Exchange Rate Volatility

and Keynesian Economics

Classical vs. Keynesian

Economics

Classical economics
assumes that prices are
flexible and that money
is neutral (money doesnt
affect output). This is
equivalent to a vertical
supply curve.

Classical vs. Keynesian

Economics

Classical economics
assumes that prices are
flexible and that money
is neutral (money doesnt
affect output). This is
equivalent to a vertical
supply curve.
Therefore, changes in
demand leave output
unchanged, but raise
prices.

Classical vs. Keynesian

Economics

Keynesians agree that

the classical solution is
correct in the long run
Keynesians, however,
argue that prices are
fixed in the short run.
This suggests a
horizontal supply curve.

Classical vs. Keynesian

Economics

Keynesians, however,
argue that prices are
fixed in the short run.
This suggests a
horizontal supply curve.
Therefore increases in
demand increase output
without raising prices.

Fixed Prices and the Real

Exchange Rate

Recall, that the real exchange rate is

equal to
q = eP*/P

Fixed Prices and the Real

Exchange Rate

Recall, that the real exchange rate is

equal to
q = eP*/P

With flexible prices and PPP, the real

exchange rate is constant (and equal to
one).

Fixed Prices and the Real

Exchange Rate

Recall, that the real exchange rate is equal

to
q = eP*/P

With flexible prices and PPP, the real

exchange rate is constant (and equal to
one).
However, with prices fixed in the short run,
changes in the nominal exchange rate are
reflected in the real exchange rate

Fixed Prices and the LM

Curve

As with classical theory, we start with the

quantity theory of money
MV = PY
However, rather than solving for price, we now
solve for output

Fixed Prices and the LM

Curve

As with classical theory, we start with the

quantity theory of money
MV = PY
However, rather than solving for price, we now
solve for output
Y = MV/P
Velocity is an increasing function of the
interest rate. Therefore, higher interest rates
are associated with higher output. This is the
LM curve

The LM Curve

The LM curve
describes a money
market equilibrium
with fixed prices (Y =
MV/P)

The LM Curve
The LM curve describes
a money market
equilibrium with fixed
prices (Y = MV/P)
Increasing the money
supply shifts LM to the
right, raising output
and lowering interest
rates.
Where does this extra
output go?

The IS Curve
The

IS curve describes an
equilibrium in the goods market
Y = C + I + G + NX

Or, Equivalently,
S = I + (G-T) + NX

The IS Curve
Typical

assumptions include:

Savings (S) is increasing in income and

the interest rate
Investment (I) is decreasing in the
interest rate
The Government deficit (G-T) is
independent of output and the interest
rate
Net Exports (NX) is decreasing in income

The IS Curve
Given

the previous assumptions

and the equilibrium condition
S = I + (G-T) + NX

The IS Curve
Given

the previous assumptions

and the equilibrium condition
S = I + (G-T) + NX

rise in income increases savings

and lowers the trade balance.
To maintain equilibrium, interest
rates must fall to stimulate
domestic investment

The IS Curve

The IS curve reflects the

negative relationship
between output and
interest rates in goods
markets

The IS Curve

The IS curve reflects the

negative relationship
between output and
interest rates in goods
markets
An increase in the
government deficit
increases interest rates (to
increase private savings
and discourage private
investment) and raises
income (to further
stimulate domestic savings)
IS curve shifts right

The Balance of Payments

Recall, that the balance of payments

equilibrium is given by
CA = KFA

That is, a trade deficit (surplus) must be

matched by an equal capital inflow
(outflow)
CA is increasing in income and
decreasing in the interest rate while KFA
is increasing in the interest rate

The Balance of Payments

Rising income
worsens the trade
deficit. To attract
foreign capital,
interest rates must
increase an upward
sloping balance of
payments curve

The Balance of Payments

A currency
depreciation
improves the trade
deficit and, hence,
shifts the BOP curve
to the right

Capital Mobility & BOP

Low mobility of
capital creates a
very steep BOP
curve (large interest
rate increases are
required to attract
foreign capital)

Capital Mobility & BOP

High mobility of
capital creates a
very flat BOP curve
(small interest rate
increases attract
foreign capital)

Putting it all together

An equilibrium is
a combination of
(e,r,and y) that
clears all three
markets.

Exchange Rates & Money

Shocks

Suppose the Federal

Reserve increases
the Money Supply by
10%
In the long run, the
dollar will depreciate
by 10% (the classical
solution), but what
about the short run?

Exchange Rates & Money

Shocks

The increase in
money shifts LM to
the right. This lowers
interest rates and
raises output

Exchange Rates & Money

Shocks

The increase in money

shifts LM to the right.
This lowers interest
rates and raises output
Further, the
combination of lower
interest rates (deters
capital inflow) and
increased income
(induces more imports)
creates a BOP Deficit

Exchange Rates & Money

Shocks

Therefore, the dollar

must depreciate to
correct the
imbalance shifting
the BOP curve to the
right

Interest Parity

Recall that assets must always pay

equal same currency returns. How
should the exchange rate respond to a
falling interest rate?

Interest Parity

Recall that assets must always pay

equal same currency returns. How
should the exchange rate respond to a
falling interest rate?
(r r*) = % change in e($/L)

Interest Parity

Recall that assets must always pay

equal same currency returns. How
should the exchange rate respond to a
falling interest rate?
(r r*) = % change in e($/L)

A falling interest rate should cause a

dollar appreciation

Summing Up

The 10% increase in the money supply

creates a long run 10% depreciation of
the dollar
In the short run, low interest rates and
rising output create a BOP deficit which
depreciates the currency
However, at some point, the dollar must
appreciate.
How do we reconcile these facts?

Exchange Rate Dynamics

1.6
1.4
1.2
1
0.8

Nominal

0.6
0.4
0.2
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

How about the real

exchange rate?
Recall

that in the short run, the

real exchange rate exactly mimics
the nominal exchange rate.
In the long run, however, as prices
adjust, the real exchange rate
returns to its long run value of one.

Exchange Rate Dynamics

1.6
1.4
1.2
1

Nominal
Real

0.8
0.6
0.4
0.2
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Keynesian Economics and

Exchange Rates
The

strong correlation between

real and nominal exchange rates is
due to short run price rigidities.
Exchange rate volatility is due to
short run BOP changes and interest
rate parity.

Government Deficits

Suppose that the

government deficit
increases.
The long run impact
should be zero.

Government Deficits

However, in the short

run, the IS curve shifts
right output increases
and interest rates rise.
In this example, the
worsening of the trade
deficit is more than
offset by higher interest
rates attracting foreign
capital. A balance of
payments surplus is
created.

Summing up
The

long run effect is zero

In the short run, a BOP surplus is
created causing a currency
appreciation
However, interest parity suggests
that higher domestic interest rates
imply a currency depreciation

Exchange Rate Dynamics

1.2
1
0.8
Nominal
Real

0.6
0.4
0.2
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Deficits and Low Capital

Mobility

Consider the
previous example,
but with a lower
capital mobility.
Now, due to lower
capital inflows, a
short run BOP is
created causing a
currency
depreciation.

Exchange Rate Dynamics

1.4
1.3
1.2
Nominal
Real

1.1
1
0.9
0.8
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Keynesian Economics and

Exchange Rates
The strong correlation between real
and nominal exchange rates is due
to short run price rigidities.
Exchange rate volatility is due to
short run BOP changes and interest
rate parity.
Capital mobility is responsible for
much of the exchange rate volatility