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# econ122lec7slides - Econ 122 Lecture 7: Monetary Policy and...

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Econ 122 Lecture 7: Monetary Policy and Nominal Exchange Rate Determination Joel M. David UCLA August 26, 2010 Joel M. David (UCLA) August 26, 2010 1 / 30

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Introduction PPP implies that the exchange rate is determined by the relative price levels in two countries. What determines those price levels? Monetary theory tells us that it is the supply and demand of money. We will consider a theoretical model of the determinants of nominal variables such as the nominal exchange rate, the price level, in&ation, and the quantity of money. We will use a similar small open economy to that previously studied, building in the implications of PPP, uncovered interest parity, and a market for money. Joel M. David (UCLA) August 26, 2010 2 / 30
The Quantity Theory of Money Why do people choose to hold money? In our model, they will hold money to facilitate transactions. The quantity theory of money asserts that a key determinant of the exchange rate is the quantity of money created by central banks. According to this theory, people hold a relatively constant fraction of their income in the form of money in order to perform transactions. Let Y be real income, M d nominal money balances (the demand for money) and P the price level. Then M d = κ PY (1) This implies that the real demand for money is M d P = κ Y (2) which shows that the real demand for money is determined by nonmonetary factors, such as aggregate output. Joel M. David (UCLA) August 26, 2010 3 / 30

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The Quantity Theory of Money II Let M s be the nominal money supply, i.e., cash in circulation plus checking deposits. In equilibrium, money supply must equal money demand: M s = M d = M and so M s P = κ Y Denoting foreign variables with a & , similar equations hold abroad: M & s P & = κ & Y & (3) Let E and e denote the nominal and real exchange rates respectively and M the supply and demand for money. PPP implies e = 1 so E = P P & . We can combine equations to &nd E = P P & = M κ Y M & κ & Y & = M M & κ & Y & κ Y (4) κ Y and κ & Y & are non-monetary variables. The quantity of money M and M & depends on the exchange rate regime maintained by the central banks. Joel M. David (UCLA) August 26, 2010 4 / 30
The Quantity Theory of Money - Evidence Joel M. David (UCLA) August 26, 2010 5 / 30

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The Quantity Theory of Money - Evidence II Joel M. David (UCLA) August 26, 2010 6 / 30
Exchange Rate Regimes Under a &oating exchange rate regime, the nominal exchange rate E is determined by the market, and the supply of money M s and M & s is determined exogenously. Suppose the domestic central bank increases the money supply M s : From (4), we see that this will cause a proportionate increase in E , i.e., a depreciation of the domestic currency . This is because the foreign currency is becoming relatively scarce and so more expensive. From (3), there is also a proportionate increase in P , i.e., in&ation of the domestic currency (since the RHS is constant). This is because HHs ±nd themselves with more money than they want to hold and reduce their money holding by purchasing goods. The increase in demand drives up the price for those goods.

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## This note was uploaded on 07/27/2011 for the course ECON 122 taught by Professor Staff during the Summer '08 term at UCLA.

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econ122lec7slides - Econ 122 Lecture 7: Monetary Policy and...

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