International Finance Theory and Policy
by Steven M. Suranovic

Finance 70-1

Monetary Policy with Floating Exchange Rates

In this section we use the AA-DD model to assess the effects of monetary policy in a floating exchange rate system. Recall from Chapter 40, that the money supply is effectively controlled by a countrys central bank. In the case of the US, this is the Federal Reserve Board, or FED for short. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in section 40-5.

Expansionary Monetary Policy

Suppose the economy is originally at a super equilibrium shown as point F in the adjoining diagram. The original GNP level is Y1 and the exchange rate is E$/1. Next, suppose the US central bank, the FED, decides to expand the money supply. As shown in section 60-4, money supply changes cause a shift in the AA-curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., ↑MS is an AA-upshifter). This is depicted in the diagram as a shift from the red AA to the blue AA line.

There are several different levels of detail that can be provided to describe the effects of this policy. Below we present three descriptions with increasing degrees of completeness. First the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result: The increase in AA causes a shift in the super-equilibrium point from F to H. In adjusting to the new equilibrium at H, GNP rises from Y1 to Y2 and the exchange rate increases from E$/1 to E$/2. The increase in the exchange rate represents an increase in the British pound value and a decrease in the US dollar value. In other words, it is an appreciation of the pound and a depreciation of the dollar. Since the final equilibrium point H is above the initial iso-CAB line CC, the current account balance increases. (see section 60-7 for a description of CC) If the CAB were in surplus at F then the surplus increases, if the CAB were in deficit, then the deficit falls. Thus, US expansionary monetary policy causes an increase in GNP, a depreciation of the US dollar and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description:

Consider the upward shift of the AA curve due to the increase in the money supply. Since exchange rates adjust much more rapidly than GNP, the economy will initially adjust back to the new AA curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E$/1 to E$/1, representing a depreciation of the US dollar.

Now at point G, the economy lies to the left of the DD-curve. Thus, GNP will begin to rise to get back to G&S market equilibrium on the DD-curve. However, as GNP rises the economy moves to the right above the AA curve which forces a downward readjustment of the exchange rate to get back to AA. In the end, the economy will adjust in a stepwise fashion from point G to point H, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the super-equilibrium at point H.

Notice that in the transition the exchange rate first rises to E$/1, above the rate it will ultimately reach at E$/2, before settling back to super-equilibrium value. This is an example of exchange rate overshooting. In the transition, the exchange rate overshoots its ultimate long-run value.

Exchange rate overshooting is used as one explanation for the volatility of exchange rates in floating markets. If many small changes occur frequently in an economy, the economy may always be in transition moving to a super-equilibrium. Because of the more rapid adjustment of exchange rates, it is possible that many episodes of overshooting, both upwards and downwards, can occur in a relatively short period of time.

Complete Adjustment Story:

Step 1) When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid non-money assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average US interest rates, which in turn will result in a lower US rate of return in the FOREX market. Since RoR$ < ROR now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the and a depreciation of the US $. Thus, the exchange rate, E$/, rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher US money supply. Since the money market and foreign exchange markets adjust very swiftly to the money supply change, the economy will not remain off the new A'A' curve for very long.

Step 2) Now that the exchange rate has risen to E$/1, the real exchange has also increased. This implies foreign goods and services are relatively more expensive while US G&S are relatively cheaper. This will raise demand for US exports, curtail demand for US imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall stimulating an increase in production and thus, GNP. This is represented by a rightward shift from point G.

Step 3) As GNP rises, so does real money demand, causing an increase in US interest rates. With higher interest rates, the rate of return on US assets rises above that in the UK and international investors shift funds back to the US resulting in a $ appreciation ( depreciation), that is, a decrease in the exchange rate E$/. This moves the economy downward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus, the rightward shift from point G in the diagram results in quick downwards adjustment to regain equilibrium in the asset market on the AA curve, as shown.

Step 4) Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in US interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram.

Step 5) The equilibrium at H, lies to the northeast of F along the original DD curve. As shown in section 60-7, the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.

Contractionary Monetary Policy

Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA-curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.

The quick effects however, are as follows. US contractionary monetary policy will cause a reduction in GNP, a reduction in the exchange rate, E$/, implying an appreciation of the US dollar and a decrease in the current account balance.

International Finance Theory and Policy - Chapter 70-1: Last Updated on 3/28/05