Chapter 19 MONEY SUPPLIES, PRICE LEVELS, AND THE ...

Chapter 19
MONEY SUPPLIES, PRICE LEVELS,
AND THE BALANCE OF PAYMENTS
In the Keynesian model, the international transmission of shocks took place via the trade
balance, with changes in national income or interest rates altering the demand for goods.
This chapter presents an alternative view in which the demand for money, rather than the
Keynesian consumption function, is the crucial behavioral function.
Desired holdings of domestic currency are assumed to be a function of the level of
domestic income. When consumers find themselves holding more domestic currency than
they want, they spend the excess. Under fixed exchange rates, the implied change in
international reserves becomes the channel through which shocks are transmitted abroad.
This view is known as the Monetary Approach to the Balance of Payments. (The flexible
exchange rate version is known as the Monetary Approach to Exchange Rates, and
appears in Chapter 25.)
The model presented in this chapter is of a small country; in this context, a small country is
one that cannot affect foreign prices. This chapter provides an extensive discussion of the
Law of One Price. It also explains the concepts of absolute and relative purchasing power
parity (PPP), as well as the empirical evidence regarding these propositions. Finally, the
chapter reviews the properties of the model when the monetary authorities try to sterilize,
that is, when they try to keep the domestic money supply constant in the wake of changes
in the stock of foreign exchange reserves.
SHORT-ANSWER QUESTIONS
1. What is meant by the term "sterilization of international reserve flows"? How is
sterilization typically accomplished in the United States? How do governments in
countries with less well-developed financial markets accomplish sterilization?
2. True or false:
Under the gold standard, a country running a balance of payments deficit will
necessarily experience a decrease in its monetary base.
3. True or false:
According to the monetary approach to the balance of payments, an increase in the
growth rate of the money supply improves the trade balance and raises income in
the short run, but has no effect on the trade balance and income in the long run.

4. Evaluate the following statement.
If the Law of One Price holds for all traded commodities, then it follows that
Purchasing Power Parity holds.
5. What is the difference between "absolute PPP" and "relative PPP"? Which
concept do you think is more likely to hold up to empirical testing?
6. The textbook lists the following four reasons why empirical tests may reject
purchasing power parity:
(a) Tariffs and transportation costs.
(b) Shifts in the real terms of trade.
(c) Nontraded goods and services.
(d) Imperfect information, contracts, and inertia in consumer behavior.
In each case, state whether relative PPP, absolute PPP, or both will fail.
7. Why do economists turn to Canadian data to study the behavior of exchange rates
under fixed and floating regimes? What does Canada's exchange rate data suggest
about the volatility of exchange rates under a floating exchange rate regime?
8. How could you use data on the prices of various computer chips to test whether
"sticky prices" play an important role in exchange rate variability?
9. "A return to the gold standard would make all countries better off because it
would reduce world inflation and stabilize exchange rates."
Do you agree or disagree? [Don't worry, this isn't really a short-answer question.
Many dissertations have been written on this subject.]
10. What is the distinction between the monetarist approach to the balance of
payments and global monetarism?
11. If annual inflation is 5 percent in the U.S. and 100 percent in Brazil, what is
happening to the dollar/cruzado exchange rate?

PROBLEMS
1. Testing for Purchasing Power Parity:
The table below gives the prices of food, clothing, and housing in the home and
foreign country. The weights are the shares of each good in the consumer price
indices.
Home Foreign
Prices Shares Prices Shares
Food 20 0.40 60 0.35
Clothing 7 0.10 40 0.15
Housing 40 0.50 100 0.50
The current spot exchange rate is .30 units of home currency per foreign currency
unit.
(a) Does the condition for purchasing power parity hold?
(b) Housing can be considered a nontraded good. Does purchasing power
parity hold if only traded goods are included in the price indices? (Note:
Remember the shares will change because consumption of food and
clothing are now measured as shares of the total consumption of traded
goods.)
(c) Suppose the shares given in the table for the home country are from
estimates of PPP conducted 10 years ago. If, in fact, purchasing power
parity held, what would it have told you about recent trends in food and
clothing consumption in the home country?
2. Short-Run and Long-Run Analysis in a World of Fixed Exchange Rates:
Suppose that in the short run, changes in international reserves are sterilized by the
Central Bank to keep the exchange rate fixed. In the long run, the Central Bank
abandons sterilization and allows the money supply to adjust.
(a) Suppose the money supply increases. What happens to the trade balance,
output and investment in the short run? In the long run? Use a diagram to
illustrate your answer.
(b) Suppose there is an increase in government spending. What happens to the
trade balance, output, and investment in the short run? In the long run?
(As in part (a), use a diagram to illustrate your answer.)

3. Regional Differences in Purchasing Power:
(a) Do you think a test of PPP for consumers in Manhattan and consumers in
Dallas would hold?
(b) Does a difference in purchasing power imply that there is a lack of
arbitrage?
4. Arbitrage and the Law of One Price:
(a) Suppose consumers are very naive and care only about prices stated in their
own currency, ignoring changes in the exchange rate. If firms selling
foreign goods in this country are competitive, will the Law of One Price
hold?
(b) Suppose that, in fact, firms collude in setting the price of foreign goods.
How does this affect the Law of One Price? Would you expect the
deviations from PPP to be permanent or temporary?
5. Solving a Persistent Balance-of-Payments Problem:
(a) What policy regime will cause a persistent balance-of-payments problem
according to the monetary approach to the balance of payments?
(b) Why might a government pursue this policy?
(c) What policy advice would you give to such a country?
6. The Real-Balance Effect:
In the simple models we have been using so far, we assume that consumers hold all
of their wealth in the form of money balances, rather than as bonds, stocks or any
of the other ways that people may hold their savings. The real value of the
consumer's money balances is the amount of money held divided by the price level.
(a) A devaluation of the currency raises the price of domestic goods. What
does this do to consumers' real balances? How will consumers alter their
spending in response to this change in wealth?
(b) Suppose the Central Bank increases the money supply by depositing $100
in every consumer's checking account, increasing the total money supply by
one percentage point. How will consumers alter their spending?
(c) If domestic currency can only be spent on domestic goods, what must
happen (eventually) to the price level? What happens to real balances?
A SIMPLIFIED MONETARIST MODEL (Questions 7 to 11):

Equations (1) to (3) are a "model" of the simplest version of the monetarist model.
The first two equations state that the domestic money supply is spent entirely on
the home country's good, Y, and the foreign money supply is spent entirely on the
foreign good, Y*. This means that domestic currency is needed to purchase
domestic goods, so foreign residents have to exchange their currency for domestic
currency to purchase imports. The demand for each currency is thus unit elastic
with respect to changes in output. The third equation is the condition for PPP.
(1) M = P.Y
(2) M*= P*.Y*
(3) E.P*= P
To keep things relatively simple, assume that prices adjust immediately to changes
in the money supply or output, so that there is never any excess demand or supply
of Y and Y*, or for real money balances. You can think of this assumption as the
"global monetarist" position, or as applying only to the long run when prices adjust
fully to their new equilibrium level.
7. Suppose the domestic money supply increases.
(a) What happens to the price of the domestic good? Does the exchange rate
appreciate or depreciate?
(b) Suppose that the domestic Central Bank is required to keep E fixed. What
must the Central Bank do to accomplish this?
8. The foreign country's Central Bank wishes to revalue its currency.
(a) What can it do to accomplish this?
(b) Under our extreme assumption of perfectly flexible prices, what effect does
this have on the price of the domestic good?
9. The home country discovers more Y lying on its beaches. What effect does this
have on prices given constant money supplies? On the exchange rate E?
10. Define the real exchange rate. In the monetarist model, how is the real exchange
rate affected by
(a) a 10% increase in the money supply?
(b) a 10% devaluation of currency?
(c) a 10% increase in domestic output?

11. In the very simple model presented here, it was assumed that the price level adjusts
immediately so that the money supply (M) always equals money demand (P.Y).
(a) Under the assumption of no capital flows, what is true of the trade balance?
(b) Suppose money demand adjusts slowly so that the balance of payments is
given by
BOP = ?(Md - M),
where ? is the rate of adjustment. What happens to the trade balance in
response to an increase in the domestic money supply?