Exchange Rate Economics: Theories and Evidence

The sticky-price monetary model 127
cleared at B by a fall in output which,in turn,is induced by the real exchange rate
appreciation and an increase in the real interest rate (i falls by less than p). Once
we move from the short-run period into one in which prices are free to move,
prices will be falling (due to the effect on aggregate demand of the decline in competitiveness
and the increase in the real interest rate),the nominal interest rate
will also be falling and the exchange rate depreciating as we move to the
new equilibrium. The increased demand for real money balances is satisfied in
the new equilibrium because the inflation-adjusted interest rate has fallen,making
interest-bearing assets less attractive. In fact,real money balances in the new equilibrium
will have increased by the interest semi-elasticity of the demand for money
times the monetary contraction (i.e. α 2 µ),whilst all real variables stay unchanged;
in the long-run the model therefore exhibits standard neoclassical properties. 8
Consider,finally,an unanticipated increase in the level of the money supply,
the announcement and implementation of which are simultaneous. Since the
price level and the exchange rate in this model are homogeneous of degree 1 in
the money supply,the new steady-state equilibrium must be one in which q and l are
unchanged. Thus in terms of Figure 5.13 the original and ‘new’ long-run equilibria
are at a point such as A,and the saddle path SP 1 is relevant for both before and after
the change in the money supply. Hence starting from l 1 the increase in the money
supply increases liquidity to l 2 (i.e. l 1 = m 1 − p 1 , l 2 = m 2 − p 1 where m 2 > m 1 ). The
real exchange rate must therefore jump to q 2 and,since the exchange rate will
be expected to appreciate to equilibrium,the nominal interest rate will fall on
impact and output will expand. Over time this increases the price level,reduces
real money balances,raises the interest rate and appreciates the exchange rate:
eventually the system returns to A. The story is similar to that portrayed earlier for
the simple SPMA model. The earlier shock does,however,allow us to tell a rather
interesting story (due to Buiter and Miller 1981b).
We have seen that a reduction of the monetary growth rate results in a painful
adjustment of output to the new steady state. The basic reason for this is that the
q
SP 1
q 2
q
Y
SP 2
A
B
X
O l 1 l 2 l 2
l
Figure 5.13 Level and growth changes in the money supply.