Chapter Introduction

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Exchange Rates I: The Monetary Approach in the Long Run

This chapter develops the monetary model of long-run exchange rate determination. It begins by describing PPP, which it then integrates into the classical theory of price determination to yield the basic monetary model of exchange rate determination. Next it studies some applications of the model and looks at the empirical evidence. It next generalizes the model to incorporate interest elastic money demands. Finally, it compares alternative nominal anchors.

  1. Exchange Rates and Prices in the Long Run: Purchasing Power Parity and Goods Market Equilibrium
  2. Money, Prices, and Exchange Rates in the Long Run: Money Market Equilibrium in a Simple Model
  3. The Monetary Approach: Implications and Evidence
  4. Money, Interest Rates, and Prices in the Long Run: A General Model
  5. Monetary Regimes and Exchange Rate Regimes
  6. Conclusions

Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses a purchasing power as against commodities and services in that foreign country.

Gustav Cassel, of the Swedish school of economics, 1922

The fundamental things apply / As time goes by.

Herman Hupfeld, songwriter, 1931 (featured in the film Casablanca, 1942)

1. U.S. and Canada as an example of inflation, exchange rates, and purchasing power

2. This will chapter will:
a. Develop the purchasing power parity hypothesis
b. Develop the monetary theory of price level determination
c. Put a and b together to arrive at the monetary approach to exchange rates

3. The monetary approach provides a theory of exchange rate determination in the long run.
In the next chapter it will pin down the expected future spot rate, which, combined with UIP and a theory of interest rate determination, will yield a complete theory of the exchange rate in the short run and in the long run.

The cost of living is usually rising, but it rises in some places more than others. From 1970 to 1990, for example, a standardized Canadian basket of consumer goods rose in price considerably. In 1970 a Canadian would have spent C$100 (100 Canadian dollars) to purchase this basket; by 1990 the same basket cost C$392. Thus, Canadian prices rose by 292%. Over the same period, in the United States, a basket of goods that initially cost $100 in 1970 had risen in cost to $336 by 1990. Thus, U.S. prices rose by only 236%. Both countries witnessed serious inflation, but Canadian prices rose more.

Did these price changes cause U.S. goods to appear relatively cheaper? Would they have caused Canadians to start spending more on U.S. goods, or Americans to spend less on Canadian goods?

The answer to these questions is no. In 1970 C$1 was worth almost exactly $1 (1 U.S. dollar). So in 1970 both baskets cost the same when their cost was expressed in a common currency, about C$100 = $100. By 1990, however, the Canadian dollar had depreciated relative to its 1970 value and C$1.16 was needed to buy $1.00. Thus, the $336 U.S. basket in 1990 actually cost $336 × 1.16 = C$390 when expressed in Canadian currency—almost the same price as the C$392 Canadian basket! (Conversely, expressed in U.S. currency, the Canadian basket cost about 392/1.16 = $338, almost the same as the $336 U.S. basket.)

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In this example, although Canadian prices rose about 16% more than U.S. prices, U.S. residents also found that each of their U.S. dollars could buy about 16% more loonies. From the U.S. point of view, the cost of the baskets in each country expressed in U.S. dollars rose by about the same amount. The same was true from the Canadian perspective with all prices expressed in loonies. Economists (such as Gustav Cassel, quoted previously) would say that the relative purchasing power of each currency (in terms of U.S. versus Canadian goods) had remained the same.

Is it a coincidence that the changes in prices and exchange rates turned out that way? One of the oldest and most fundamental macroeconomic hypotheses, dating back to the sixteenth century, asserts that this outcome is not a coincidence at all—and that in the long run, prices and exchange rates will always adjust so that the purchasing power of each currency remains comparable over baskets of goods in different countries (as here, where $100 and C$100 could purchase comparable amounts of goods in 1970, and also in 1990). This hypothesis, which we explore in this chapter, provides another key building block in the theory of how exchange rates are determined. In the last chapter, uncovered interest parity provided us with a theory of how the spot exchange rate is determined, given knowledge of three variables: the expected future exchange rate, the home interest rate, and the foreign interest rate. In this chapter we look at the long run to see how the expected future exchange rate is determined; then, in the next chapter, we turn to the short run and discuss how interest rates are determined in each country. When all the pieces are put together, we will have a complete theory of how exchange rates are determined in the short run and the long run.

Mention that this long-run model will be used to pin down the expected future spot rate that appeared in UIP, leading to a general theory of the exchange rate both in the short run and in the long run.

Since prices are assumed to be flexible in the long run, say that this model is also known as the Flexible Price Model of exchange rate determination.

If investors are to make forecasts of future exchange rates, they need a plausible theory of how exchange rates are determined in the long run. The theory we develop in this chapter has two parts. The first part involves the theory of purchasing power, which links the exchange rate to price levels in each country in the long run. This theory provides a partial explanation of the determinants of long-run exchange rates, but it raises another question: How are price levels determined? In the second part of the chapter, we explore how price levels are related to monetary conditions in each country. Combining the monetary theory of price level determination with the purchasing power theory of exchange rate determination, we emerge with a long-run theory known as the monetary approach to exchange rates. The goal of this chapter is to set out the long-run relationships between money, prices, and exchange rates.