Chapter 2

Money, Interest Rate and the Exchange Rate

Introduction
Monetary developments influence the exchange rate both by changing interest rates and by
changing people's expectations about future exchange rates. Expectations about future
exchange rates are closely connected with expectations about the future money prices of
countries' products; these price movements, in turn, depend on changes in money supply and
demand. In examining monetary influences on the exchange rate, we therefore look at how
monetary factors influence output prices along with interest rates. Expectations of future
exchange rates depend on many factors other than money
First, the theories and determinants of money supply and demand are laid out, we use them to
examine how equilibrium interest rates are determined by the equality of money supply and
money demand. Then, the effects of monetary shifts on the exchange rate, given the prices of
goods and services, the level of output, and market expectations about the future will be
examined.

A Brief Review
What Is Money?
Money is an asset that is widely used and accepted as a means of payment.
Currency and bank deposits on which checks may be written certainly qualify as money.
These are widely accepted means of payment that can be transferred between owners at
low cost. Households and firms hold currency and checking deposits as a convenient way of
financing routine transactions as they arise. Assets such as real estate do not qualify as
money because, unlike currency and checking deposits, they lack the essential property of
liquidity.

The characteristics of money that lead people to hold it, which are central to an analysis of
the demand for money

 Money as a Medium of Exchange - serve as a medium of exchange, a generally

accepted means of payment.

 Money as a Unit of Account - widely recognized measure of value.

 Prices of goods, services, and assets are typically expressed in terms of money.
Exchange rates allow us to translate different countries' money prices into comparable
terms

 Money as a Store of Value – money can be used to transfer purchasing power from
the present into the future, it is also an asset, or a store of value.
Money's usefulness as a medium of exchange, however, automatically makes it the
most liquid of all assets - it can be transformed into goods and services rapidly and
without high transaction costs, such as brokers' fees.
Money is very liquid: it can be easily and quickly used to pay for goods and services.
Money, however, pays little or no rate of return.
Suppose we can group assets into money (liquid assets) and all other assets
(illiquid assets).
 All other assets are less liquid but pay a higher return.

Money Supply
The money supply in this lesson is the monetary aggregate the monetary authority (central
bank) calls Ml, that is, the total amount of currency and checking deposits held by
households and firms.
 Thus, Currency and checking accounts form a useful definition of money, but
bank deposits in the foreign exchange market are not a part of money supply
as these deposits are less liquid than money and are not used to finance routine
transactions.

Who controls the quantity of money that circulates in an economy, the money supply?

An economy's money supply is controlled by its central bank. The central bank directly
regulates the amount of currency in existence and also has indirect control over the amount of
checking deposits issued by private banks. The procedures through which the central bank
controls the money supply are complex, and we assume for now that the central bank simply
sets the size of the money supply at the level it desires.

The Demand for Money

Money demand is the amount of assets that people are willing to hold as money (instead of
illiquid assets).
  We will consider individual money demand and aggregate money demand.

What are the factors that determine the amount of money an individual desires to hold.

1. Expected returns/interest rate on money relative to the expected returns on other

assets.

Currency pays no interest. Checking deposits often do pay some interest, but they
offer a rate of return that usually fails to keep pace with the higher return offered by
less liquid forms of wealth. When you hold money, you therefore sacrifice the higher
interest rate you could earn by holding your wealth in a government bond, a large
time deposit, or some other relatively illiquid asset.
Since the interest paid on currency is zero while that paid on "checkable" deposits
tends to be relatively constant, the difference in rates of return between money in
general and less-liquid alternative assets is reflected by the market interest rate: The
higher the interest rate, the more you sacrifice by holding wealth in the form of money
other things equal, people prefer assets offering higher expected returns. Because an
increase in the interest rate is a rise in the rate of return on less liquid assets relative to
the rate of return on money, individuals will want to hold more of their wealth in
nonmoney assets that pay the market interest rate and less of their wealth in the form
of money if the interest rate rises.
All else equal, a rise in the interest rate causes the demand for money to fall.
The interest rate measures the opportunity cost of holding money rather than interest-bearing
bonds. A rise in the interest rate therefore raises the cost of holding money and causes money
demand to fall.
2. Risk: the risk of holding money principally comes from unexpected inflation, thereby
unexpectedly reducing the purchasing power of money.

It is risky to hold money because an unexpected increase in the prices of goods and
services could reduce the value of your money in terms of the commodities you
consume
 but many other assets have this risk too, so this risk is not very important in
money demand

 Because any change in the riskiness of money causes an equal change in the
riskiness of bonds, changes in the risk of holding money need not cause
 individuals to reduce their demand for money and increase their demand for
interest-paying assets.

3. Liquidity: The main benefit of holding money comes from its liquidity. Households
and firms hold money because it is the easiest way of financing their everyday
purchases. A need for greater liquidity occurs when either the price of transactions
increases or the quantity of goods bought in transactions increases.

Therefore, a rise in the average value of transactions carried out by a household or

firm causes its demand for money to rise.

Aggregate Money Demand

The above discussion of individual demand for money is used to derive the determinants of
aggregate money demand, the total demand for money by all households and firms in the
economy. Aggregate money demand is just the sum of all the economy's individual money
demands.
What Influences Aggregate Demand for Money?

1. Interest rates: money pays little or no interest, so the interest rate is the opportunity
cost of holding money instead of other assets, like bonds, which have a higher
expected return/interest rate.
 A higher interest rate means a higher opportunity cost of holding money 
lower money demand - a rise in the interest rate causes each individual in the
economy to reduce her demand for money. All else equal, aggregate money
demand therefore falls when the interest rate rises.
2. Prices: The economy's price level is the price of a broad reference basket of goods
and services in terms of currency. If the price level rises, individual households and
firms must spend more money than before to purchase their usual weekly baskets of
goods and services. To maintain the same level of liquidity as before the price level
increase, they will therefore have to hold more money.
 Thus, a higher price level means a greater need for liquidity to buy the same
amount of goods and services  higher money demand.
3. Income: greater income implies more goods and services can be bought, so that more
money is needed to conduct transactions.
  A higher real national income (GNP) means more goods and services are
being produced and bought in transactions, increasing the need for
liquidity  higher money demand.

A Model of Aggregate Money Demand

The aggregate demand for money can be expressed by:
Md = P x L (R, Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates
L(R, Y) is the aggregate real money demand

The value of L (R, Y) falls when R rises, and rises when Y rises. To see why we have
specified that aggregate money demand is proportional to the price level, imagine that all
prices doubled but the interest rate and everyone's real incomes remained unchanged. The
money value of each individual's average daily transactions would then simply double, as
would the amount of money each wished to hold.
Alternatively:
Md/P = L(R, Y)
 Aggregate real money demand is a function of national income and interest
rates.
This way of expressing money demand shows that the aggregate demand for liquidity,
L(R, Y), is not a demand for a certain number of currency units but is instead a demand to
hold a certain amount of purchasing power in liquid form. The ratio M d/P —that is,
desired money holdings measured in terms of a typical reference basket of
commodities—equals the amount of purchasing power people would like to hold in
liquid form.
For a given level of real GNP, changes in interest rates cause movements along the L(R,
Y) schedule. Changes in real GNP, however, cause the schedule itself to shift.
The Money Market
The money market is in equilibrium when the money supply set by the central bank equals
aggregate money demand.
 The condition for equilibrium in the money market is:
 Ms = Md
Alternatively, we can define equilibrium using the supply of real money and the
demand for real money (by dividing both sides by the price level):
Ms/P = L(R,Y)
This equilibrium condition will yield an equilibrium interest rate.
Given the price level, P, and output, Y the equilibrium interest rate is the one at which
aggregate real money demand equals the real money supply.
In Figure below, the aggregate real money demand schedule intersects the real money supply
schedule at point 1 to give an equilibrium interest rate of R. The money supply schedule is
vertical at Ms/P because Ms is set by the central bank while P is taken as given.

Why the interest rate tends to settle at its equilibrium level

Consider if the market is initially at point 2, with an interest rate, R2, that is above R1.
At point 2 the demand for real money holdings falls short of the supply by Q1 — Q2, so there
is an excess supply of money.
 When there is an excess supply of money, there is an excess demand for interest
bearing assets – If individuals are holding more money than they desire given the
interest rate of R2, they will attempt to reduce their liquidity by using some money to
purchase interest-bearing assets.
Since there is an aggregate excess supply of money at R2, however, not everyone can
succeed in doing this: there are more people who would like to lend money to reduce
 their liquidity than there are people who would like to borrow it to increase theirs.
Those who cannot unload their extra money try to tempt potential borrowers by
lowering the interest rate they charge for loans below R2. The downward pressure on
the interest rate continues until the rate reaches R1.
Once the market reaches point 1, there is therefore no further tendency for the interest
rate to drop.
 People with an excess supply of money are willing to acquire interest
bearing assets (by giving up their supply of money) at a lower interest
rate.
 Potential money holders are more willing to hold additional quantities of
money as the interest rate (the opportunity cost of holding money) falls.
Consider if the market is initially at point 3, with an interest rate, R3, that is below R1
There is excess demand for money equal to Q2 — Q1 at point 3. Individuals therefore
attempt to sell interest-bearing assets such as bonds to increase their money holdings
(that is, they sell bonds for cash). At point 3, however, not everyone can succeed in selling
enough interest-bearing assets to satisfy his or her demand for money.
Thus, people bid for money by offering to borrow at progressively higher interest rates
and push the interest rate upward toward R1
 When there is an excess demand for money, there is an excess supply of interest
bearing assets.
 People who desire money but do not have access to it are willing to sell
assets with a higher interest rate in return for the money balances that
they desire.
 Those with money balances are more willing to give them up in return for
interest bearing assets as the interest rate on these assets rises and as the
opportunity cost of holding money (the interest rate) rises.

 The market always moves toward an interest rate at which the real money supply
equals aggregate real money demand. If there is initially an excess supply of money,
the interest rate falls, and if there is initially an excess demand, it rises.

Interest Rates and the Money Supply

The effect of increasing the money supply at a given price level is illustrated in Figure below.
1
Initially the money market is in equilibrium at point 1, with a money supply M and an
interest rate R1. Since we are holding P constant, a rise in the money supply to M2 increases
the real money supply from M1/P to M2/P. With a real money supply of M2IP, point 2 is the
new equilibrium and R2 is the new, lower interest rate that induces people to hold the
increased available real money supply.

The process through which the interest rate falls is by now familiar. After MS is increased by
the central bank, there is initially an excess real supply of money at the old equilibrium
interest rate, R1, which previously balanced the market. Since people are holding more
money than they desire, they use their surplus funds to bid for assets that pay interest. The
economy as a whole cannot reduce its money holdings, so interest rates are driven down as
unwilling money holders compete to lend their excess cash balances. At point 2, the interest
rate has fallen sufficiently to induce an increase in real money demand equal to the increase
in the real money supply.

A fall in MS causes an excess demand for money at the interest rate that previously balanced
supply and demand. People attempt to sell interest-bearing assets—that is, to borrow—to
rebuild their depleted real money holdings.
Since they cannot all be successful when there is excess money demand, the interest rate is
pushed upward until everyone is content to hold the smaller real money stock.
Therefore, an increase in the money supply lowers the interest rate, while a fall in the
money supply raises the interest rate, given the price level and output.
Output and the Interest Rate
An increase in output causes the entire aggregate real money demand schedule to shift to the
right, moving the equilibrium away from point 1. At the old equilibrium interest rate, R1.
there is an excess demand for money equal to Q2 — Q1 (point 1'). Since the real money
supply is given, the interest rate is bid up until it reaches the higher new equilibrium level R2
(point 2). A fall in output has opposite effects, causing the aggregate real money demand
schedule to shift to the left and therefore causing the equilibrium interest rate to fall.

Therefore, an increase in real output raises the interest rate, while a fall in real output lowers
the interest rate, given the price level and the money supply.

Money and Exchange rate in the short run

The interest parity condition predicts how interest rate movements influence the exchange
rate, given expectations about the exchange rate’s future level. We also know how shifts in a
country’s money supply affect the interest rate on nonmoney assets denominated in its
currency, we can see how monetary changes affect the exchange rate. We will discover that
an increase in a country’s money supply causes its currency to depreciate in the foreign
exchange market, while a reduction in the money supply causes its currency to appreciate.
and other macroeconomic variables. In this section we continue to take the price level (along
with real output) as given, and for that reason we label the analysis of this section short run.
Short run, unlike long run, does not allow for the complete adjustment of the price level
(which may take a long time) and for full employment of all factors of production. To
analyze the relation between money and the exchange rate in the short run, we combine two
diagrams: the foreign exchange market - how equilibrium in it is determined given interest
rates and expectations about future exchange rates.

The downward-sloping expected euro return schedule shows the expected return on euro
deposits, measured in dollars. The schedule slopes downward because of the effect of current
exchange rate changes on expectations of future depreciation: A strengthening of the dollar
today (a fall in E$/€) relative to its given expected future level makes euro deposits more
attractive by leading people to anticipate a sharper dollar depreciation in the future. At the
intersection of the two schedules (point 1'), the expected rates of return on dollar and euro
deposits are equal, and therefore interest parity holds and
Money market - how a country's equilibrium interest is determined in its money market
Figure a - Simultaneous equilibrium in money market and the foreign exchange market

The above Figure portrays the link between the U.S. money market and the foreign exchange
market — the U. S. money market determines the dollar interest rate, which in turn
affects the exchange rate that maintains interest parity or equilibrium foreign exchange
market.
The model of asset market linkages (the links between the money and foreign exchange
markets) used to examine how the dollar/euro exchange rate changes when the Federal
Reserve changes the U.S. money supply M.s
At the initial money supply M1s, the money market is in equilibrium at point 1 with an
interest rate R1$. Given the euro interest rate and the expected future exchange rate, a dollar
interest rate of R1$ implies that foreign exchange market equilibrium occurs at point 1', with
an exchange rate equal to E1$/€.
What happens when the Federal Reserve raises the U.S. money supply from M1us to M2us?
This increase sets in motion the following sequence of events:
 At the initial interest rate R1$ there is an excess supply of money in the U.S. money
market, so the dollar interest rate falls to R2$ as the money market reaches its new
equilibrium position (point 2).
 Given the initial exchange rate E1$/€ and the new, lower interest rate on dollars, R2$,
the expected return on euro deposits is greater than that on dollar deposits. Holders of
dollar deposits therefore try to sell them for euro deposits, which are momentarily
more attractive.
 The dollar depreciates to E2$/€, as holders of dollar deposits bid for euro deposits.
The foreign exchange market is once again in equilibrium at point 2' because the
exchange rate move to E2$/€ causes a fall in the dollar's expected future depreciation
rate sufficient to offset the fall in the dollar interest rate.
Thus, an increase in a country's money supply causes its currency to depreciate in the foreign
exchange market.
A reduction in a country's money supply causes its currency to appreciate in the foreign
exchange market.

How would a change in the euro money supply affect the US money market and foreign
exchange market?
 An increase in the EU money supply causes a depreciation of the euro (appreciation
of the dollar).
 A decrease in the EU money supply causes an appreciation of the euro (a depreciation
of the dollar).
The increase in the EU money supply reduces interest rates in the EU, reducing the expected
return on euro deposits.
This reduction in the expected return on euro deposits leads to a depreciation of the euro.
The change in the EU money supply does not change the US money market equilibrium.

Short run scenario: changes in the money supply affect the domestic interest rate, as well as
the exchange rate.
 An increase in the domestic money supply
 lowers the domestic interest rate,
 lowering the rate of return on domestic deposits,
 Causing the domestic currency to depreciate.
Initially the U.S. money market is in equilibrium at point 1’ and the foreign exchange market
is in equilibrium at point with an exchange rate E1$/€. An increase in Europe’s money supply
lowers R€ and therefore shifts to the left the schedule linking the expected return on euro
deposits to the exchange rate. Foreign exchange market equilibrium is restored at point 2’
with an exchange rate of E2$/€. We see that the increase in European money causes the euro
to depreciate against the dollar (that is, causes a fall in the dollar price of euros). Similarly, a
fall in Europe’s money supply would cause the euro to appreciate against the dollar (that is,
E$/€ would rise). The change in the European money supply does not disturb the U.S. money
market equilibrium, which remains at point 1.
Price Levels and the Exchange Rate in the Long Run

Exchange rates are determined by interest rates and expectations about the future, which are,
in turn, influenced by conditions in national money markets.
To understand fully long-term exchange rate movements, however, we must further consider
the linkages among monetary policies, inflation, interest rates, and exchange rates and
examine factors other than money supplies and demands—for example, demand shifts in
markets for goods and services—that also can have sustained effects on exchange rates.

In the long run, national price levels play a key role in determining both interest rates and the
relative prices at which countries' products are traded. A theory of how national price levels
interact with exchange rates is thus central to understanding why exchange rates can change
dramatically over periods of several years. We begin our analysis by discussing the theory of
purchasing power parity.
 Purchasing power parity (PPP), which explains movements in the exchange rate
between two countries' currencies by changes in the countries' price levels.
Next, we examine the reasons why PPP may fail to give accurate long-run predictions
and show how the theory must sometimes be modified to account for supply or
demand shifts in countries' output markets.
The Law of One Price
The law of one price states that in competitive markets free of transportation costs and
official barriers to trade (such as tariffs), identical goods sold in different countries must sell
for the same price when their prices are expressed in terms of the same currency.

For example, if the dollar/pound exchange rate is $1.50 per pound, a sweater that sells for
$45 in New York must sell for £30 in London. The dollar price of the sweater when sold in
London is then ($1.50 per pound) x (£30 per sweater) = $45 per sweater, the same as its price
in New York.

Let’s continue with this example to see why the law of one price must hold when trade is free
and there are no transport costs or other trade barriers. If the dollar/pound exchange rate were
$1.45 per pound, you could buy a sweater in London by converting $43.50 (= $1.45 per
pound × £30) into £30 in the foreign exchange market. Thus, the dollar price of a sweater in
London would be only $43.50. If the same sweater were selling for $45 in New York, U.S.
importers and British exporters would have an incentive to buy sweaters in London and ship
them to New York, pushing the London price up and the New York price down until prices
were equal in the two locations. Similarly, at an exchange rate of $1.55 per pound, the dollar
price of sweaters in London would be $46.50 (= $1.55 per pound × £30), $1.50 more than in
New York. Sweaters would be shipped from west to east until a single price prevailed in the
two markets.

When trade is open and costless, identical goods must trade at the same relative prices
regardless of where they are sold. We can state the law of one price formally as follows: Let
PiUS be the dollar price of good when sold in the United States, PiE the corresponding euro
price in Europe. Then the law of one price implies that the dollar price of good is the same
wherever it is sold.

PiUS = (E$/€) x (PiE)

Equivalently, the dollar/euro exchange rate is the ratio of good i’s U.S. and European money
prices.
E$/€) = PiUS /PiE

Law of one price - Price of a particular good i should be the same when priced in the same
currency

Purchasing Power Parity

• Purchasing power parity is the application of the law of one price across countries for
all goods and services, or for representative baskets of goods and services.
• It states that the exchange rate between two countries’ currencies equals the ratio of
the countries’ price levels.

The PPP theory, therefore, predicts that a fall in a currency’s domestic purchasing power (as
indicated by an increase in the domestic price level or inflation rate) will be associated with
proportional currency depreciation in the foreign exchange market.

Symmetrically, PPP predicts that an increase in the currency’s domestic purchasing power
will be associated with a proportional currency appreciation.

To express the PPP theory in symbol, let PUS be the dollar price of a reference commodity
basket sold in the United States and PE the euro price of the same basket in Europe. Assume
for now that a single basket accurately measures money’s purchasing power in both
countries. Then PPP predicts a dollar/euro exchange rate of
E$/€ = PUS /PE
If, for example, the reference commodity basket costs $200 in the United States and €160 in
Europe, PPP predicts a dollar/euro exchange rate of $1.25 per euro ($200 per basket/€160 per
basket). If the U.S. price level were to triple (to $600 per basket), so would the dollar price of
a euro. PPP would imply an exchange rate of $3.75 per euro=($600 per basket/€160 per
basket).

The Relationship between PPP and the Law of One Price

Superficially, the statement of PPP given by equation E$/€ = PUS /PE looks like the law of one
price, which says that E$/€ = PiUS /PiE for any commodity i. There is a difference between PPP
and the law of one price, however: The law of one price applies to individual commodities
(such as commodity i), while PPP applies to the general price level, which is a composite of
the prices of all the commodities that enter into the reference basket.

If the law of one price holds true for every commodity, of course, PPP must hold
automatically as long as the reference baskets used to reckon different countries’ price levels
are the same.
Even when the law of one price fails to hold for each individual commodity, the argument
goes, prices and exchange rates should not stray too far from the relation predicted by PPP.
When goods and services become temporarily more expensive in one country than in others,
the demands for its currency and its products fall, pushing the exchange rate and domestic
prices back in line with PPP. The opposite situation of relatively cheap domestic products
leads, analogously, to currency appreciation and price level inflation. PPP thus asserts that
even when the law of one price is not literally true, the economic forces behind it will help
eventually to equalize a currency’s purchasing power in all countries.

Purchasing power parity comes in two forms:

• Absolute PPP: It postulates that the equilibrium exchange rate is equal to the ratio of
the price levels in the two nations. Absolute PPP is the one that has already been
discussed.
E$/€ = PUS/PEU
• The Relative PPP: postulates that the change in the exchange rate over a period of
time should be proportional to the relative change in the price levels (inflations) in the
two nations.
(E$/€,t - E$/€, t –1)/E$/€, t –1 = US, t - EU, t
 where t = inflation rate from period t-1 to t
It asserts that prices and exchange rates change in a way that preserves the ratio of each
currency’s domestic and foreign purchasing powers.

If the U.S. price level rises by 10 percent over a year while Europe’s rises by only 5 percent,
for example, relative PPP predicts a 5 percent depreciation of the dollar against the euro. The
dollar’s 5 percent depreciation against the euro just cancels the 5 percent by which U.S.
inflation exceeds European inflation, leaving the relative domestic and foreign purchasing
powers of both currencies unchanged.
Monetary approach to the exchange rate
• Monetary approach to the exchange rate: uses monetary factors to predict how
exchange rates adjust in the long run.
 It uses the absolute version of PPP.
 It assumes that prices adjust in the long run.
 In particular, price levels adjust to equate real (aggregate) money supply with
real (aggregate) money demand. This implies:
PUS = MsUS/L (R$, YUS)
PEU = MsEU/L (R€, YEU)
• To the degree that PPP holds and to the degree that prices adjust to equate real money
supply with real money demand, we have the following prediction:
• The exchange rate is determined in the long run by prices, which are determined by
the relative supply of money across countries and the relative real demand of money
across countries.
Predictions about changes in:
1. Money supply: a permanent rise in the domestic money supply
 causes a proportional increase in the domestic price level,
 Causing a proportional depreciation in the domestic currency (through PPP).
 same prediction as long run model without PPP
2. Interest rates: a rise in the domestic interest rate
 lowers domestic money demand,
 increasing the domestic price level,
 Causing a proportional depreciation of the domestic currency (through PPP).
3. Output level: a rise in the domestic output level
  raises domestic money demand,
 decreasing the domestic price level,
 causing a proportional appreciation of the domestic currency (through PPP).
• All three changes affect money supply or money demand, thereby causing prices to
adjust to maintain equilibrium in the money market, thereby causing exchange rates to
adjust to maintain PPP.
• A change in the level of the money supply results in a change in the price level.
• A change in the money supply growth rate results in a change in the growth rate of
prices (inflation).
• Other things equal, a constant growth rate in the money supply results in a
persistent growth rate in prices (persistent inflation) at the same constant rate.
• Inflation does not affect the productive capacity of the economy and real
income from production in the long run.
• Inflation, however, does affect nominal interest rates. How?
The Fisher effect
• The Fisher effect (named affect Irving Fisher) describes the long run relationship
between nominal interest rates and inflation.
• If Pe is the price level expected in a country for a year from today, the expected
inflation rate in that country, e, is the expected percentage increase in the price level
over the coming year,
e = (Pe - P)/P.

• From the interest parity condition we can derive the Fisher effect:
(Ee$/€ - E$/€)/E$/€ = R$ - R€
• If financial markets expect (relative) PPP to hold, then expected exchange rate
changes will equal expected inflation between countries:
(Ee$/€ - E$/€)/E$/€ = eUS - eEU
• R$ - R€ = eUS - eEU
The above equation (or The Fisher effect) tells us that all else equal, a rise in a country’s
expected inflation rate will eventually cause an equal rise in the interest rate that deposits of
its currency offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in
the interest rate.
• Suppose that the Federal Reserve unexpectedly increases the money supply growth
rate at time t0.
• Suppose also that the inflation rate is π in the US before t0 and π + π after this time.
Suppose inflation is consistently 0% in Europe.
• The interest rate adjusts according to the Fisher effect to reflect this higher inflation
rate.
 • The increase in nominal interest rates decreases real money demand.
• To maintain equilibrium in the money market, prices must jump so that PUS = MsUS/L
(R$, YUS).
• To maintain PPP, the exchange rate will then jump (the dollar will depreciate): E$/€ =
PUS/PEU
Thereafter, the money supply and prices grow at rate π +  π and the domestic currency
depreciates at the same rate

The Role of Inflation and Expectations

In the model long run model without PPP,
• changes in money supply levels lead to changes in price levels.
• There is no inflation in the long run, but only during the transition to the long run
equilibrium.
• During the transition, inflation causes the nominal interest rate to increase to its long
run rate.
• Expectations of inflation cause the expected return on foreign currency to increase,
making the domestic currency depreciate before the transition period.
• In the monetary approach (with PPP), the rate of inflation increases permanently
because the growth rate of the money supply increases permanently.
• With persistent inflation (above foreign inflation), the monetary approach also
predicts an increase in the nominal interest rate.
• Expectations of higher domestic inflation cause the purchasing power of foreign
currency to increase relative to the purchasing power of domestic currency, thereby
making the domestic currency depreciate.
• In the long run model without PPP, expectations of inflation cause the exchange rate
to overshoot (cause the domestic currency to depreciate more than) its long run value.
• In the monetary approach (with PPP), the price level adjusts with expectations of
inflation, causing the domestic currency to depreciate, but with no overshooting.

Shortcomings of PPP
• There is little empirical support for purchasing power parity.
 The prices of identical commodity baskets, when converted to a single
currency, differ substantially across countries.
Relative PPP is more consistent with data, but it also performs poorly to predict exchange
rates.
Reasons why PPP may not be a good theory:
1. Trade barriers and non-tradable goods and services
2. Imperfect competition
3. Differences in price level measures
Trade barriers and non-tradable
 Transport costs and governmental trade restrictions make trade
expensive and in some cases create non-tradable goods or services.
 Services are often not tradable: services are generally offered within a
limited geographic region (e.g., haircuts).
 The greater the transport costs, the greater the range over which the
exchange rate can deviate from its PPP value.
 One price need not hold in two markets.
Imperfect competition may result in price discrimination: “pricing to market”.
 A firm sells the same product for different prices in different markets to
maximize profits, based on expectations about what consumers are willing to pay.
Differences in price level measures
 price levels differ across countries because of the way representative groups
(“baskets”) of goods and services are measured.
 Because measures of goods and services are different, the measure of their prices
need not be the same