# Cornerstone of the monetary approach to the exchange

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cornerstone of the monetary approach to the exchange rate, which serves as the first model of the long-run exchange rate developed in this chapter. This first model also demonstrates how ongoing inflation affects the long-run exchange rate. The monetary approach to the exchange rate uses PPP to model the exchange rate as the price level in the home country relative to the price level in the foreign country. The money market equilibrium relationship is used to substitute money supply divided by money demand for the price level. The Fisher relationship allows us to substitute expected inflation for the nominal interest rate. The resulting relationship models the long-run exchange rate as a function of relative money supplies, the inflation differential and relative output in the two countries; E = (M/M * )·l(p e - p *e , (Y * /Y)) The l function represents the ratio of foreign to domestic money demand; thus, both the difference in expected inflation rates and the output ratio enter the function with a positive sign. An increase in inflation at home means higher home interest rates (through the Fisher

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111 equation) and lower home money demand. An increase in foreign output raises foreign money demand. One result from this model that students may find initially confusing concerns the relationship between the long-run exchange rate and the nominal interest rate. The model in this chapter provides an example of an increase in the interest rate associated with exchange rate depreciation. In contrast, the short-run analysis in the previous chapter provides an example of an increase in the domestic interest rate associated with an appreciation of the currency. These different relationships between the exchange rate and the interest rate reflect different causes for the rise in the interest rate as well as different assumptions concerning price rigidity. In the analysis of the previous chapter, the interest rate rises due to a contraction in the level of the nominal money supply. With fixed prices, this contraction of nominal balances is matched by a contraction in real balances. Excess money demand is resolved through a rise in interest rates which is associated with an appreciation of the currency to satisfy interest parity. In this chapter, the discussion of the Fisher effect demonstrates that the interest rate will rise in response to an anticipated increase in expected inflation due to an anticipated increase in the rate of growth of the money supply. There is incipient excess money supply with this rise in the interest rate. With perfectly flexible prices, the money market clears through an erosion of real balances due to an increase in the price level. This price level increase implies, through PPP, a depreciation of the exchange rate. Thus, with perfectly flexible prices (and its corollary PPP), an increase in the interest rate due to an increase in expected inflation is associated with a depreciation of the currency.
• Winter '08
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