Exchange Rate Economics: Theories and Evidence

The new open economy macroeconomics part 1 261
the exchange rate that arises from the money market equilibrium conditions. It is
downward sloping because an increase in the home country’s relative consumption
raises the demand for money in that country which,in turn,must lead to a fall
in its relative price level and a currency appreciation. The schedule intersects the
vertical axis at m − m ∗ ,which is the equilibrium exchange rate response if prices
are fully flexible.
The schedule GG captures the effect of the home–foreign consumption differential
on the exchange rate stemming from the current account relationship
and provides an important link between the short-run equilibrium (where the current
account is not required to be in equilibrium) and the long-run (where the
current account must be in balance). The GG schedule is positively sloped
because home consumption can rise relative to foreign consumption if the exchange
rate depreciates in the short-run,permitting home output to rise above foreign
output (see equations (10.20) and (10.23)). More precisely this may be seen in the
following way. Subtract (10.36) from (10.35) we obtain:
[
]
´F = (1 − n) (ŷ −ŷ ∗ ) − (Ĉ − Ĉ ∗ ) − Ŝ . (10.38)
Using (10.20) to eliminate the output differential in (10.38),which with short-run
price stickiness simply equals:
ŷ t −ŷ ∗ t = θŜ t ,(10.39)
and using (10.29) to substitute out for f ′ ,and noting (10.31) we obtain:
Ŝ =
δ(1 + θ)+ 2θ
δ(θ 2 (Ĉ − Ĉ ∗ ). (10.40)
− 1)
This relationship indicates that the GG schedule is upward sloping because home
consumption can rise relative to foreign consumption only if the exchange rate
depreciates in the short-run which permits home output to rise relative to foreign
output.The short- and long-run equilibrium exchange rate and consumption differential
lie at the intersection of the MM and GG schedules. The formal solution
for this intersection is:
Ŝ =
ɛ[δ(1 + θ)+ 2θ]
δ(θ 2 − 1) + ɛ[δ(1 + θ)+ 2θ] ( ˆM − ˆM ∗ )1. Note that since the prices of domestic
goods are preset,this expression also represents the terms of trade. In Figure 10.2,
point A represents the initial equilibrium and B the equilibrium after a monetary
expansion with the M ′ M ′ schedule representing the post-shock monetary expansion.
Note that the exchange rate effects of a monetary impulse are smaller,the
larger is the price elasticity of aggregate demand. As θ approaches infinity the GG
schedule becomes horizontal (i.e. as home and foreign goods become very close
substitutes,small exchange rate changes lead to very large shifts in demand with
preset prices).