6 Conclusions

1. The chapter developed the theory of PPP and embedded it in a simple monetary model of exchange rate determination with flexible prices.

2. In the long run, money growth causes a proportional increase in prices and the exchange rate.

3. PPP and UIP imply that real interest rates will equalize in the long run.

4. Allowing money demand to depend on interest rates makes the model more complex and realistic. It predicts that money growth will cause prices to increase more, by reducing money demand.

5. The model permitted interesting long-run forecasting exercises. These long-run forecasts can have short-run effects because, like all asset prices, the current spot rate depends upon its expected future value. This will enter into the next chapter.

This chapter emphasized the determinants of exchange rates in the long run using the monetary approach. We employed PPP and a simple monetary model (the quantity theory) to study an equilibrium in which goods are arbitraged and prices are flexible. Under these assumptions, in the home country, changes in the money supply pass through into proportional changes in the price level and the exchange rate.

We also found that uncovered interest parity and PPP implied that real interest rates are equalized across countries. This helped us develop a monetary model that was more complex—and more realistic—because it allowed money demand to fluctuate in response to changes in the interest rate. In that setting, increases in money growth lead to higher inflation and a higher nominal interest rate and, hence, via decreases in money demand, to even higher price levels. Still, the same basic intuition holds, and one-time changes in the money supply still lead to proportional changes in prices and exchange rates.

The monetary approach to exchange rates provides a basis for certain kinds of forecasting and policy analysis using the flexible-price model in the long run. But such forecasts matter even in the short run because today’s spot exchange rate depends, like all asset prices, on the exchange rate expected to prevail in the future. To make these connections clear, in the next chapter we bring together the key ideas of arbitrage (from the previous chapter) and expectations (from this chapter) to form a complete model of the exchange rate.

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