1 Exchange Rate Determination(3) Monetary Approach Dr. J. D. Han King’s College U.W. O.

1. “Money is all that matters” “Just every road leads to Rome, every theory becomes monetary theory.” -A Monetarist 2

2. Interest Parity and Money Supply: Short-run analysis In the short-run, interest rate is negatively correlated with Money Suppy (-) in the IS-LM or Neo-Classical approach. - An increase in Money Supply leads to a lower interest rate, which results in a lower Rate of Return on domestic assets, and thus into capital outflows. This leads to a depreciation of domestic currency or a rise in FOREX Rates. 3

In short, a country with a relatively liberal monetary policy will experience Depreciation of its own currency and a rise in FOREX rate. 4

5 3. PPP and Money Supply Purchasing Power Parity is fundamentally broken down to 1) Nominal Factor such as Money Supply; and “Monetary Approach” -> Focus of this chapter 2) Real Factors such as Demand and Supply of Trade Goods(‘Tradables’) Excess Supply lowers P domestic <-Excess Supply can happen due to i) innovation on the supply side and/or ii) suppressed demand -> Real Factor Analysis of FOREX Rate as a separate PPP(next one)

6 1) Monetary Theory relates Price Level to Money Supply : Long-run Analysis FOREX rate = Relative Value of Two Currencies = Relative Worth of Two Monies = Relative Inverse of Price Levels = Relative Money Supplies (M) - Relative Real Economic Perfomance/Growth (y) + Relative Stability of Monetary Situations(V) between domestic and foreign countries

2) Quantity Theory of Exchange M V = P y (absolute version) P = M V / y  % M +  % V =  %P   % y (relative version)  =  % M +  % V -   % y 7

8 Absolute PPP M V = P y P = M V/y (1) Absolute Quantity Equation of Exchange + PPP: M f V f = P f y f P f = M f V f /y f S = P/P f = (M V/y)/ (M f V f/ /y f ) if we assume V = V f = 1 for now S = (M / y) / (M f /y f ) = (M/M f ) ( y f / y)

* How to use the equation of S = (M / y) / (M f /y f ) = M/M f * y f / y? S will rise -when M/M f rises; “when domestic country’s monetary authority carries out a relatively more liberal(Expansionary) Monetary Policy, the foreign currency will appreciate/domestic currency will depreciate.” - y f / y rises; “if the foreign country’s economic performance/economic growth is better than domestic country’s, foreign currency will appreciate.” 9

**It makes a sense: Foreign Currency will appreciate/ domestic currency will depreciate if Foreign country’s monetary policy is more conservative(a good thing) and its economic performance is better( a good thing). 10

(2) Relative Version of PPP Instead of multiplication or division, we would like to express in terms of addition and subtraction, or in linear forms. It is easier to look at. 11

Step 1: relative PPP   % S =  %P -  %P f = π - π f 12

13 Step 2: Monetary Theory of Quantity Equation of Exchange Money supply mainly determines Price Level: M V = P y M f V f = P f y f Speed of money creation mainly determines Inflation Rate Δ%P =  = Δ% M - Δ% y + Δ%V Δ%P f =  f = Δ% M f - Δ% y f + Δ%V f

14 Step 3: PPP + Quantity Equation of Exchange Combining the above two equations, we get Δ % S = π e - π ef = Δ% M- Δ % M f - (Δ% y - Δ%y f ), if Δ%V - Δ%V f = 0. FOREX rate depends mainly on Money Supply conditions.

15 *Summary of Relative PPP  % S =  %P -  %P f - (1)  %P =  % M -  % y (+  % V) - (2)  %P f =  % M f -  % y f ( +  % V f ) - (3) Pluging (2) and (3) into (1), we get  % S= (  % M-  % M f ) - (  % y -  % y f )

16 Conclusion Precisely speaking, FOREX rates are determined by i) the difference in money creation (between the domestic and the foreign countries) and ii) the difference in economic growth. In the short-run, changes in y or y f would be relatively smaller than changes in M or M f. Thus, in the short-run, changes in FOREX are due primarily to differences in the rates of money creation between domestic and foreign countries.

17 * FOREX and Monetary Policy: Country with an Easy Monetary Policy faces a rising FOREX Rate: Easy Monetary Policies – A Large Quantity of Money – Low Value of Money – High Price of Foreign Currency in that Domestic Money – High FOREX Rate

18 * Inflation Rate, Relative Speed of Money Creation, and FOREX Rate: FX rate depends mainly on inflation differential, which in turn depends on Relative Speeds of Money Creation between two countries. -> A country with a higher speed of money creation will experience Depreciation of its own currency, or a rise in FOREX rates