# L11_SRD3 - Monetary Approach with Flexible Prices Price...

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1 1 Lecture 11 Spot rate determination 3 Monetary Approach with Flexible Prices Price level equates money demand and money supply: (M / P ) = L(Y, i) (+ -) Foreign: (M* / P*) = L(Y*, i*) (+ - ) Remember: i = r + E(% Δ P) 2 Lecture 11 Spot rate determination 3 The spot rate as an “asset”: affected by future events Notice that from international Fisher effect: E[S t+1 ] - S t (i - i ) t S t 1+ i t That is, E(% Δ S t+1 ) (i - i ) t (i - i*) t =

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2 3 Lecture 11 Spot rate determination 3 Exchange rate as an “asset” 1. ln S t = (m - m*) t + η (y* - y) t + ( κ * −κ) t + ε (i - i*) t Plugging in the international fisher effect: ln S t = (m - m*) t + η (y* - y) t + ( κ * −κ) t + ε E[% Δ S t+1 ] = (m - m*) t + η (y* - y) t + ( κ * −κ) t + ε E[lnS t+1 |S t ] To find the expected change in S, use next period’s prediction for S (plug in 1 for next period). But that depends on E[% Δ S t+2 ], and so on and so on…. 4 Lecture 11 Spot rate determination 3 Main points of flexible-price monetary model Exchange rate will depend on fundamentals (money supply, output, etc.) today and all expected future fundamentals. Price is fully flexible and nominal and real exchange rate is quite stable. Output never changes money supply; money supply never changes output.
3 5 Lecture 11 Spot rate determination 3 The same “rules” apply in all thought experiments: equation for money demand M/P = L(Y, i) condition for PPP q = SP*/P Fisher condition linking inflation to interest rates i = r + % Δ P e only expected future changes affect inflation Main points of flexible-price monetary model 6 Lecture 11 Spot rate determination 3 Thought question: An unexpected one-time, permanent increase in output : time Y t 0 Y t

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4 7 Lecture 11 Spot rate determination 3 An unexpected one-time, permanent increase in output: time Y t 0 Y t Q: What happens to the price level? P 8 Lecture 11 Spot rate determination 3 An unexpected one-time, permanent increase in output: time Y t 0 Y t Q: What happens to the price level? (remember M is fixed) hint: (M / P) = L(Y, i) P
5 9 Lecture 11 Spot rate determination 3 An unexpected one-time, permanent increase in output: time Y t 0 Y A: Price level decreases because money demand has increased (\$/goods in home country falls) P P t 10 Lecture 11 Spot rate determination 3 An unexpected one-time, permanent increase in output: time Y t 0 Y t Q: What happens to the spot exchange rate? hint: remember PPP! P P t S

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6 11 Lecture 11 Spot rate determination 3 An unexpected one-time, permanent increase in output: time Y t 0 Y t A: Depends on what happens to the real exchange rate… P P t S 12 Lecture 11 Spot rate determination 3 Real exchange rate: q = SP*/P Suppose Y increases and home and foreign goods are perfect substitutes.
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## This note was uploaded on 04/12/2008 for the course ECON 442 taught by Professor Chari during the Winter '08 term at University of Michigan.

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L11_SRD3 - Monetary Approach with Flexible Prices Price...

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