Lecture 15
EXCHANGE RATES: THE MONETARY APPROACH

Key concepts

• Equilibrium in the money market
• Purchasing power parity
• Exchange rates in the long run

1. Equilibrium in the money market

• Real money supply = Real money demand

• In the Home country:   M / P = L(Y,R)

• In Foreign:   M*/P* = L*(Y*,R*)

2. Price levels in the two countries

• Home:   P = M / L(Y,R)

• Foreign:   P* = M* / L*(Y*,R*)

3. Purchasing power parity

• P = EP*

• Note: E is the exchange rate measured as the price of the foreign currency in home currency

4. Equilibrium exchange rate

• Using PPP:   E = P / P*

• Using money mkt eqbm:   E = [M/M*] [L*(Y*,R*)/L(Y,R)]

• The home currency will depreciate (E will rise) if:
  • Home's money supply increases
  • Foreign's money supply decreases
  • Home's real money demand decreases
  • Foreign's real money demand increases