The Money Market and Exchange Rate
What will happen to the exchange rate, if the central bank increases the real money supply? How will the trajectory of the exchange rate and other economic parameters change?
Referring to Fig. 14.14.
Fig. 14.14. The money market and the exchange rate
The top chart shows the parity of interest rates, the lower graph shows the domestic money market. It is necessary to remember that the exchange rate is taken in the opposite form, i.e. the amount of the national currency for one unit of foreign currency, so that upward movement on the vertical axis means depreciation of the national monetary unit, and movement down the vertical axis is its strengthening. In addition, since the money market chart is given in a 90 ° turn, an increase in the money supply will mean a downward movement along the vertical axis of money, and a rise in the interest rate will move right along the horizontal axis.
Let the economy initially be in situation 1, the real money supply is equal to the value , the interest rate inside the country balances the demand and supply of money at the level i 1, the exchange rate corresponds to E 1. The parity of interest rates is formed under the condition of stable currency expectations .
The Central Bank decides to increase the nominal money supply: M s ↑.
In the short term, since the price level has not changed, the real money supply will increase to the value . The new amount of money in the economy will reduce the demand for money and lead to a decrease in the internal equilibrium interest rate to the level i 2. The new short-term equilibrium will be at point 2 on the lower chart of the money market.
Lowering the internal interest rate will have a negative impact on the world's capital flows. There will be an outflow of capital from the country. Capital outflow at a floating exchange rate means a fall in demand for the national currency and a depreciation of its currency (depreciation). Knowing - from previous experience and on the basis of theoretical preparation - that the national monetary unit will depreciate as the central bank increases the supply of money, economic agents will change their currency expectations in the direction of lowering the international value of the national currency. The parity function of interest rates will therefore move to E 2 with currency expectations . Therefore, with the internal interest rate i 2, the new exchange rate will be equal to E 2. The situation in the economy will move to point 2 and on the top graph.
The increase in the memorial offer of money has another consequence. In the long run, under the influence of the increased amount of money in the economy, prices will rise. As we know, economic agents are not subject to monetary illusion or the phenomenon of information asymmetry in the long run. The rate of inflation and inflationary expectations in general usually corresponds to the growth rates of the money supply.
With the growth of domestic chains, the real supply of money will return to the previous initial level . The internal rate of interest will return to the value i 1, corresponding to the world interest rate. The outflow of capital will cease. The pressure on the exchange rate will also end. But since currency expectations are now formed on the basis of depreciation of the national currency, the new final exchange rate corresponding to the interest rate parity will be equal to Е 3. The economy will return to situation 1 on the lower chart and will be in situation 3 on the top graph.
Thus, under the impact of expectations of depreciation of the national currency with the growth of the supply of money, the exchange rate depreciates in the short term to a greater extent than in the long-term period: E SR & gt; E LR. This phenomenon is called in the economy the deviation of the exchange rate ( overshooting ).
Let's sum up. Consider the dynamics of the country's economic parameters after monetary expansion.
The increase in nominal money supply occurs once and unexpectedly for economic agents. The money supply graph is shown in Fig. 14.15. The point t 0 characterizes the start of the stimulating monetary policy of the central bank.
The dynamics of the price level is shown in Fig. 14.16. In the short term, as the increase in the supply of money was unexpected, prices do not change, they are fixed in business contracts. As economic agents overcome the monetary illusion and asymmetry of information, and as the previous contracts expire, prices begin to rise. New contracts include higher inflation and inflationary expectations. The long-term price trajectory corresponds to the growth rate of the money supply.
Fig. 14.15. Dynamics of money supply
Fig. 14.16. Dynamics of domestic prices
As prices remain at the initial level in the short run, the real money supply increases, which entails a reduction in the nominal interest rate (Figure 14.17). If money is abundant, market participants are ready to keep assets in the form of money only at a lower price - a lower rate of interest. In addition, part of the increased nominal money supply can enter the banking system in the form of deposits. With an increase in the deposit activity of individuals and firms, banks will lower interest rates on them.
However, in the long run, with a rise in prices in accordance with the growth rate of money, the real supply of money returns to its original volume. And the nominal interest rate also returns to the previous level.
Fig. 14.17. Dynamics of the nominal interest rate
The nominal exchange rate is subject to a deviation effect. The depreciation of the currency in the short term will be higher than in the long-term period, when the effect of deviation will exhaust itself. Therefore, the trajectory of the nominal exchange rate looks like in Fig. 14.18: E N2 = E SR & gt; E N3 = E LR & gt; E N1.
Fig. 14.18. Dynamics of the nominal exchange rate
In this process, not only the nominal, but also the real exchange rate is changing (Figure 14.19). At the initial drop in the nominal exchange rate, the price level remains unchanged. Therefore, the real exchange rate also falls - there is a real depreciation of the national currency. However, in the long run, the rate of depreciation of the nominal exchange rate corresponds to the rate of price growth (and the growth rate of the money supply) - and the real exchange rate returns to its original value.
Thus, monetary expansion is accompanied by numerous effects in both the short and long-term periods. The reverse phenomena will be characteristic for the procedure of monetary compression.
Fig. 14.19. Dynamics of the real exchange rate
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