Using the flexible-price monetary approach to the exchange rate, explain what pr

Question

Using the flexible-price monetary approach to the exchange rate, explain what predictions would make about the behaviour of the nominal exchange rate in response to each of the following shocks:

(i) An anticipated permanent future monetary expansion.

(ii) A permanent reduction in the world nominal interest rate.

(iii) An anticipated future increase in domestic real GDP, say because of the discovery of a large oil deposit.

(iv) A temporary decrease in the demand for money.

(v) A permanent reduction in the world nominal interest rate to which the domestic government responds with a fiscal policy change designed to keep the domestic real exchange rate from changing.

Explanation / Answer

Consider the given problem here under “monetary approach to exchange rate” the exchange rate is given by, “E(H/F) = PF/PH, where “PF” be the foreign price and “PH” be the home price. Now, the price will be determined by the money market, => price in foreign as well in home will adjust until the money market clear.

So, the home price is given by, PH = MH/LH, here “MH” and “LH” are the home money supply and the home demand for money. Similarly, for the foreign country the same relation is given by, PF = MF/LF.  

i).

Now, an anticipated permanent future monetary expansion leads to increase price level, => as the “PH” increases implied decrease in “E(H/F)”, => exchange rate decreases. Similarly, if the foreign money supply increases implied increase in “PF”, => the nominal exchange rate increases.

ii).

Now, as we know that the demand for money is negatively related to the demand for money, => as the “i" increases implied the demand for money decreases and vice versa.

Now, a permanent world nominal interest rate is given by increase in “iF”, => decrease in “LF”, => as “LF” decreases implied increase in “PF=MF/LF”. So, as the “PF” increases implied the nominal exchange rate also increases.

iii).

Now, as we know that the demand for money is positively related to the demand for money, => as the “Y" increases implied the demand for money increases. Now, an anticipated increase in real GDP implied the demand for money increases implied “PH=MH/LH” decreases. So, as the “PH” decreases implied decrease in nominal exchange rate.

iv).

Now, a temporary decrease in the demand for money leads to increase in “PH”. Now, as “PH” increases implied the nominal exchange rate decreases.

v).

Now, as we know that the demand for money is negatively related to the demand for money, => as the “i" increases implied the demand for money decreases and vice versa. So, as the world interest rate decreases implied “LF” increases implied “PF=MF/LF” decreases. So, as the “PF” decreases implied the nominal exchange rate also decreases.

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