Week 3 Flashcards
(184 cards)
1
Q
Why does the Purchasing Power Parity (PPP) theory fail to explain large short-term exchange rate fluctuations?
A
PPP assumes exchange rates are driven solely by goods price differences across countries. However, in reality, short-term fluctuations can result from financial market dynamics, capital flows, or speculative activities unrelated to goods prices.
2
Q
How do money and capital flows challenge the validity of PPP in modern economies?
A
PPP focuses only on goods prices, neglecting the impact of money and capital flows such as investments in bonds, stocks, and other financial instruments. These flows often play a larger role in driving exchange rates than goods price differences.
3
Q
Explain how exchange rate expectations undermine the PPP framework using an example.
A
Exchange rate expectations can lead to immediate currency movements. For instance, if investors expect a currency to depreciate in the future, it may depreciate now as they act on their expectations. PPP does not account for such forward-looking behaviors.
4
Q
What was the impact of Mario Draghi’s quantitative easing (QE) announcement on the euro, and why does this example highlight the limitations of PPP?
A
Draghi’s QE announcement increased expectations of future money supply, leading to an immediate depreciation of the euro against the dollar despite the current money supply remaining constant. This demonstrates that expectations, not just goods prices, significantly influence exchange rates.
5
Q
Discuss how incorporating asset markets into exchange rate models provides a more realistic approach than PPP.
A
Asset markets incorporate the role of expectations, money supply, and financial instruments in determining exchange rates. Unlike PPP, this approach accounts for the dynamic interactions between currency values and future returns on assets, making it more flexible and realistic.
6
Q
Why is the carry trade strategy not explained by PPP?
A
The carry trade exploits interest rate differentials between countries, borrowing in low-interest rate currencies and investing in high-interest rate ones. PPP does not address financial flows or interest rate dynamics, which are central to this strategy.
7
Q
Provide an example of how capital flows can lead to currency appreciation or depreciation, bypassing the principles of PPP.
A
If a country experiences a surge in foreign investment due to attractive stock market returns, its currency may appreciate due to higher demand. This appreciation can occur independently of goods price differences, which PPP focuses on.
8
Q
Why does PPP struggle to explain currency movements in the presence of speculative trading?
A
Speculative trading is driven by market sentiment and future expectations rather than goods prices. Speculators might buy or sell a currency in anticipation of future policy changes or economic events, causing volatility that PPP cannot account for.
9
Q
Explain how an increase in the expected future money supply can affect current exchange rates, using the asset approach.
A
An increase in the expected future money supply can lead to a depreciation of the currency today. Investors anticipate lower future returns on the currency, sell it in the present, and drive its value down, consistent with the asset approach but not PPP.
10
Q
What are the limitations of using PPP as a long-term exchange rate model when compared to asset-based models?
A
While PPP might explain long-term trends based on relative price levels, it ignores factors like capital flows, monetary policy, speculative behavior, and expectations, which are crucial in the short to medium term. Asset-based models incorporate these dynamics, providing a more comprehensive explanation.
11
Q
Why does Uncovered Interest Parity (UIP) require that investors do not hedge exchange rate risk?
A
UIP assumes that investors rely on their expectations of future exchange rates without using forward contracts or other hedging tools. The lack of hedging introduces exchange rate risk, which is inherent in the “uncovered” nature of foreign investments.
12
Q
How does speculation in the foreign exchange market help restore UIP when the foreign interest rate exceeds the domestic interest rate (r*>r)?
A
If r* > r, foreign investments are more attractive. Investors sell domestic currency to buy foreign currency, increasing the supply of the domestic currency in the forex market. This causes the domestic currency to depreciate, reducing the expected future depreciation (Et[s˙]) until UIP is restored.
13
Q
What are the main conditions required for UIP to hold, and why are they important?
A
Perfect capital mobility: Investors must freely move capital across borders to exploit interest rate differentials.
Equal currency risk or risk neutrality: Investors must perceive currencies as equally risky or disregard risk entirely. These conditions ensure that interest rate differentials reflect expected exchange rate movements without distortions.
14
Q
Why might UIP fail in the presence of a risk premium, and how does this affect the formula?
A
If investors perceive one currency as riskier, they demand a higher return, creating a risk premium. This alters the UIP formula to
r -r* = Et[s˙] + riskpremium, meaning the interest rate differential no longer solely reflects expected exchange rate movements.
15
Q
Illustrate how UIP explains currency depreciation when a central bank raises foreign interest rates (r*)
A
When r* increases, foreign investments become more attractive. Investors convert domestic currency into foreign currency, causing the domestic currency to depreciate. This depreciation adjusts Et[s˙] until the interest rate differential matches the expected depreciation, restoring UIP.
16
Q
Why is perfect capital mobility critical for UIP, and what happens if this condition is not met?
A
Perfect capital mobility ensures that investors can freely move funds to exploit interest rate differentials. Without it, barriers like capital controls or transaction costs prevent arbitrage, allowing interest rate differences to persist independently of expected exchange rate changes.
17
Q
How does speculation in the foreign exchange market help restore UIP when r* - r?
A
When r*-r, foreign investments appear more attractive. Speculators convert domestic currency into foreign currency, increasing the supply of the domestic currency in the forex market. This causes the domestic currency to depreciate (St increases). The expected future depreciation (Et[s˙]) decreases until the interest rate differential matches the adjusted expectation, restoring UIP.
18
Q
Explain the role of exchange rate expectations (Et[s˙]) in ensuring UIP is restored during speculative activity.
A
Speculative activity adjusts the current spot exchange rate (St) based on expectations of future exchange rates (Et[St+1]). If investors expect too high a depreciation (Et[s˙]), speculation causes the domestic currency to depreciate until Et[s˙] aligns with the interest rate differential, restoring UIP.
19
Q
Why does UIP require the condition
r - r* = Et[s˙] to hold, and how does speculation ensure this?
A
UIP states that the interest rate differential
(r - r*) must equal the expected rate of currency depreciation (Et[s˙]). Speculation drives adjustments in St by increasing or decreasing demand for currencies, ensuring that the spot rate reflects these expectations and satisfies UIP.
20
Q
What happens to the domestic currency if the expected depreciation (Et[s˙]) is too high compared to the interest rate differential
(r - r*)
A
If Et[s˙] is too high, foreign investment becomes more attractive, leading to an outflow of capital from the domestic economy. This increases the supply of the domestic currency in the forex market, causing it to depreciate (St rises). As depreciation occurs, Et[s˙] decreases until it aligns with r - r*
21
Q
How does UIP form the basis of exchange rate theory?
A
UIP establishes a relationship between interest rate differentials (r - r*) and exchange rate expectations (Et [s˙]). It suggests that the current spot exchange rate (St) depends on the domestic interest rate (r) and market expectations of future spot rates. However, full exchange rate theory requires modeling both r and Et[s˙].
22
Q
If r* is fixed, what factors primarily determine the current spot exchange rate (St ) under UIP?
A
If r*is exogenous, St is determined by:
The domestic interest rate (r): Higher r makes domestic currency more attractive, causing appreciation.
Expectations of future exchange rates (Et[s˙]): If depreciation is expected, St adjusts to reflect those expectations.
23
Q
Describe how UIP explains the depreciation of the domestic currency when domestic interest rates (r) are lowered.
A
Lower domestic interest rates (r) reduce the return on domestic investments relative to foreign investments (r*). This prompts investors to move capital abroad, increasing the supply of domestic currency in the forex market. As a result, the domestic currency depreciates until UIP is restored.
24
Q
What role does risk neutrality play in the validity of UIP, and what happens if investors are risk-averse?
A
UIP assumes investors are risk-neutral, treating all currencies as equally risky. If investors are risk-averse, they may demand a risk premium for holding certain currencies. This risk premium disrupts the equality
r - r* = Et[s˙], meaning UIP may not hold strictly in such cases.
25
Why does UIP provide only a partial explanation of exchange rate dynamics, and what components must be added for a complete theory?
UIP focuses on the relationship between interest rate differentials and exchange rate expectations but does not model how domestic interest rates (r) or expectations (Et[s˙]) are formed. A complete theory must include models of monetary policy, inflation expectations, and market sentiment to fully explain exchange rate dynamics.
26
What happens to the forward exchange rate (f) when both CIP and UIP hold, and why?
When both CIP and UIP hold, the forward exchange rate f equals the expected future spot exchange rate (Es). This is because the forward rate reflects market expectations of the future spot rate, and arbitrage ensures that discrepancies are eliminated.
27
Explain the mechanism by which arbitrage eliminates differences when f > Es.
If f > Es, arbitrageurs sell forward contracts since the forward rate offers a higher return than the expected spot rate. This increases the supply of forward contracts, pushing f down until it equals Es.
28
What arbitrage action occurs if f < Es, and what is the result?
If f < Es, arbitrageurs buy forward contracts because the expected spot rate offers a higher return. This increases the demand for forward contracts, driving f up until it equals Es.
29
Why is the forward exchange rate f considered a reflection of market expectations about the future spot exchange rate Es?
The forward rate f reflects market expectations because it incorporates all available information about future economic conditions. Investors’ expectations about the future spot rate Es drive their actions in the forward market, aligning f with Es.
30
How does CIP ensure no arbitrage when forward contracts are used?
CIP ensures no arbitrage by equating the return on a domestic investment with the return on a hedged foreign investment. This condition links the forward exchange rate f to interest rate differentials, ensuring that investors cannot profit from differences in forward and spot markets.
31
Explain how UIP and CIP together imply that the forward rate is determined by expectations of the future spot rate.
UIP links interest rate differentials to expected changes in the spot rate, while CIP equates the forward rate to these differentials. Together, they imply that f reflects Es, as any deviation would create arbitrage opportunities and adjust f to align with Es.
32
If the domestic interest rate (r) is 5% and the foreign interest rate (r*) is 6%, what does UIP predict about the expected rate of currency appreciation or depreciation (Es)?
UIP predicts that Es = r – r*. Substituting the values, Es = 5 – 6 = –1%. This means the domestic currency is expected to appreciate by 1% relative to the foreign currency.
33
What happens to Es immediately after a shock where r* increases from 6% to 9%, while r remains at 5%?
Immediately after the shock, UIP does not hold because the market is in disequilibrium. Es = r – r* = 5 – 9 = –4%, but this is not valid until the exchange rate adjusts. The spot rate (st) must increase (domestic currency depreciates) to restore equilibrium.
34
Explain the adjustment process when r* unexpectedly increases, making foreign investments more attractive.
Capital outflow: Higher r* prompts investors to move capital abroad.
Currency depreciation: Capital outflow increases the supply of the domestic currency, causing it to depreciate (st rises).
Restoring equilibrium: Depreciation continues until the domestic currency becomes so weak that investors expect it to appreciate in the future, offsetting the interest differential. Equilibrium is restored when r – r* = Es.
35
After adjustment, if r = 5% and r* = 9%, and the UIP equilibrium holds, what does Es = –4% signify?
Es = –4% signifies that the market expects the domestic currency to appreciate by 4% in the future. This expected appreciation offsets the 4% interest rate differential, restoring UIP equilibrium.
36
Why does a change in the spot rate (st) not necessarily change Es?
Es depends on both the spot rate (st) and the future expected spot rate (Et[st+1]). If st rises and Et[st+1] rises by the same amount, Es remains unchanged. If Et[st+1] rises by less or more than st, Es could increase or decrease.
37
Describe a scenario where st rises but Es decreases.
If the spot rate st rises but the expected future spot rate Et[st+1] rises by less than st, the difference Et[st+1] – st (which defines Es) decreases. For example, if st rises by 3% but Et[st+1] rises only by 1%, Es decreases.
38
What mistake do people commonly make when observing a rise in st, and why is it incorrect?
People often assume that a rise in st automatically decreases Es. This is incorrect because Es = Et[st+1] – st. If Et[st+1] rises along with st, Es may remain unchanged or even increase, depending on the relative magnitudes of their changes.
39
How does the market's expectation of future depreciation change during the adjustment process after an interest rate shock?
During the adjustment, the depreciation of the domestic currency increases the spot rate (st), causing the expected future depreciation (Es) to adjust. Once the domestic currency is weak enough, the market begins to expect future appreciation, restoring UIP equilibrium.
40
Why does the actual depreciation of the domestic currency during adjustment differ from the new expected depreciation (Es) in equilibrium?
During adjustment, the domestic currency depreciates significantly to correct the disequilibrium caused by the interest rate shock. However, in the new equilibrium, Es reflects the market's expectation of future appreciation rather than the magnitude of the past depreciation. This ensures that r – r* = Es holds.
41
What role does purchasing power parity (PPP) play in the flexprice monetary model?
PPP is assumed in the flexprice monetary model because it focuses on the long run, where the relationship between prices and exchange rates stabilizes. PPP provides a link between domestic and foreign price levels and exchange rates, with the assumption that exchange rate adjustments restore competitiveness when domestic prices rise relative to foreign prices.
42
Why do prices (p) adjust to clear the money market in this model rather than interest rates (r)?
This model is a long-run theory where changes in the money supply directly impact the price level. If the money supply doubles, the price level doubles in the long run to restore equilibrium in the money market. Interest rates are determined by other factors, such as UIP and inflation expectations.
43
What determines the long-run domestic interest rate (r) in the flexprice monetary model?
The long-run domestic interest rate is determined by:
The foreign interest rate (r*)
The difference between expected domestic inflation (E[p˙]) and expected foreign inflation (E[p*˙])
This relationship is derived from combining UIP and the Fisher effect.
44
Explain the Fisher effect in the context of the flexprice monetary model.
The Fisher effect states that in the long run, higher expected inflation (E[p˙]) leads to a proportional rise in the nominal interest rate (i). Since the real interest rate adjusts for inflation, this increase in expected inflation also raises r and expected exchange rate depreciation (E[s˙]).
45
How does a one-time increase in the money supply affect long-run expected inflation and the domestic interest rate?
A one-time increase in the money supply causes a temporary rise in prices but does not affect the long-run expected inflation rate (E[p˙]). Consequently, the domestic interest rate (r) remains unchanged in the long run.
46
What happens to the long-run domestic interest rate (r) when there is a sustained increase in the money growth rate?
A sustained increase in the money growth rate raises the long-run expected inflation rate (E[p˙]). As a result, the domestic interest rate (r) also increases to reflect the higher inflation expectations.
47
What is the relationship between exchange rate depreciation (s˙), domestic inflation (p˙), and foreign inflation (p*˙) in the flexprice monetary model?
The relationship is given by relative PPP: s˙ = p˙ – p*˙. This means that the exchange rate depreciation equals the difference between the domestic and foreign inflation rates.
48
How does an increase in domestic inflation (p˙) affect the expected exchange rate depreciation (E[s˙]) in the long run?
An increase in domestic inflation (p˙) relative to foreign inflation (p*˙) raises the expected exchange rate depreciation (E[s˙]). This is because higher domestic inflation makes domestic goods less competitive, leading to a weaker domestic currency over time.
49
Why doesn’t a temporary price increase due to higher money supply affect long-run inflation expectations?
A temporary price increase from a one-time change in money supply is not sustained and does not impact the long-run growth rate of prices (inflation). Inflation expectations depend on ongoing trends, not single events.
50
What happens to the competitiveness of domestic goods when the domestic price level (p) rises relative to foreign prices (p*)?
When domestic prices (p) rise relative to foreign prices (p*), domestic goods become less competitive in international markets. The exchange rate (s) must adjust (depreciate) to restore competitiveness, consistent with PPP.
51
How does the flexprice monetary model incorporate the endogeneity of prices compared to simpler PPP theories?
In the flexprice monetary model, prices (p and p*) are determined within the model by the interaction of money supply and demand, whereas simpler PPP theories treat prices as exogenous and focus only on their relationship with exchange rates.
52
Describe the adjustment process in the exchange rate when there is a sustained increase in domestic money growth.
A sustained increase in domestic money growth raises inflation expectations (E[p˙]), leading to higher domestic interest rates (r) and expected exchange rate depreciation (E[s˙]). The currency depreciates over time to maintain PPP as higher prices reduce competitiveness.
53
What misconception might arise from observing a rising spot exchange rate (s) and its impact on Es˙?
A common misconception is assuming that a rising spot rate (s) always reduces Es˙. In reality, both the spot rate (s) and expected future spot rate (E[st+1]) matter. If E[st+1] rises by more than s, Es˙ could increase.
54
Why is the flexprice monetary model considered a long-run theory, and how does this impact its assumptions?
The flexprice monetary model is a long-run theory because it assumes that markets, especially the money market, fully adjust to changes over time. This justifies assumptions like PPP and the proportional relationship between money supply and price levels. Short-term deviations are not accounted for.
55
Explain the relationship between real interest parity (RIP), uncovered interest parity (UIP), and purchasing power parity (PPP).
RIP is derived from combining UIP and PPP. UIP ensures that interest rate differentials are offset by expected currency depreciation, while PPP links exchange rates and inflation. RIP merges these principles to state that real interest rates between two open economies equalize in the long run after adjusting for inflation expectations.
56
How does RIP reflect the openness of an economy?
RIP depends on the ability to invest and borrow freely across borders. In a perfectly open economy, capital flows freely, ensuring that differences in real interest rates are arbitraged away. This equalization reflects the openness and integration of financial markets.
57
What is the impact of a restrictive monetary policy on real interest rates (r) in the short run and long run?
Short run: Restrictive monetary policy, interpreted as a reduction in money supply, creates a scarcity of money, pushing nominal interest rates and real interest rates (r) higher.
Long run: Restrictive monetary policy, interpreted as a lower money growth rate, reduces expected inflation (E[p˙]). With lower inflation expectations, real interest rates (r) decrease over time.
58
Why has the European Central Bank's (ECB) restrictive monetary policy contributed to low real interest rates in the eurozone over the years?
The ECB's low money growth policy aims to curb inflation, which has successfully reduced expected inflation (E[p˙]) in the long run. Since real interest rates (r) depend inversely on inflation expectations, this policy has kept long-term real interest rates low.
59
If real interest rates are lower in one country than another, what might this indicate about inflation expectations or monetary policy?
Lower real interest rates could indicate:
Higher expected inflation (E[p˙]) in the country with lower real rates.
Expansionary monetary policy aimed at stimulating growth.
This difference often triggers capital outflows to countries with higher real interest rates until parity is restored.
60
How does a sudden increase in inflation expectations (E[p˙]) affect real interest rates and RIP equilibrium?
An increase in domestic inflation expectations (E[p˙]) reduces the real interest rate (r = i – E[p˙]). This disrupts RIP equilibrium as the real interest rate differential widens. Capital flows will then adjust exchange rates or nominal rates until real interest parity is restored.
61
Explain why a country with consistently higher inflation might have difficulty maintaining RIP with other countries.
Higher inflation increases E[p˙], lowering real interest rates and creating persistent deviations from RIP. For RIP to hold, either the nominal interest rates must increase proportionally (unlikely in cases of weak monetary policy), or capital outflows must continuously adjust the exchange rate.
62
What role do capital flows play in restoring RIP when real interest rates differ across countries?
Capital flows exploit real interest rate differentials. For example:
If real interest rates are higher abroad, domestic investors move capital overseas, increasing the supply of domestic currency.
This causes domestic currency depreciation, raising E[s˙], until RIP (r – E[p˙] = r* – E[p*˙]) is restored.
63
A central bank unexpectedly tightens monetary policy by lowering the money growth rate. Explain the short-term and long-term effects on RIP.
Short-term: The restrictive policy may cause real interest rates to rise temporarily due to capital inflows and tight liquidity. RIP may be disrupted as domestic rates exceed foreign rates.
Long-term: The lower money growth rate reduces inflation expectations (E[p˙]), lowering real interest rates. RIP equilibrium is restored as real rates equalize across countries.
64
Why does RIP assume perfect capital mobility, and what happens if this assumption does not hold?
RIP assumes perfect capital mobility because unrestricted capital flows ensure real interest rate equalization. If capital mobility is limited (e.g., through capital controls), real interest rate differentials can persist due to a lack of arbitrage opportunities.
65
What are the implications of RIP for monetary policy coordination among open economies?
RIP implies that monetary policies in open economies are interconnected. A country's real interest rate policies affect global capital flows and exchange rates, forcing other countries to consider these spillover effects when designing their policies.
66
If a country maintains higher nominal interest rates than its trading partners but also has higher inflation expectations, how does this affect RIP?
Higher nominal interest rates combined with higher inflation expectations could keep the real interest rate similar to trading partners, ensuring RIP holds. However, if inflation expectations rise disproportionately, the real interest rate may fall below parity, causing capital outflows.
67
Explain why the price level (p) adjusts to clear the money market in this model, rather than the real interest rate (r).
In this model, the money market clears through price adjustments because it operates as a long-run theory. The price level (p) adjusts to align money demand with a fixed money supply (ms). Real interest rates (r) are determined by international bond market equilibrium (UIP), so they are not the adjustment mechanism for the money market.
68
Using the equilibrium condition
m = p + ηy − σr, explain the effect of an increase in money supply m on price levels p.
An increase in the money supply (m) leads to an increase in the price level (p) to maintain equilibrium in the money market. Since ηy (income effect) and σr (interest rate effect) are fixed, the price level must rise proportionally to balance the equation.
69
How does a relative increase in domestic money supply (m > m*) affect the exchange rate (s) in the long run?
A relative increase in domestic money supply (m > m*) causes the domestic price level (p) to rise, reducing the value of the domestic currency. Using the exchange rate equation
s = (m − m*) − η(y − y*) + σ(r − r*), this leads to an increase in s (currency depreciation).
70
Describe the role of elasticity (η) in the money demand equation when there is a shock to real income (y).
The elasticity of money demand with respect to income (η) determines how sensitive money demand is to changes in y. A higher η means that a shock to y has a larger impact on money demand, requiring greater adjustments in the price level (p) to restore equilibrium.
71
Suppose the central bank increases the interest rate (r) in response to inflationary pressures. What is the immediate effect on money demand and price levels?
An increase in r decreases money demand (md) because of the negative relationship (−σr). To restore equilibrium, the price level (p) must decrease to match the reduced money demand with the fixed money supply (m).
72
How does an increase in foreign income (y*) relative to domestic income (y) affect the exchange rate (s)?
An increase in foreign income (y* > y) makes foreign goods relatively more competitive, leading to an appreciation of the foreign currency. From the exchange rate equation
s = (m − m*) − η(y − y*) + σ(r − r*), the term −η(y − y*) becomes negative, decreasing s (domestic currency appreciates).
73
A country experiences a simultaneous increase in money supply (m) and income (y). How do these changes interact to influence the price level (p)?
An increase in m raises p (price level), while an increase in y also increases money demand, which offsets some of the upward pressure on p. The net effect on p depends on the relative magnitudes of the changes in m and ηy (income elasticity of money demand).
74
Real-life case: Suppose the Federal Reserve increases U.S. interest rates (r) while the European Central Bank keeps its rates constant (r*). What is the impact on the USD/EUR exchange rate (s)?
An increase in U.S. interest rates (r > r*) makes U.S. assets more attractive, leading to capital inflows and a higher demand for USD. This causes the USD to appreciate relative to the EUR. Using the exchange rate equation s = (m − m*) − η(y − y*) + σ(r − r*), the term σ(r − r*) increases, reducing s (indicating appreciation of the USD).
75
How does PPP (Purchasing Power Parity) connect exchange rates with the demand for foreign goods?
PPP states that exchange rates (s) align prices across countries. If domestic prices (p) are higher than foreign prices adjusted by the exchange rate (p* + s), demand will shift entirely to foreign goods, leading to an increased demand for foreign currency.
Example: If the price of a domestic good is $100, while the foreign equivalent is priced at $90, the demand will favor the foreign product unless the exchange rate offsets the price gap.
76
What causes changes in domestic prices (p) according to the economic model?
Domestic prices (p) depend on the balance between money supply (m) and money demand (md). If money supply exceeds money demand (m > md), there is excess currency, leading to a decrease in the value of the currency and an increase in prices.
77
How does an increase in money supply (m) impact the exchange rate (s) through PPP?
An increase in money supply leads to excess money (m > md), which raises the domestic price level (p). According to PPP, higher prices lead to a depreciation of the domestic currency, increasing the exchange rate (s). This is because a higher domestic price makes domestic goods less competitive
78
Explain the short-run effect of an increase in the real interest rate (r) on the exchange rate (s).
In the short run, an increase in the real interest rate (r) leads to capital inflows because foreign investors find domestic assets more attractive. This causes the domestic currency to appreciate, leading to a decrease in the exchange rate (s).
79
How does the long-run effect of a higher real interest rate (r) differ from its short-run effect on the exchange rate (s)?
In the long run, an increase in the real interest rate leads to higher expected inflation (Ep˙), which reduces the demand for the domestic currency and leads to a depreciation of the domestic currency, increasing the exchange rate (s). The long-run effect differs because expectations about inflation become dominant over short-term capital inflows.
80
What is the role of expectations in determining exchange rate volatility?
Expectations play a significant role because the current exchange rate is influenced by anticipated future events like money supply changes or economic policies.
Example: When ECB President Mario Draghi announced plans for quantitative easing (QE), expectations about higher future money supply drove an immediate depreciation of the euro, even before QE's implementation.
81
How does an increase in expected future inflation (Ep˙) impact the real interest rate (r)?
An increase in expected future inflation (Ep˙) leads to a higher nominal interest rate (r), as nominal interest rates must adjust to maintain real returns. This reflects the Fisher effect, where higher expected inflation leads to higher nominal rates to compensate for the erosion of purchasing power.
82
Why does a change in monetary supply (m) affect exchange rates through changes in PPP?
An increase in monetary supply leads to excess money in circulation, which raises the domestic price level (p). According to PPP theory, higher domestic prices make the domestic currency less competitive, leading to a depreciation of the domestic currency and an increase in the exchange rate (s).
83
What happens to the exchange rate if expectations of future money supply (m*) are expected to increase?
If expectations of future money supply (m*) are expected to increase, the exchange rate will depreciate immediately. Investors anticipate higher inflation driven by the expected monetary expansion, leading to capital outflows, reducing demand for the domestic currency, and increasing the exchange rate (s).
84
What is the economic impact of a central bank implementing restrictive monetary policy on real interest rates?
Restrictive monetary policy involves reducing money supply or raising interest rates to control inflation. In the short run, this leads to higher real interest rates (r) due to a tighter money supply. However, in the long run, it reduces expected inflation (Ep˙), which may lead to lower real interest rates (r). Example: The European Central Bank's strategy of low money growth has kept real interest rates low.
85
Explain the relationship between exchange rates and asset pricing.
Exchange rates can be thought of as asset prices because they represent the present value of expected future payoffs, similar to how stock prices depend on anticipated dividends. For example, foreign currency acts as a way to store purchasing power, with its value dependent on expected future money supply (m*), expected economic output (y*), and anticipated future exchange rate movements (Es˙).
86
What are the short- and long-run effects of an increase in the real interest rate (r) on the exchange rate (s) when expectations about future inflation remain unchanged?
Short run: An increase in the real interest rate leads to capital inflow, which appreciates the currency and decreases the exchange rate (s).
Long run: An increase in r leads to higher expected inflation (Ep˙), causing the domestic currency to depreciate, which increases the exchange rate (s).
87
Why is monetary policy's effect on the exchange rate sensitive to changes in expectations?
Monetary policy changes affect expectations about future money supply and inflation. For instance, a central bank's announcement signaling a change in monetary policy can alter investor expectations about the future path of inflation and money supply, leading to immediate changes in the exchange rate even before actual monetary actions are implemented.
88
How can an increase in real income (y) affect the exchange rate through PPP?
An increase in real income raises demand for goods, which can lead to a higher demand for money. If money supply does not change, this leads to higher domestic prices (p). According to PPP, higher domestic prices result in a depreciation of the domestic currency, which leads to an increase in the exchange rate (s).
89
What is the role of expectations about future fundamentals in exchange rate movements?
Expectations about future fundamentals like money supply (m*), foreign output (y*), and exchange rate movements (Es˙) influence investor decisions. For example, if the market expects a future increase in money supply, it will lead to an immediate depreciation of the exchange rate (s) due to anticipated inflation.
90
How can changes in expectations lead to volatility in the exchange rate?
Exchange rates are sensitive to changes in expectations about future fundamentals (e.g., money supply, economic policies). For example, a policy announcement by a central bank can alter expectations about inflation or money supply, leading to rapid changes in exchange rates even if no immediate monetary actions occur.
91
Why do shocks in monetary supply or interest rates affect exchange rates (s) through PPP and UIP mechanisms?
Shocks in monetary supply affect exchange rates by changing the domestic price level (p), leading to changes in PPP equilibrium. Similarly, changes in interest rates affect capital flows and investor expectations through UIP conditions. Both mechanisms adjust exchange rates (s) to restore market equilibrium.
92
What happens to the equilibrium in the money market when the central bank increases the money supply? Explain the initial effect on the interest rate.
When the central bank increases the money supply, it creates an excess of money in the market, disturbing the initial equilibrium. To restore equilibrium, the interest rate adjusts downward (r falls) because the excess money supply lowers borrowing costs.
93
Explain the relationship between a rising exchange rate (s) and the goods market. How does this affect domestic and foreign goods?
As the exchange rate (s) rises, domestic goods become cheaper for foreign consumers, which can lead to increased demand for domestic goods. Conversely, foreign goods become more expensive for domestic consumers. This shifts demand in the goods market, leading to a slight increase in domestic prices (p) in the short run.
94
Why are prices considered "sticky" in the short run, and how does this affect the adjustment process after a change in the money supply?
Prices are considered sticky in the short run because they adjust more slowly compared to exchange rates or interest rates. When the money supply is increased, this causes changes in the goods market and leads to a temporary increase in prices (p). However, because of price stickiness, this adjustment is only partial in the short run, which creates feedback loops across the money, goods, and international markets.
95
How does a rise in domestic prices (p) impact the real money supply and return the money market to equilibrium?
An increase in domestic prices reduces the real money supply (ms/p) because money has less purchasing power. This imbalance disturbs the money market by creating a new demand for adjustment. To return to equilibrium, the central bank allows the interest rate (r) to adjust again, balancing the real money supply and demand.
96
How does the initial increase in money supply create feedback loops across the money market, international bond market, and goods market?
The initial increase in money supply leads to:
A fall in the interest rate, lowering the attractiveness of domestic bonds and leading to capital outflows.
This causes the domestic currency to depreciate, increasing the exchange rate (s).
A higher exchange rate makes domestic goods cheaper for foreign consumers and foreign goods more expensive for domestic consumers, which shifts demand in the goods market.
Sticky prices lead to a partial adjustment in the price level, which then reduces real money supply (ms/p).
This imbalance leads to a new adjustment in the interest rate (r) to return the system toward equilibrium.
These interconnected effects repeat until the long-run equilibrium is achieved.
97
If prices are sticky and do not adjust fully in the short run, how does this affect the adjustment mechanism of the monetary model?
Sticky prices mean that the adjustment in prices (p) in response to monetary shocks is slow. This means the feedback mechanism between the money market, international bond market, and goods market is less direct in the short run. While the initial effects, like changes in r and s, operate quickly, the adjustment in p lags behind. This partial adjustment can lead to further disturbances until equilibrium is fully restored over time.
98
What role does the expected exchange rate (Es˙) play in the sticky price monetary model's adjustment process?
The expected exchange rate (Es˙) adjusts as changes in monetary supply and interest rates influence capital flows and market expectations. When the central bank increases the money supply, expectations about a depreciating domestic currency may rise. These expectations drive investor behavior, leading to capital outflows and changes in international bond markets. Thus, the adjustment of Es˙ connects monetary policy changes to shifts in international markets and the exchange rate.
99
What would be the long-run outcome if the central bank persistently increased the money supply in the sticky price monetary model?
In the long run, continuous increases in the money supply would lead to sustained inflation as prices adjust fully. The real money supply (ms/p) would stabilize at a new equilibrium, but the nominal exchange rate would remain higher. The goods market would adjust to restore full employment, but real income levels would not change significantly—only nominal variables like prices and the nominal exchange rate would adjust.
100
How does the sticky price model differ from the flexprice model in terms of market clearing and price adjustments?
In the sticky price model, prices adjust slowly over the short run, leading to temporary market imbalances. The money market is cleared by changes in the interest rate (r), the international bond market is cleared by changes in the exchange rate (s), and the goods market is cleared by changes in price levels (p). In contrast, the flexprice model assumes that prices adjust immediately to ensure market clearing, avoiding temporary imbalances.
101
According to the sticky price model, how does the central bank's money supply setting impact market equilibrium?
The central bank sets the money supply (ms = m), and the interest rate (r) adjusts to ensure equilibrium in the money market. With y and p fixed in the short run, r becomes the only adjusting variable that balances money demand (md = p + ηy - σr) with money supply.
102
What is the role of expectations (Es˙) in the international bond market within the sticky price model?
Expectations about future exchange rates (Es˙) in the international bond market are based on how far the current exchange rate (s) is from its long-run equilibrium exchange rate (s^). Es˙ depends on θ(s^ - s), where θ represents the speed at which deviations from equilibrium are expected to correct. This reflects investor expectations and capital flows in response to anticipated changes.
103
Explain the Phillips curve within the sticky price model. What does it describe about the relationship between demand and price levels?
The Phillips curve is given by p∙ = π(d - y), where:
p∙ = rate of price change
π = degree of price flexibility
d = demand for home-produced goods
y = supply of goods (output)
It describes that if demand (d) exceeds supply (y), prices will rise, and if demand is less than supply, prices will fall. Price adjustment is slow, governed by π, leading to temporary short-run imbalances.
104
How does the sticky price model incorporate the concept of real exchange rates into the demand for domestic goods?
The demand for domestic goods depends on:
d = β + α(s - p + p*) + ϕy
β = autonomous demand
α(s - p + p*) = real exchange rate effect on demand
ϕy = domestic income effect on demand (with ϕ < 1)
The real exchange rate effect captures how a change in the nominal exchange rate (s) and price levels impacts demand for domestic goods, while ϕ reflects the sensitivity of demand to changes in domestic income.
105
What does the equilibrium condition d = y signify in the goods market in the long run, and how is this affected in the short run?
The equilibrium condition d = y signifies that, in the long run, demand for domestic goods will match their supply. In the short run, however, prices adjust slowly (due to sticky prices), leading to temporary imbalances between demand (d) and output (y).
106
If the central bank increases the money supply, what is the chain of effects in the sticky price model leading to a new equilibrium?
Central bank increases the money supply (ms = m).
Money market adjusts by lowering the interest rate (r), as excess money leads to lower borrowing costs.
A lower r reduces the attractiveness of domestic bonds compared to foreign ones, leading to capital outflows.
Capital outflows cause the domestic currency to depreciate, leading to an increase in the exchange rate (s).
A higher s makes domestic goods cheaper to foreign consumers and foreign goods more expensive for domestic consumers, shifting demand in the goods market.
Prices adjust slowly (sticky prices) in the short run, leading to a temporary imbalance.
The short-run price increase reduces real money supply (ms/p), leading to a new adjustment in the interest rate (r).
This process continues until long-run equilibrium is achieved.
107
What is the significance of the parameter θ in the sticky price model's international bond market dynamics?
The parameter θ represents the speed at which expectations adjust toward the long-run equilibrium exchange rate (s^). A higher θ indicates that investors expect the exchange rate to return to equilibrium more quickly, while a lower θ indicates slower adjustments. This parameter affects how rapidly capital flows respond to deviations in the exchange rate from equilibrium.
108
How would a sudden expectation of inflation impact the interest rate and the exchange rate in the sticky price model?
A sudden expectation of inflation leads to higher expected future exchange rates (Es˙).
This raises demand for foreign bonds compared to domestic bonds, leading to capital outflows.
Capital outflows cause the domestic currency to depreciate, increasing the nominal exchange rate (s).
The money market adjusts by increasing the interest rate (r) to maintain equilibrium in response to higher demand for money.
109
What would happen in the goods market if the exchange rate (s) increases significantly in the short run under sticky price assumptions?
If the exchange rate (s) increases, foreign consumers will find domestic goods cheaper, leading to higher demand for those goods. Conversely, domestic consumers may shift toward foreign goods because they become relatively more expensive. This would lead to a shift in the goods market, causing temporary imbalances until prices adjust toward equilibrium.
110
Why is the interest rate considered the adjusting variable in the money market within the sticky price model?
The central bank sets the money supply (ms = m), and with y and p fixed in the short run, the interest rate (r) must adjust to ensure equilibrium in the money market (md = ms). This adjustment in r balances the excess demand or supply in the market due to changes in monetary policy or external shocks.
111
How does sticky price behavior affect the response of the economy to a sudden monetary policy shock?
Sticky prices cause prices to adjust only partially in the short run, leading to temporary imbalances across markets (money, goods, international bonds). Monetary policy shocks first lead to changes in the money market (interest rate changes), followed by effects in international markets (exchange rate adjustments) and demand shifts in the goods market. Prices adjust slowly, delaying the return to equilibrium.
112
What is the role of real income effects (ϕy) in the demand function for domestic goods in the sticky price model?
Real income effects (ϕy) capture how changes in a country's income affect the demand for its goods. A higher income increases demand for domestic goods, while a lower income decreases it. The parameter ϕ measures the sensitivity of demand to these income changes, with values less than 1 reflecting that the effect is relatively inelastic.
113
How does a depreciation in the domestic currency impact the Phillips curve adjustment process under sticky price assumptions?
A depreciation of the domestic currency leads to an increase in imported goods prices and shifts demand toward domestic goods. This raises demand (d) in the short run, leading to a temporary increase in prices as described by the Phillips curve (p∙ = π(d - y)). This reflects the short-run price adjustment resulting from changes in demand pressures.
114
What does the Dornbusch sticky price model say about the relationship between the real exchange rate (RER) and competitiveness in the economy?
In the Dornbusch model, an increase in the RER makes domestic goods cheaper relative to foreign goods, improving the competitiveness of the domestic economy. Conversely, a decrease in the RER makes foreign goods cheaper relative to domestic goods, reducing domestic competitiveness. The RER influences the trade balance and international demand for domestic products.
115
How does the Dornbusch model violate absolute PPP, and what does this imply for the real exchange rate (RER)?
In the Dornbusch model, the RER is typically nonzero because it is influenced by real factors like output and productivity, which violate absolute PPP. Absolute PPP implies that the exchange rate adjusts to equalize price levels across countries, leading to a zero RER in the long run. However, Dornbusch allows for real shocks and other factors that prevent the RER from being zero, reflecting deviations from PPP.
116
What is the relationship between relative productivity (y) and the real exchange rate (RER) in the Dornbusch model?
In the Dornbusch model, if productivity increases, output rises, and domestic goods become cheaper relative to foreign goods because the economy can produce more for the same price. As a result, the RER increases, making the domestic economy more competitive. This reflects how real economic factors, such as productivity improvements, can influence the RER, violating relative PPP.
117
How does Dornbusch’s model explain the long-run impact of a money supply shock on the real exchange rate (RER)?
A money supply shock in the Dornbusch model leads to proportional adjustments in the nominal exchange rate (s) and domestic price level (p). However, this shock does not affect the long-run RER, as it is consistent with relative PPP. In the long run, the RER remains unchanged because the money supply only affects nominal variables (prices and exchange rates) and not real fundamentals like competitiveness.
118
What is the role of sticky prices in the Dornbusch model compared to the flexprice model?
In the Dornbusch model, prices adjust slowly (sticky prices) in the short run, leading to temporary imbalances between demand and supply. This contrasts with the flexprice model, which assumes that prices adjust instantaneously to clear markets. In Dornbusch's framework, sticky prices cause the economy to adjust gradually, influencing both nominal and real variables over time.
119
What is the implication of the Dornbusch model for the exchange rate in response to productivity shocks?
A productivity shock changes the RER because it alters the real fundamentals of the economy. An increase in productivity makes domestic goods cheaper, leading to a higher RER, which improves the domestic economy's international competitiveness. This violates the assumptions of PPP because the RER is no longer constant and changes with real factors like productivity.
120
In the Dornbusch model, how does the exchange rate (s) adjust to a shock in the money supply?
In the Dornbusch model, a shock to the money supply results in a proportional adjustment of the nominal exchange rate (s) and the domestic price level (p). However, since this shock is a nominal factor, it does not affect the real exchange rate (RER) in the long run, which remains unchanged. This is consistent with relative PPP, where nominal changes do not affect real competitiveness.
121
How does the Dornbusch model account for deviations from PPP in the short run?
The Dornbusch model allows for deviations from PPP in the short run due to sticky prices. While absolute and relative PPP may hold in the long run, the presence of sticky prices means that prices do not adjust immediately to changes in monetary or real shocks, leading to temporary deviations from PPP and making the real exchange rate (RER) nonzero in the short run.
122
How does an increase in productivity affect the domestic economy and international trade in the Dornbusch model?
An increase in productivity makes domestic goods cheaper relative to foreign goods because the economy can produce more for the same price. This leads to an improvement in the RER, making the domestic economy more competitive. As a result, foreign consumers demand more domestic goods, and the domestic economy exports more, improving the trade balance.
123
In the Dornbusch model, what happens when the exchange rate (s) is not at its long-run equilibrium (s^)?
When the exchange rate (s) deviates from its long-run equilibrium (s^), expectations about future exchange rates (Es˙) adjust to reflect the deviation. Investors expect the exchange rate to return to equilibrium over time, leading to changes in capital flows. These expectations influence the current exchange rate and eventually bring it back to equilibrium, but only after some time due to sticky prices and the gradual adjustment process.
124
How does Dornbusch's model describe the effect of money supply shocks on the competitiveness of domestic goods?
In the Dornbusch model, a shock to the money supply leads to a proportional increase in the domestic price level (p) and the nominal exchange rate (s). However, this does not affect the real exchange rate (RER) in the long run, meaning there is no change in the competitiveness of domestic goods. This is consistent with relative PPP, where nominal shocks do not affect the real exchange rate or the relative competitiveness of domestic goods.
125
What happens to the real exchange rate (RER) if there is a persistent increase in the domestic price level (p) due to inflation?
If there is a persistent increase in the domestic price level (p) due to inflation, the real exchange rate (RER) will typically decrease because the domestic goods become more expensive relative to foreign goods. This reduces the international competitiveness of the domestic economy, leading to a lower RER, which could worsen the trade balance and lead to less demand for domestic exports.
126
How does Dornbusch’s model explain the short-term behavior of the exchange rate (s) after a monetary policy shock?
In the short term, after a monetary policy shock (e.g., an increase in the money supply), the nominal exchange rate (s) adjusts quickly due to changes in capital flows and investor expectations. However, since prices are sticky, the adjustment in the exchange rate does not immediately result in price level changes. Over time, prices begin to adjust, and the economy moves towards a new long-run equilibrium.
127
In the Dornbusch model, what would happen to the real exchange rate (RER) if there is a sudden increase in the foreign country’s productivity?
If a foreign country experiences a sudden increase in productivity, its goods become cheaper relative to domestic goods, leading to a decrease in the RER for the domestic country. This makes the domestic economy less competitive, as foreign goods become relatively cheaper, reducing demand for domestic products in international markets.
128
What does the Dornbusch model suggest about the long-term relationship between nominal exchange rates and real exchange rates?
The Dornbusch model suggests that while nominal exchange rates and price levels adjust to money supply shocks in the long run, the real exchange rate (RER) is primarily determined by real economic factors such as productivity and output. Changes in the money supply or nominal exchange rates do not affect the RER in the long run, which reflects the real competitiveness of the economy, consistent with relative PPP.
129
What is the key difference between short-run and long-run effects of money supply shocks in the Dornbusch model?
Short-run effect: A money supply shock leads to changes in the nominal exchange rate and domestic prices, with nominal adjustments happening faster than real adjustments.
Long-run effect: Money supply shocks do not change the long-run real exchange rate (RER) because they only affect nominal factors, while real economic fundamentals remain unchanged.
130
How does the Dornbusch model refine the UIP framework to determine the current exchange rate?
The Dornbusch model refines the UIP (Uncovered Interest Parity) framework by specifying the origin of the interest rate (r) and the expectation of future exchange rates (Et[t+1]). It explains that r is determined by equilibrium in the domestic money market
(m = p + ηy − σr), while expectations (Et[t+1]) are regressive, meaning that if the current exchange rate is too far from its long-run equilibrium, people expect it to return to equilibrium over time.
131
What are the two main factors that UIP relies on to determine the current exchange rate in the Dornbusch framework?
The two main factors are:
The current interest rate differential (r − r*), i.e., the difference between the domestic interest rate and the foreign interest rate.
The expected future exchange rate (Et[t+1]), which accounts for expectations about how the exchange rate will evolve over time.
132
How is the current domestic interest rate (r) determined in the Dornbusch model?
The current domestic interest rate (r) is determined by equilibrium in the domestic money market, where money demand (md) equals money supply (m). The equation governing this is m = p + ηy − σr, meaning changes in money supply or other economic factors influence r by adjusting the equilibrium between money supply and demand.
133
What is the role of expectations in the Dornbusch model, and how are they modeled?
Expectations are regressive in the Dornbusch model, meaning that if the exchange rate today (st) is too far from its long-run equilibrium (s^), people expect it to gradually return toward s^ over time. Expectations are modeled by Et[t+1] = θ(s^ − st) + st, where θ represents how quickly participants expect the exchange rate to close the gap toward equilibrium.
134
What does a higher value of θ imply about market expectations in the Dornbusch framework?
A higher value of θ implies that market participants expect the exchange rate to return to its long-run equilibrium (s^) more quickly. This means that the adjustment toward equilibrium is faster as θ increases.
135
How does the Dornbusch model incorporate expectations into the goods market’s determination of the equilibrium exchange rate?
The Dornbusch model assumes that expectations are anchored to the distance between the current exchange rate and its long-run equilibrium (s^). If the current exchange rate (st) is too far from its equilibrium, participants expect it to move back toward the long-run equilibrium over time. This mechanism links goods market conditions to exchange rate expectations and is embedded in the UIP relationship.
136
What are the three markets that the Dornbusch model integrates, and how do they interact in determining the exchange rate?
The Dornbusch model incorporates the following three markets:
Money market: Determines the domestic interest rate (r) based on money supply and demand.
Bond market: Establishes the UIP condition by linking r with expected future exchange rates (Et[t+1]).
Goods market: Determines the equilibrium exchange rate (s^) through real economic conditions and output levels.
These markets interact to ensure that money supply shocks, productivity changes, or other economic adjustments influence both current and expected exchange rates.
137
How does Dornbusch’s model view deviations from equilibrium in the short run?
Dornbusch's model suggests that deviations from equilibrium are temporary because market participants adjust their expectations over time. If the exchange rate (st) deviates too far from its long-run equilibrium (s^), people recognize this as unsustainable and revise their expectations to return the exchange rate toward equilibrium.
138
How does the Dornbusch model treat changes in money supply in terms of interest rates and exchange rates?
A change in the money supply affects the domestic interest rate (r) through adjustments in the money market equilibrium (m = p + ηy − σr). Changes in the domestic interest rate then feed into the UIP condition *r − r = Et[t+1]**, affecting expectations about the exchange rate (Et[t+1]) and leading to changes in the nominal exchange rate (st).
139
What is the economic intuition behind Et[t+1] = θ(s^ − st) + st in the Dornbusch model?
The equation shows that expectations about the future exchange rate depend on two components:
The gap between the current exchange rate (st) and its equilibrium value (s^).
The speed of adjustment (θ), which determines how quickly market participants expect this gap to close.
If the exchange rate is far from equilibrium, the expectation will shift toward equilibrium over time, influenced by θ.
140
How does a capital flow mechanism align with UIP in Dornbusch’s model?
According to the Dornbusch model, if the domestic interest rate (r) rises relative to the foreign rate (r*), capital flows into the domestic bond market to take advantage of higher returns. This capital inflow increases demand for the domestic currency, leading to currency appreciation and changes in the nominal exchange rate (st). This dynamic aligns with the UIP condition r − r = Et[t+1].*
141
What role does the bond market play in the Dornbusch framework for UIP and exchange rate determination?
The bond market determines the UIP relationship by connecting the domestic interest rate (r) and expected future exchange rates (Et[t+1]). Changes in interest rates due to shifts in monetary policy, economic shocks, or other factors influence capital flows between countries, thereby adjusting exchange rates to restore UIP equilibrium.
142
How would an unexpected monetary tightening in a country influence its exchange rate under the Dornbusch model?
Monetary tightening reduces the money supply, leading to higher domestic interest rates (r). The higher interest rate makes domestic bonds more attractive, increasing capital inflow into the country. This leads to an appreciation of the domestic currency in the short term, reflecting the expectations adjustment toward higher future returns.
143
Why is the GG line upward sloping?
The GG line is upward sloping because if the exchange rate (s) increases, the domestic currency weakens, making domestic goods cheaper for foreign buyers. This leads to an increase in net exports, demand for domestic goods, and eventually an increase in the domestic price level (p) to restore equilibrium.
144
Does the GG line show the immediate response to changes in exchange rate or price?
No, the GG line represents where the goods market would eventually settle in equilibrium, not the immediate response. Prices are sticky in the short run, so immediate adjustments do not occur.
145
What does the MB line represent?
The MB line represents the combined equilibrium of the money market and international bond market. It shows the immediate adjustment necessary for equilibrium when money supply changes, affecting interest rates and exchange rates.
146
If the domestic price level (p) decreases, what happens to the money market and exchange rate under the MB line?
If p decreases, money demand (md) decreases, leading to md < ms. To restore equilibrium, the interest rate (r) must fall. This leads to excess demand for foreign bonds, which creates pressure for the spot exchange rate (s) to rise.
147
Why is the MB line downward sloping?
The MB line is downward sloping because a decrease in the domestic price level leads to lower money demand, which in turn leads to a decrease in interest rates (r). This causes an increase in demand for foreign bonds, leading to a rise in the exchange rate (s).
148
What is the immediate short-run response when the money supply (ms) increases, assuming prices are sticky?
When ms increases and prices are sticky, the immediate short-run response is that the exchange rate (s) rises sharply to clear the money and bond market. This is shown by a short-run jump in s above the new long-run equilibrium value.
149
What is overshooting, and why does it occur in the MB line adjustment?
Overshooting occurs because when ms increases and prices are sticky, the exchange rate (s) rises sharply to restore equilibrium in the money and bond market. The adjustment goes beyond the long-run equilibrium value (s^) due to capital outflows and expectations about future exchange rates.
150
How does price stickiness contribute to the phenomenon of overshooting?
If prices are sticky, they do not adjust immediately after a change in money supply. As a result, the exchange rate (s) bears the full burden of adjustment in the short run, leading to overshooting, as it must offset the excess money supply without the immediate support of price adjustments.
151
What would happen if prices were fully flexible in response to an increase in money supply?
If prices were fully flexible, they would immediately adjust to offset the effects of the increased money supply. As a result, there would be no overshooting because prices would rise in proportion to the increase in money supply, and the exchange rate would adjust proportionally without any delay.
152
What happens when there is a sudden increase in money supply (ms) in the short run, assuming prices are sticky?
When money supply (ms) increases in the short run, the immediate response is that the exchange rate (s) jumps upward sharply (overshooting) to clear the money and bond market. As time progresses, prices begin to adjust, and the MB line shifts back toward the new long-run equilibrium.
153
How does capital outflow lead to overshooting of the exchange rate (s)?
When the money supply (ms) increases, it leads to a decrease in the domestic interest rate (r), making foreign bonds more attractive. This results in capital outflow, which puts upward pressure on the spot exchange rate (s). To stop the outflow, s overshoots its long-run equilibrium value to stabilize expectations and restore equilibrium.
154
What does it mean for the economy to "converge back to its new long-run equilibrium" after overshooting?
After the initial sharp increase in s (overshooting), the exchange rate begins to adjust back toward its new long-run equilibrium value (s^’). This occurs because prices start to rise gradually, reducing the excess money supply and restoring equilibrium conditions.
155
What happens to the MB line when there is an increase in the money supply?
When money supply (ms) increases, the MB line shifts upward because lower interest rates (r) lead to excess demand in the international bond market, which places pressure on the exchange rate.
156
If the long-run equilibrium exchange rate (s^) is fixed, how does the spot exchange rate (s) respond to an increase in ms?
Initially, the spot exchange rate (s) rises sharply above the long-run equilibrium value (s^) due to overshooting. Over time, as prices adjust and equilibrium is restored in the bond and money markets, s converges downward toward its new long-run equilibrium value (s^’).
157
What role does Es˙ play in the overshooting mechanism?
Es˙ represents the expected change in the exchange rate. When money supply increases and r falls, capital outflows create pressure to adjust expectations. As these expectations adjust (capital outflows expected), the spot exchange rate overshoots its equilibrium to stabilize the market.
158
How does an overshooting exchange rate stabilize market conditions in the Dornbusch model?
The overshooting ensures that capital flows stabilize, as the exchange rate rises enough to offset the capital outflow pressures. This restores investor confidence and equilibrium by ensuring investors are indifferent between holding domestic versus foreign assets at the new long-run equilibrium.
159
How would the MB line behave if prices were fully flexible?
If prices were fully flexible, the MB line would not exhibit the overshooting effect. The adjustment would occur through an immediate proportional increase in both the exchange rate and price level without delays or sharp movements.
160
Why are sticky prices crucial for understanding overshooting in monetary economics?
Sticky prices mean that prices do not adjust immediately in response to changes in money supply. This causes the exchange rate (s) to bear the full burden of adjustment in the short run, leading to overshooting until prices eventually start to adjust and equilibrium is restored.
161
Why does the Dornbusch model assume that goods prices are sticky, and how does this lead to overshooting?
The Dornbusch model assumes that in the short run, goods prices are sticky and do not adjust immediately to economic shocks. This price stickiness causes exchange rates to adjust rapidly in response to monetary policy changes, leading to overshooting, where the exchange rate moves beyond its long-run equilibrium before stabilizing.
162
How does the Dornbusch model explain prolonged departures from Purchasing Power Parity (PPP) without requiring irrational behavior?
According to the Dornbusch model, prolonged departures from PPP can occur in the short run because of monetary policy, expectations, and price stickiness, even if all economic agents are rational. These factors can lead to deviations of the exchange rate from PPP predictions without any irrational behavior by market participants.
163
Why are exchange rates more volatile than goods prices, as suggested by the Dornbusch model?
The Dornbusch model suggests that exchange rates are more volatile than goods prices because they react quickly to capital inflows, speculation, and expectations about future exchange rates, while goods prices adjust more slowly due to sticky prices.
164
What is "overshooting," and how does the Dornbusch model explain this phenomenon?
Overshooting refers to the exchange rate (s) moving beyond its long-run equilibrium value after a monetary shock before eventually returning to equilibrium. The Dornbusch model explains this by emphasizing how capital inflows, expectations, and changes in interest rates lead to short-run volatility and overcorrection in response to monetary shocks.
165
How do capital inflows and outflows impact exchange rates according to the Dornbusch model?
The Dornbusch model highlights that capital flows (both inflows and outflows) significantly affect exchange rates. For example, capital inflows can lead to an appreciation of the domestic currency, while capital outflows lead to depreciation. This is a key mechanism through which the exchange rate adjusts in response to changes in economic conditions and monetary policy.
166
How does the Dornbusch model account for the role of interest rates in the money market equilibrium?
The Dornbusch model assumes that the interest rate (r) clears the money market by adjusting in response to changes in the money supply or demand. This adjustment ensures market equilibrium and directly influences the exchange rate (s) in the short run, linking monetary policy to exchange rate movements.
167
In the context of monetary policy shocks, why can exchange rates overshoot their new equilibrium values?
Exchange rates can overshoot their new equilibrium values because capital markets adjust more quickly than goods prices, and expectations about future changes play a strong role. When monetary policy changes, interest rates and capital flows adjust rapidly, leading to initial sharp movements in exchange rates before a gradual return to equilibrium.
168
What is the role of expectations in the Dornbusch model when it comes to the behavior of exchange rates?
Expectations play a central role in the Dornbusch model because market participants anticipate how exchange rates will adjust over time. If the exchange rate is too low or too high relative to long-term equilibrium (s^), expectations will drive s toward its equilibrium value over time. Expectations are often regressive, meaning deviations tend to self-correct as market participants adjust their behavior.
169
How does the Dornbusch model ensure that changes in monetary policy are reflected in the exchange rate?
The Dornbusch model integrates monetary policy through the money market equilibrium condition. Changes in the money supply affect interest rates, and these interest rates, in turn, influence the exchange rate through Uncovered Interest Parity (UIP) conditions. This allows monetary policy changes to directly impact the short-run movements of the exchange rate
170
What does money neutrality imply about the effects of changes in the money supply in the long run?
Money neutrality implies that changes in the money supply have no long-run effect on real variables such as output, employment, or the real exchange rate. While monetary policy influences nominal variables in the short and medium run, over time, real variables return to their natural equilibrium levels.
171
How does a change in the money supply affect nominal exchange rates in the short run?
Changes in the money supply can alter nominal exchange rates in the short run due to changes in inflation expectations and interest rates. For example, an increase in the money supply raises inflation, reduces the interest rate, and may lead to a depreciation of the currency.
172
What are the effects of an increase in the money supply on employment in the short or medium run?
An increase in the money supply leads to higher spending, which can boost output and reduce unemployment in the short and medium run. This occurs because lower interest rates stimulate investment and consumer demand, thereby increasing demand for labor.
173
Why does monetary policy have real effects in the short run, but these effects do not persist in the long run?
Monetary policy has real effects in the short run because wages and prices are sticky, and changes in the money supply influence interest rates, exchange rates, and output. However, in the long run, prices and wages adjust fully, and changes in the money supply no longer affect real variables, demonstrating money neutrality.
174
How does monetary policy influence business cycles in the short and medium run through interest rates?
Monetary policy can smooth business cycles by changing the money supply, which affects inflation and interest rates. For instance:
An increase in the money supply reduces interest rates, making borrowing cheaper, encouraging investment, and boosting economic growth during recessions.
A decrease in the money supply raises interest rates, dampening spending and stabilizing the economy during periods of overheating.
175
How can monetary policy influence business cycles through exchange rate mechanisms?
An increase in the money supply leads to higher inflation, which reduces the interest rate, making domestic bonds less attractive to foreign investors. This triggers capital outflows, causing the domestic currency to depreciate. A weaker currency makes exports cheaper and imports more expensive, boosting net exports and helping stabilize the economy.
176
What is the difference between unsterilized and sterilized foreign exchange interventions by the central bank?
Unsterilized forex intervention: The central bank buys or sells foreign currency, which affects the money supply and therefore impacts the nominal exchange rate.
Sterilized forex intervention: The central bank intervenes in the forex market but simultaneously conducts open market operations to neutralize changes in the money supply, leaving the nominal exchange rate unaffected.
177
What are the risks of using monetary policy to stabilize an economy, as mentioned in the Dornbusch framework?
Monetary policy can lead to short-term overshooting of the exchange rate, which can create volatility and adjustment costs in the tradables sector. For example, capital flows reacting quickly to monetary changes may lead to misaligned investment patterns, creating long-term disruptions for international trade sectors.
178
How does the current account impact exchange rate determination, and what does the Dornbusch model suggest about its role?
The Dornbusch model suggests that capital flows are the primary driver of exchange rate movements, with the current account (trade in goods and services) playing a relatively minor role. However, in real life, trade imbalances and the current account can significantly influence exchange rate movements, even if they are not the dominant driver in this theoretical model.
179
Why does an increase in the money supply lead to a temporary overshooting of the nominal exchange rate?
An overshooting occurs because the exchange rate adjusts faster to monetary shocks than other variables like prices or wages. When the money supply increases, interest rates fall quickly, leading to capital outflows and a rapid depreciation of the currency. Prices adjust more slowly, leading to this temporary overshooting effect.
180
How does the Dornbusch model's assumption of nominal exchange rate adjustment impact monetary policy effectiveness?
The Dornbusch model assumes that the nominal exchange rate adjusts quickly to monetary shocks (due to capital flows and expectations), while prices adjust more slowly. This allows monetary policy to have a temporary real effect on the economy by affecting exchange rates, boosting exports, and stimulating demand.
181
What would happen if prices were fully flexible rather than sticky after a monetary supply shock?
If prices were fully flexible, the shock would lead to immediate price adjustments (Δp = Δms), meaning there would be no overshooting or temporary effects on output or employment. This is because the economy would instantaneously return to equilibrium without the time lag seen when prices are sticky.
182
How can monetary policy lead to adjustment costs in the tradables sector following a sudden monetary shock?
When monetary policy causes capital outflows or overshooting in the exchange rate, firms in the tradables sector may face higher costs or misalignment in investments. This is because their costs and competitive positions become unstable as exchange rates fluctuate, leading to increased adjustment costs, as they need to shift production or investments.
183
How does an increase in the money supply impact exports and imports under Dornbusch’s framework?
An increase in the money supply leads to higher inflation, lower interest rates, and a depreciation of the domestic currency. This makes exports cheaper and imports more expensive, increasing net exports and helping to stimulate economic growth temporarily.
184
What is a key implication of monetary policy for policymakers in terms of its long-run effects versus its short-run effects?
Monetary policy has short-run effects by influencing output, employment, and exchange rates through interest rate and capital flow adjustments. However, in the long run, monetary policy primarily affects inflation, as prices and wages adjust fully over time, and real variables return to their natural equilibrium. Thus, monetary policy is most effective for stabilizing business cycles in the short and medium term rather than permanently influencing real economic output.
