Summary – Chapter 6
Money, Prices, and Exchange Rates in the Long Run
6.1 – Overview
- The principle of monetary neutrality asserts that nominal variables do not affect real variables
- Exchange rates are the rates at which foreign money is traded for domestic money
- External competitiveness is the ability of countries to export goods to others at given levels of
nominal wages, nominal prices, and nominal exchange rates
- The nominal exchange rate is the value of foreign currency in terms of domestic money
- The real exchange rate is the cost of foreign goods in terms of domestic goods, defined as the
nominal exchange rate adjusted by prices at home and abroad
- Even though the real exchange rate is fluctuating in the short-run and the medium-term, the
neutrality of money implies that the real exchange rate is constant in the long run and not dependent
of monetary factors
6.2 – Money and the Neutrality Principle
6.2.1 – Money
- In economics, money is only what you use when you purchase something. It is an asset which is
readily accepted in exchange by others
- Ultimately, money only affects the price level, leaving the real side of economy untouched
- The neutrality principle states that the money supply does not affect real variables such as real
output or unemployment, but rather the price level
6.2.2 – Money and Prices
- Money is a medium of exchange
- The demand for money is the level of money, either narrow or broad, which households, firms and
governments choose to hold, given the level of economic activity, nominal interest rates, and the
cost of moving between money and other assets
- Denoting the real GDP as Y, the price level as P, the nominal GDP as PY, the proportion of income
households hold as cash as k and the demand for money as M, we can show that M is proportional to
the nominal GDP:
𝑀 = 𝑘𝑃𝑌
- This equation is known as the Cambridge Equation
- As the purchasing power of money is inversely proportional to the price level, we can rearrange the
Cambridge Equation in real terms:
𝑀
= 𝑘𝑌
𝑃
- The more money circulates in the monetary system, the higher the inflation rate, and the lower the
real purchasing power of money
- Hyperinflation is a term used to describe periods of extremely high inflation, usually when the
monthly rate exceeds 50%
- The neutrality principle implies that inflation (π) is equal to the growth rate of money
∆𝑀
𝜋=
𝑀
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑚𝑜𝑛𝑒𝑦 𝑔𝑟𝑜𝑤𝑡ℎ
- An increase in the money supply means that there is an increase in the supply of money
- Households and firms hold cash in a proportion k of their purchases, which means they demand
money
6.2.3 – Money, Prices, and Output
- Nominal variables do not affect real variables in the long run, which is also called the dichotomy
principle
- The dichotomy principle delinks the nominal and real sides of the economy, following from the
monetary neutrality principle
- Nominal money demand increases proportionately to GDP as long as k remains constant
- The growth rate of money demand is equal to the sum of GDP growth and inflation
∆𝑀
∆𝑌
=
𝜋
+
𝑀
𝑌
𝑀𝑜𝑛𝑒𝑦 𝑔𝑟𝑜𝑤𝑡ℎ = 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 + 𝐺𝐷𝑃 𝑔𝑟𝑜𝑤𝑡ℎ
- This formula can also be written as
∆𝑀
∆𝑌
𝜋
=
−
𝑀
𝑌
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑀𝑜𝑛𝑒𝑦 𝑔𝑟𝑜𝑤𝑡ℎ − 𝐺𝐷𝑃 𝑔𝑟𝑜𝑤𝑡ℎ
- Money demand is driven by GDP growth
- Growth is an endogenous variable for inflation which can help to ultimately restore long-run money
market equilibrium
- In the long run, inflation is a monetary phenomenon, and occurs when the nominal money supply
grows faster than real money demanded by the public
6.4 – Nominal and Real Exchange Rates
- The neutrality principle applies in particular to the exchange rate
6.3.1 – Nominal Exchange Rates
- Exchange rates can be quoted in either the British terms or European terms
- British terms are used when the foreign currency gets quoted in one unit of the domestic currency
(i.e. 1.35$ = 1.00€)
- European terms are used when the domestic currency gets quoted in one unit of the foreign
currency (i.e. 0.83€ = 1£)
- An appreciation is a market determined increase in the value of a currency (less of that currency
must be used to buy one unit of a foreign currency)
- A depreciation is a market determined decrease in the value of a currency (more of that currency
must be used to buy one unit of a foreign currency)
6.3.2 – Real Exchange Rates
- The higher the price level, the less one can buy with one unit of money
- The relative price ratio between two currencies is always expressed in the same currency
- Real exchange rates compare broad price indices such as the CPI
- The real exchange rate is the ratio of two index numbers, or average prices for different baskets of
goods in two different places
- The real exchange rate is an index defined as
𝑆𝑃
𝑃
𝜎= ∗ =
∗
𝑃
𝑃 /𝑆
Both prices
in foreign
currency
Both prices
in domestic
currency
- Real exchange rates appreciate when 𝜎 increases, and depreciate when 𝜎 declines
6.3.3 – Movements in Nominal and Real Exchange Rates
- Nominal and real exchange rates move equally as long as inflation is the same home and abroad
- When the nominal exchange rate S is constant, and inflation at home is higher than abroad,
domestic prices are rising faster than foreign prices and the ratio 𝑃/𝑃∗ is increasing
- The real exchange rate can then appreciate for two reasons: (1) when the nominal exchange rate
appreciates and inflation rates at home and abroad are equal, and (2) when the nominal exchange
rate is stable but inflation is higher at home
- The rate change of the real exchange rate is
∆𝜎
∆𝑆 ∆𝑃 ∆𝑃∗
∆𝑆
=
+
− ∗
=
+
𝜋
−
𝜋∗
𝜎
𝑆
𝑃
𝑃
𝑆
Rate or
change of the
real exchange
rate
Rate of
= change of the * +
nominal
exchange
rate
Domestic
inflation -_
rate
Foreign
inflation
rate
- The inflation differential is the difference between the domestic and the foreign inflation rates
- A real appreciation is a loss of competitiveness, as our goods become expensive relative to foreign
goods
6.3.4 – Measuring the Real Exchange Rate in Practice
- Measuring the real exchange rate imposes two problems; (1) foreign stands for the rest of the
world, which means various countries with various currencies and different trade relationships, and
(2) in defining which prices to compare
- The average exchange rates and average foreign price levels are used in order to weigh the relative
importance of the partner country. The weights they are given depend on the importance to the
domestic market in trade and financial flows
- The corresponding values of S and 𝜎 are called nominal and real effective exchange rates
- An effective exchange rate is the index consisting of a weighted average of a country’s exchange
rates in relation to its main trading partners
- Many definitions for the real exchange rates exist apart from the CPI:
1. External terms of trade is the ratio of export to import prices, or how many units of
imports are needed to purchase one unit of exports
2. Internal terms of trade is the ratio between non-traded and traded good prices
3. The last measure is that of the price of labour, using wages, total earnings or total labour
costs
6.4 – The Exchange Rate in the Long Run: Purchasing Power Parity
- In the long run, countries which have high rates of inflation also have currencies which depreciate
at the same rate
- Currencies with a low rate of inflation appreciate in the long run
- By treating the foreign inflation (𝜋 ∗) as given, the lower the domestic inflation, the higher the rate
of appreciation:
∆𝑆
= 𝜋∗ − 𝜋
𝑆
- This property is supposed to hold in the long run
- By rewriting the formula, we get
∆𝜎 ∆𝑆
=
+ 𝜋 − 𝜋∗ = 0
𝜎
𝑆
- This states that in the long run, the real exchange rate is constant over the long run
- The purchasing power parity (PPP) is a horizontal line corresponding to the foreign inflation rate,
because at fixed exchange rates purchasing power parity rules out permanent differences between
domestic and foreign inflation
- The PPP uses the logic that monetary policy is more expansionary at home than abroad, and
therefore, inflation at home will be higher than abroad. If the nominal exchange rate remains
constant, the real exchange rate appreciates and domestic goods and services become more
expansive abroad. This goes on until the nominal exchange rate will depreciate and will work towards
restoring competitiveness. Therefore, the PPP just implies that in the long run, countries will retain
their competitiveness
- the relative PPP is a situation occurring when the cost of the same basket of goods in different
countries increases at the same rate once converted into a common currency
- The absolute PPP is a theory asserting that price levels are equalized across countries once they are
converted into a common currency
- The Law of One Price asserts that domestic and foreign prices are equal when converted in the
same currency. It can apply good by good or to a basket of goods
- Arbitrage is the simultaneous purchase and sale of assets of identical characteristics to earn a profit
without risk-taking: spatial arbitrage responds to diverging asset prices across different market
locations, yield arbitrage responds to differing asset returns and triangular arbitrage to three asset
prices that are not mutually consistent
- Absolute PPP is a much stronger hypothesis than relative PPP as relative PPP requires that the real
exchange rate has to be constant while PPP wants it to be equal to unity
- When inflation is low, the relative PPP does not move one-to-one with the rate of depreciation
- In the short run, sharp movements of the nominal exchange rate imply sharp movements of the
real exchange rate, with implications for the real economy
- Real exchange rates can change depending on the fundamental real economy