International Finance Theory and Policy
by Steven M. Suranovic

Finance 70-3

Expansionary Monetary Policy with Floating Exchange Rates in the Long-Run

If expansionary monetary policy occurs when the economy is operating at full employment output, then the money supply increase will eventually put upward pressure on prices. Thus, we say that eventually, or in the long-run, the aggregate price level will rise and the economy will experience an episode of inflation in the transition. See section 40-14 for a complete description of this process.

Here we will describe the long-run effects of an increase in the money supply using an AA-DD model. We break up the effects into short-run and long-run components. In the short-run, the initial money supply effects are felt and investor anticipations about future effects are implemented. In the long-run we allow the price level to rise.

Suppose the economy is originally at a super equilibrium shown as point F in the adjoining diagram. The original GNP level is YF and the exchange rate is E1. YF represents the full-employment level of output, which also implies that the natural rate of unemployment prevails. Any movement of the economy to the right of YF will cause an eventual increase in the aggregate price level. Any movement to the left of YF causes an eventual decrease in the price level.

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 AA line to the red AA line.

In the long-run adjustment story several different changes in exogenous variables will occur sequentially, thus it is difficult to describe the quick final result. Thus, we will only describe the transition process in partial detail.

Partial Detail:The increase in the money supply causes the first upward shift of the AA-curve as shown as step 1 in the diagram. Since exchange rates adjust much more rapidly than GNP, the economy will quickly adjust 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 E1 to E2, representing a depreciation of the US dollar.

The second effect is caused by changes in investor expectations. Investors generally track important changes in the economy, including money supply changes, because these changes can have important implications for the returns on their investments. Investors who see an increase in money supply in an economy at full employment are likely to expect inflation to occur in the not so distant future. When investors expect future US inflation, and when they consider both domestic and foreign investments, they will respond today with an increase in their expected future exchange rate, Ee$/. There are two reasons to expect this immediate effect.

1)      First, investors are very likely to understand the story we are in the process of explaining now. As we will see below, the long run effect of a money supply increase for an economy, initially at full employment, is an increase in the exchange rate, E$/, i.e., a depreciation of the dollar. If investors believe the exchange rate will be higher next year due to todays FED action, then it makes sense for them to raise their expected future exchange rate in anticipation of that effect. Thus, the average Ee$/ will rise among investors who participate in the FOREX.

2)      Second, investors may look to the purchasing power parity (PPP) theory for guidance. PPP is generally interpreted as a long-run theory of exchange rate trends. If PPP holds in the long-run then E$/ = P$/P. In other words, the exchange rate will equal the ratio of the two countrys price levels. If P$ is expected to rise due to inflation, then PPP predicts that the exchange rate, E$/, will also rise and the $ will depreciate.

The timing of the change in Ee$/ will depend on how quickly investors recognize the money supply change, compute its likely effect, and incorporate it into their investment plans. Since investors are typically very quick to adapt to market changes, the expectations effect should take place in the short-run, perhaps long before the inflation ever occurs. In some cases the expectations change may even occur before the FED increases the money supply, if investors anticipate the FED action.

The increase in the expected exchange rate (note this means a decrease in the expected future dollar value) causes a second upward shift of the AA-curve as shown as step 2 in the diagram. Again, rapid exchange rate adjustment implies the economy will quickly adjust to the new AA-curve at point H directly above. The exchange rate will now increase from E2 to E3, representing a further depreciation of the US dollar.

Once at point H, aggregate demand, which is on the DD curve to the right of H, exceeds aggregate supply, which is still at YF. 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 above the AA curve which forces a downward readjustment of the exchange rate to get back to asset market equilibrium on AA. In the end, the economy will adjust in a stepwise fashion from point H to point I, 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 temporary super-equilibrium at point I.

The next effect occurs because GNP, now at Y2 at point I, has risen above the full employment level at YF. This causes an increase in US prices meaning that P$, the US price level, begins to rise. The increase in US prices has two effects as shown in the new adjoining diagram. An increase in P$ is both a DD left-shifter and an AA down-shifter. (See sections 60-2 and 60-4, respectively)

In step 3, we depict a leftward shift of DD to DD. DD shifts left because higher US prices will reduce the real exchange rate. This makes US G&S relatively more expensive compared with foreign G&S, thus reducing export demand, increasing import demand and thereby reducing aggregate demand.

In step 4, we depict a downward shift of AAto AA. AA shifts down because a higher US price level reduces real money supply. As the real money supply falls, US interest rates rise leading to an increase in the rate of return for US assets as considered by international investors. This in turn raises the demand for US dollars on the FOREX leading to a dollar appreciation. Since this effect occurs for any GNP level, the entire AA curve shifts downward.

Steps 3 and 4 will both occur simultaneously since both are affected by the increase in the price level. Ii is impossible to know which curve will shift faster or precisely how far each curve will shift. However, we do know two things. First, the AA and DD shifting will continue as long as GNP remains above the full employment level. Once GNP falls to YF, there is no longer upward pressure on the price level and the shifting will cease. Second, the final equilibrium exchange rate must lie above the original exchange rate. This occurs because output will revert back to its original level, the price level will be higher and according to PPP, eventually the exchange rate will have to be higher as well.

The final equilibrium will be at a point like J, which lies to the left of I. In this transition, the exchange rate will sometimes be rising, as when DD shifts left, and will sometimes be falling, as when AA shifts down. Thus the economy will wiggle its way, up and down, from point I to J. Once at point J there is no reason for prices to rise further, and no reason for a change in investor expectations. The economy will have reached its long-run equilibrium.

Note that one cannot use the iso-CAB line to assess the long-run effect on the current account balance. In the final adjustment, although the final equilibrium lies above the original iso-CAB line, in the long-run the P$ changes will raise the iso-CAB lines making it impossible to use these to identify the final effect.

However, in adjusting to the long-run equilibrium, the only two variables affecting the current account that will ultimately change are the exchange rate and the price level. If these two rise proportionally to each other, as they would if purchasing power parity held, then there will be no long-run effect on the current account balance.

The final long-run effect of an increase in the US money supply in a floating exchange rate system is a depreciation of the US dollar and no change in real GNP.Along the way, GNP temporarily rises and unemployment falls below the natural rate. However, this spurs an increase in the price level, which reduces GNP to its full employment level and raises unemployment back to its natural rate. US inflation occurs in the transition while the price level is increasing.

International Finance Theory and Policy - Chapter 70-3: Last Updated on 2/23/05