Money Growth, Inflation, and Depreciation
When developing the theory of PPP, we examined both absolute and relative PPP.
Because economists are often more interested in studying the behavior of inflation rather
than the level of prices, it is convenient to express the fundamental equations in rates of
change rather than in levels.
Define the growth rates of the variables for a given country i as follows:
Note that the expression for the inflation rate comes from the definition of money
demand.
We know from relative PPP that the percentage change in the exchange rate is equal
to the inflation differential:
Inserting the definitions of growth rates from the previous equations yields
We can use this equation to see how changes in the growth rates of money supply and
real income at home and abroad affect the inflation differential and the exchange rate.
↑µH → ↑πH → > 0 (home currency depreciates, foreign appreciates)
3 The Monetary Approach: Implications and Evidence
This section examines empirical evidence and applications of the monetary model.
Exchange Rate Forecasts Using the Simple Model
We can use the monetary model to forecast the future expected level of exchange rates or
to forecast expected changes in the exchange rate. We have already seen how changes in
the money supply and real income (in levels and growth rates) affect expected future
Forecasting Exchange Rates: An Example The following example differs from the one
presented in the book in two ways. First, the numerical values differ from those used in
Case 1: A One-Time Decrease in the Home Money Supply Suppose there is a one–time
10% decrease in the home money supply. State what happens to the home price level,
exchange rate, real money balances, and real income.
Case 2: A Decrease in the Money Growth Rate Suppose the money growth rate
decreases from 7% to 5% in the home country. State what happens to the home money
supply, the home price level, the home real money balances, and the exchange rate. Plot
out the behavior of each variable over time, before and after the change in the money
growth rate.
First, we can use the fundamental equations to understand how these variables are
behaving before the change in the home money growth rate:
This implies there is no expected change in the exchange rate:
Now, let’s examine what happens when the home country reduces its money growth rate
from 7% to 5%. The inflation rate in the home country will decrease:
The foreign country’s inflation rate remains at 4% because there was no change in the
foreign money supply. Therefore, the inflation differential is now negative:
APPLICATION
Evidence for the Monetary Approach
To test the validity of the simple monetary model shown earlier, we can look at the
relationship between money growth rates and inflation differentials. We did a similar test
for relative PPP. Here, we conduct two tests. First, the fundamental equation of the
monetary approach to the price level implies that any change in the money growth rate
Second, the fundamental equation of the monetary approach to exchange rates implies
that differentials in money growth rates should reflect changes in the exchange rate. In
our previous example, we saw that a 2–point decrease in the money growth rate should
lead to a 2% appreciation in the home country’s currency (e.g., a 2% decrease in the
exchange rate). Using data comparing money growth differentials and exchange rates
APPLICATION
Hyperinflations
A hyperinflation occurs when the average price level rises by more than 50% per month
over a sustained period of time. At that rate, the price level doubles every 52 days. Here’s
why:
Episodes of hyperinflation provide an ideal situation for studying the monetary
PPP in Hyperinflations Figure 14-9 examines several episodes of hyperinflation during
the twentieth century. The empirical test used here is identical to the one used in Figure
14-2 to test relative PPP. We can see from Figure 14-9 that relative PPP seems to hold for
countries with hyperinflation.
Money Demand in Hyperinflations Figure 14-11 uses data from countries with
hyperinflation to examine the relationship between inflation and real money balances.
From this figure, we observe a clear negative relationship—the demand for real money
balances decreases as the inflation rate increases. This indicates that changes in inflation
S I D E B A R
Currency Reform
During hyperinflations, one of the first currency reforms needed is a redefinition of the
currency. The central bank usually starts adding zeroes to the denominations of paper
currency. In Zimbabwe, Z$50 million notes were common. However, once the
government decides to reform the currency, they introduce a new currency unit with
considerably fewer zeros. In the 1980s, Argentina introduced the peso Argentina,
replacing the original peso at a rate of 10,000 to 1. The Argentine currency was redefined
4 Money, Interest, and Prices in the Long Run: A General Model
In this section, we relax the assumption of constant in the simple model to allow us to
The Demand for Money: The General Model
When individuals decide how much money they want to hold, they consider the costs and
benefits of holding money relative to an alternative, less liquid asset. The deciding factors
are nominal income and the interest rate.
■ Benefits of holding money: Individuals hold money to conduct their everyday
■ Costs of holding money: Compared with other assets, money earns little or no
interest. For each $1 held in the form of money, the individual forgoes interest. As
An increase in nominal income (PY) causes a proportionate increase in aggregate
money demand. An increase in the nominal interest rate (i) leads to a decrease in the
Note that the parameter was constant in the simple model. Here, L(i) captures the
portion of money demand that depends on the nominal interest rate. The real money
demand function is
The real money demand function is illustrated in Figure 14-11. The position of the real
money demand curve depends on real income. An increase in real income leads to an
Long–Run Equilibrium in the Money Market
Money market equilibrium is determined by the intersection of real money supply and
real money demand:
Inflation and Interest Rates in the Long Run
To understand how nominal interest rates affect the exchange rate, we can combine two
theories from earlier. First, we know that the percentage depreciation in the home
currency is equal to the inflation differential from relative PPP:
The Fisher Effect
Combining the relative PPP and UIP conditions, we have the following expression:
According to this expression, an increase in the inflation rate in one country leads to a
one-for-one increase in the nominal interest rate in that country. This is known as the
Fisher effect. Note that this relationship hinges on price flexibility as a condition for
Real Interest Parity
The previous condition can be rewritten in terms of real interest rates:
The real interest rate is the inflation–adjusted interest rate. This is calculated as the
nominal interest rate less the inflation rate. In the home country, reH = (iH −
π
eH);
therefore,
If PPP and UIP hold, the expected real interest rate should be the same across countries.
This is known as real interest parity. This condition is the direct result of arbitrage in
the goods market (PPP) and foreign exchange market (UIP).
Because of real interest rate parity, expected real interest rates should be equal across
countries. We can therefore define a world interest rate, r*:
Nominal interest rates in home and foreign are therefore defined as
APPLICATION
Evidence on the Fisher Effect
This application provides an empirical test of the Fisher effect. To test the Fisher effect,
we examine the inflation differentials for the United States compared with other countries
between 1995 and 2005. We know from the theory that these differentials should move
proportionately. According to the data in Figure 14-12, the Fisher effect holds.
The Fundamental Equation Under the General Model
This section derives a fundamental equation for the general model. The main distinction
is that L is no longer a constant:
Exchange Rate Forecasts Using the General Model
We studied a one-time change in the money supply, as well as a change in the growth rate
of the money supply, using the simple model. We can see how these changes affect the
economy by using the general model. The main differences between the two models will
be shown in nominal interest rates.
The following example differs from the one presented in the book in two ways. First,
the numerical values differ from those used in the text. Second, in this example, we allow
output to grow (in the textbook, it is assumed the growth rate of output is constant).
In both cases, assume that real income grows at a rate of 3% in both the home country
and the foreign country. Assume the money supply grows at a rate of 7% in both
countries. Suppose the world real interest rate is equal to 1%.
In the simple model, we saw that a one-time change in the money supply caused a
The same is true of the foreign country. The inflation differentials are equal to zero
because both countries have the same growth rates in money supply and real income.
This implies there is no expected change in the exchange rate.
Now let’s examine what happens when the home country reduces its money growth rate
from 7% to 5%. The inflation rate in the home country will decrease:
The foreign country’s inflation rate remains at 4% because there was no change in the
growth rate of the foreign money supply. Because the home inflation rate has changed,
this implies a change in the home country’s nominal interest rate:
The home country’s nominal interest rate decreases by 2 percentage points. Because the
home country’s nominal interest rate decreased, there will be an increase in the demand
for real money balances. The growth rate of the real money supply is unchanged at 3%
because the decrease in the growth rate of the money supply is matched by a decrease in
the inflation rate. However, there is a one-time increase in the level of the demand for
real money balances.
These variables are plotted over time on the following figure:
Looking Ahead If people know that a change in money growth is coming in the future,
they will adjust their expectations of the inflation rate and exchange rates accordingly.
This highlights the importance of these expectations. Even if a change is not
implemented, the expectations for change can have consequences for the variables in the
model.
5 Monetary Regimes and Exchange Rate Regimes
The monetary approach shows us that nominal variables are linked. These variables are
of interest to policymakers. For example, we can see from the model that if the
government wishes to reduce inflation, then the central bank must reduce the money
growth rate. If the government wants to fix the exchange rate, it must change the money
supply to reflect changes in economic conditions at home and abroad.
A common objective of central bankers is to maintain low inflation. Some central
banks publicly announce an inflation target in the hopes of influencing expectations
The Long Run: The Nominal Anchor
We’ve already seen a list of nominal variables that are viable nominal anchors in the
monetary approach. Each variable anchors the inflation rate but has different drawbacks.
Exchange Rate Target We can use relative PPP to see how the home country’s inflation
rate is related to the exchange rate: