summary-ch15 - 2. Unifying Monetary and Asset Approaches....

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1 2. Unifying Monetary and Asset Approaches. Asset approach: - + = = = USD NTD USD NTD e USD NTD US T E E E i i / / / US US US US T T T T ; )Y L(i M P ; )Y L(i M P The asset approach 3 equations with three unknowns (i’s and E). In the SR, P is fixed. When money supply or demand changes, it will affect interest rate and interest rate will affect the exchange rate. Monetary Approach -- Forecast To forecast the future expected exchange rate, we also need the LR monetary approach: = = = US e T e e / US e US e US e e US T e T e T e e T P P . )Y L(i M P ; )Y L(i M P USD NTD E Monetary approach In the LR, price is adjustable. When money supply or demand changes, P will adjust and it will affect ER in the LR. Temporary and Permanent Changes: Temporary: no long run effect. Permanent: have both short run and long run effects. Consider the case when there is a permanent increase in M S In the SR (price level is fixed to P 1 ): The real M S increases from M S 1 /P 1 to M S 2 /P 1 (MS shifts to the right). i T decreases, leading to a depreciation of NTD (E 1 to E 3 ). However, it is NOT the end of story. So far, we hold E e fixed. However, a permanent change will affect people’s expectation on the exchange rate in the
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2 future. Specifically, people will expect NTD to depreciate in the future so E e increases and it causes a further depreciation from E 3 to E 2 . The increase of MS together with the expected depreciation pushes E to E 2 . The short run equilibrium at the FX market is 2’. Short Run In the LR (P adjustment): Monetary approach P CAN = M S /L(R,Y), so when M S increases to M S 2 , P will increase proportionally to P 2 , so that the level of real money supply will return from M S 2 /P 1 to M S 2 /P 2 = M S 1 /P 1 Since real MS shifts back, i T will go back to i 1 T in the LR. The value of exchange rate will fall but will still be higher than the initial level because expectation changes. E 1 < E 4 < E 2 Long run i i 1 T i 2 T M 1 T / 1 T P M 2 T / 1 T P Real Money Holdings L(i T )Y 1 T Expected Returns i 1 T i 2 T E 1 NTD/USD E 3 NTD/USD E 2 NTD/USD E NTD/USD DR 1 DR 2 FR 1 FR 2 i i 1 T i 2 T M 1 T / 1 T P M 2 T / 1 T P Real Money Holdings L(i T )Y 1 T Expected Returns i 1 T i 2 T E 1 NTD/USD E 4 NTD/USD E 2 NTD/USD E NTD/USD DR 1 DR 2 FR 1 FR 2 c 1 2 c 1’ 3’ 2’ c 1=4 2 c 4’ 3’ 2’
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3 You can observe that the long run movement of exchange rate is more volatile than the price and interest rate and price movements. Soon after the increase of MS, CAD depreciates at a large magnitude.
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summary-ch15 - 2. Unifying Monetary and Asset Approaches....

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