countries with
higher inflation rates tend to have less stability in the inflation rate, making it difficult
to forecast. If this country wants to reduce its inflation rate, state which of the
following monetary regimes is least likely to succeed: exchange rate target, money
supply target, nominal interest rate policy. Which approach is most likely to succeed?
Explain.
Answer: The nominal interest rate policy is least likely to succeed because it relies on
the central bank’s ability to control expected inflation. During a hyperinflation, even
