International Business Chapter 15 The Monetary Approach Shows That Decrease The Money Supply Will Associated With

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Short–Run Policy Analysis

We begin by studying temporary shocks. These shocks do not affect long-run prices or

expected exchange rates.

A Temporary Shock to the Home Money Supply Figure 15-8 illustrates the effects of a

temporary increase in the home money supply. The reverse would apply to a temporary

decrease in the home money supply. In these cases, the home price level remains

unchanged, as does the expected exchange rate.

In summary:

A Temporary Shock to Foreign Money Supply Figure 15-9 illustrates the effects of a

temporary increase in the foreign money supply. The reverse would apply to a temporary

decrease in the foreign money supply. The foreign price level remains unchanged, as

does the expected exchange rate.

In summary:

APPLICATION

The Rise and Fall of the Dollar, 1999–2004

During the 1990s, many countries followed monetary policies that used long-run nominal

anchors. Whereas the European Central Bank (ECB) has an explicit inflation target, the

Federal Reserve uses an implicit one. According to the Fisher effect, nominal anchoring

The Federal Reserve reacted more aggressively to an impending recession during

2000 to 2001, lowering nominal interest rates more than the ECB. Here, the data also

support the model; the dollar depreciated as expected.

After 2001, the Federal Reserve persisted in keeping the nominal interest rate below

4 A Complete Theory: Unifying the Monetary and Asset Approaches

This section combines the asset approach and the monetary approach to exchange rate

determination. This allows us to analyze the short-run and long-run effects of both

temporary and permanent shocks.

Home money market equilibrium:

Foreign money market equilibrium:

Foreign exchange market equilibrium (UIP condition):

In the asset approach, the spot exchange rate, EH/F, and the nominal interest rates, iH and

iF, adjust to ensure the money market is in equilibrium and the UIP condition is satisfied.

The expected future exchange rate is derived from the monetary approach:

Home money market equilibrium:

Foreign money market equilibrium:

Purchasing power parity condition:

S I D E B A R

Confessions of a Forex Trader

We learned in Chapter 13 that the foreign exchange market involves large volumes of

transactions. Many of these transactions involve derivatives (hedging and speculation)

that require investors to forecast the future exchange rate. There are three basic strategies

for forecasting exchange rates:

1. Economic fundamentals. This approach uses theoretical models, similar to those

2. Politics. Political instability can affect the exchange rate. Factors such as war

3. Technical methods. This approach relies on statistical methods to predict

A survey of U.K. forex traders shows they are divided equally among the three methods

mentioned earlier. Also, time plays a role in which method they decide to use. In the very

short run (intraday), investors believe that factors other than fundamentals drive exchange

Long–Run Policy Analysis

The more comprehensive model is complicated but has the benefit of linking short-run

A Permanent Shock to the Home Money Supply Figure 15-12 illustrates the effects of

a permanent increase in the home money supply. The reverse would apply to a permanent

decrease in the home money supply. In these cases, the expected exchange rate changes

The Long Run The long-run effects of this shock are derived from the monetary

approach:

The monetary approach shows that an increase in the home money supply is associated

The Short Run The short-run effects of this shock are derived from both the asset

approach (interest rates) and the monetary approach (to determine the expected exchange

rate):

The increase in the home money supply implies that the home price level will be higher

Adjustment from Short Run to Long Run The key change as the markets move from

short run to long run is the price level. In the short run, the price level is fixed. In the long

run, the price level adjusts to bring real money supply back to its initial value. The

transition is as follows:

In the end, the exchange rate does increase, but it increases more in the short run than

it does in the long run. This is because investors incorporate their long-run forecasts into

their short-run trades.

Also, note that because prices adjust slowly over time, the adjustment from short run

to long run is shown as a gradual change in variables over time (Figure 15-12).

If we consider a permanent decrease in the home money supply, we would experience

the following effects:

The monetary approach shows that a decrease in the money supply will be associated

with a decrease in the price level.

The short run—from the asset and monetary approaches:

The increase in the home money supply implies that the home price level will be lower in

the long run. This is associated with an appreciation in the home currency, so the

expected exchange rate decreases in the short run. The net effect is an appreciation in the

home currency in the short run.

The transition is as follows:

An Example This example is the reverse of the case study from the textbook. Assume

the following:

■ The home money supply decreases by 3%.

The previous assumptions imply that the real money supply decreases in the short run and

returns to its initial value as the price level decreases to bring the money market into

equilibrium. This means the price level will decrease by 3% in the long run.

UIP shows what will happen to the exchange rate in the short run. Because the home

Overshooting

There are some key differences between temporary and permanent changes in the money

supply. Note that in the case of a permanent change in the money supply, the exchange

rate changes by more in the short run than in the long run. That is, the exchange rate

This is shown Figure 15-13. Note that it applies to either an increase or a decrease in

the home money supply. Consider how a permanent decrease in the money supply would

affect these variables:

■ In the short run, the money supply jumps down to its new level.

■ The price level does not jump—it adjusts slowly downward to match the decrease

in the money supply.

■ The real money supply jumps downward in the short run, then gradually increases

to its initial level in the long run. The gradual rise in the real money supply is

Overshooting highlights the need for a nominal anchor. Without an anchor, exchange

rates are likely to be more volatile because investors’ expectations will not be anchored.

S I D E B A R

Overshooting in Practice

Countries with a nominal anchor are committing to specific values for nominal variables

(such as the spot exchange rate, the money supply, or the inflation rate). This pins down

the economy’s long-run nominal interest rates, and ultimately its exchange rates. The

adoption of a nominal anchor rules out permanent policy changes that would affect the

long-run values of prices and exchange rates.

The data show whether countries committed to a nominal anchor have less volatile

This system collapsed in 1973 because member countries no longer wanted to

“import” inflation from the United States. At the same time, Rudiger Dornbusch

5 Fixed Exchange Rates and the Trilemma

The preceding model applies to a floating exchange rate regime. The FX market adjusts

What Is a Fixed Exchange Rate Regime?

We consider the case of a fixed exchange rate (hard pegs or narrow bands) without

interventions through buying and selling foreign currency to keep the exchange rate fixed

at .

For this section, we consider Denmark’s decision to peg the value of the krone to the

euro. Denmark is the home country and the Eurozone is the foreign country. We continue

Pegging Sacrifices Monetary Policy Autonomy in the Short Run: Example

UIP shows that the fixed exchange rate implies the home nominal interest rate must be

equal to the foreign nominal interest rate because the exchange rate is not expected to

change.

This implies that the home money market is linked to the foreign money market:

Note that each time the foreign interest rate changes, the home country must adjust the

home money supply. If the central bank were to choose a different money supply, the

interest rate in the home country would differ from that in the foreign country, implying

the exchange rate would change.

Suppose the foreign interest rate increases. The previous expression shows that the

home country’s central bank must decrease its money supply. Why? If the foreign interest

rate is higher than the home interest rate, investors will seek foreign deposits, causing a

depreciation in the home currency.

We can use the model for short-run analysis. The difference is that the home money

supply is no longer exogenous; it depends on the foreign interest rate. Instead, the

exchange rate is exogenous.

■ Floating exchange rate regime. The central bank chooses the money supply

Pegging Sacrifices Monetary Policy Autonomy in the Long Run: Example

This section studies the long-run implications of the home country adopting a fixed

exchange rate regime versus a floating exchange rate regime.

From PPP:

With the fixed exchange rate, the home price level is determined by the foreign price

level. Analogous to the short-run case, this has implications for the home money market:

Effectively, the home country loses the ability to influence its nominal interest rate (in the

short run) and its price level (in the long run).

We can use the model for long-run analysis, noting that the home price level and the

money supply are no longer exogenous.

■ Floating exchange rate regime. The central bank chooses the growth in the money

■ Fixed exchange rate regime. The central bank chooses the exchange rate

The Trilemma

The fixed versus floating exchange rate regime highlights some trade-offs facing policy

makers. The following three expressions highlight possible policy goals:

1. (fixed exchange rate [promotes stability in trade and investment])

3. (monetary policy autonomy [tool for managing home country’s business

cycle])

Our comparison of fixed and floating exchange rates shows that it is not possible to

achieve all three of these goals.

These choices represent a trilemma. One of the three goals must be sacrificed to achieve

S I D E B A R

Intermediate Regimes

Countries often implement an exchange rate regime that is somewhere between fixed and

floating. In terms of the trilemma, this means the country is between two points. For

example, exchange rate bands and managed float allow for some flexibility in the

exchange rate. With an exchange rate band, the country is able to enjoy some of the

benefits of a fixed exchange rate while maintaining capital mobility and some monetary

policy autonomy.

APPLICATION

The Trilemma in Europe

Denmark has adopted a fixed exchange rate regime, pegging the Danish krone to the

euro. This implies that Denmark has sacrificed its monetary policy autonomy. What if

Denmark wanted monetary policy autonomy?

It has two options: sacrifice (1) the fixed exchange rate, or (2) international capital

mobility. The United Kingdom has opted to sacrifice (1) to achieve monetary policy

6 Conclusions

This chapter combines the models used in the previous two chapters to develop a

comprehensive model of exchange rate determination. Combining the UIP condition

from Chapter 13 and the PPP and monetary model from Chapter 14, we are now able to

APPLICATION

News and the Foreign Exchange Market in Wartime

It is difficult to measure changes in exchange rate expectations. This application

considers exchange rate movements during wars because dramatic changes in a

The U.S. Civil War 1861–1865 During the U.S. Civil War (1861–1865), the

Confederacy (South) issued its own currency, the Confederate dollar, to finance the war

effort against the Union (North). Figure 15-18 plots the exchange rate (Confederate

The Iraq War In 2003, a U.S.-led coalition invaded Iraq with the intent of overthrowing

the government, headed by Saddam Hussein. Figure 15-19 shows the exchange rates for

the two currencies used in Iraq at the time: “Swiss” dinars used in the north and

Teaching Tips

Teaching Tip 1: The “Application: Can Central Banks Always Control the Interest

Rate?” explores the limits to a central bank’s ability to influence the economy once

interest rates have reached the zero lower bound. There are other circumstances in which

the Fed has difficulty controlling interest rates. One interesting episode is the brief term

of William G. Miller as chairman of the Fed (March 1978–August 1979). This was a

period of high inflation in which markets had become sensitive to changes in monetary