ECON3066 International Money and Macroeconomics
Tutorial 1 Solution
The solutions provided here only serve as brief guidance for students to have a sense of what is
expected in answering the tutorial questions. Students are encouraged to have their own extended
answers.
1. Using the simple monetary model in which the demand for real money balances is a function of
only output, study the effects of a foreign price increase under both flexible and fixed exchange
rates.
Solution guidance: The monetary model contains two main relationships, one is aggregate
demand for money:
Md
= kY,
P
and the other is aggregate supply of money:
F X + DC = M s .
In equilibrium, supply of and demand for money must be equal:
M s = M d = kP Y,
which can be rearranged into
Ms
P = .
kY
To determine the exchange rate, we rely on the assumption of purchasing power parity (PPP):
P Ms
S= = .
P∗ kP ∗ Y
(Potential implications of PPP may be discusses here.) Under floating exchange rate regime, the
exchange rate is determined by the market, and is affected by both domestic financial market
conditions and the foreign price level.
In the above monetary model, a rise in the foreign price level P ∗ , other things being equal,
is associated with an appreciation of the domestic currency - a fall in the price of foreign
exchange rate, S. This is clearly seen by examining figure 4 in lecture 2, where the PPP line
rotates upwards. At the same time, aggregate supply of and demand for money is not affected,
thus there is no other change in the domestic economy. The floating exchange rate acts like a
valve, continually sliding up or down as required to preserve PPP in the face of disturbances
originating in either country’s domestic money markets.
Under the fixed exchange rate, most of the setups laid out above are the same except that now
the domestic price level is determined by the world money market as follows:
P = S̄P ∗ .
An increase in the foreign price level leads to the appreciation pressure on the exchange rate. To
maintain the fixed exchange rate, the domestic monetary authority has to expand the money
stock in order to increase the domestic price level, which in turn depress the exchange rate.
Specifically, the domestic monetary authority has to create credit to match the increased demand
for money. This reminds us of the “policy trilemma” that we have learned in class.
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ECON3066 International Money and Macroeconomics
Tutorial 1 Solution
2. With reference to the asset approach to the exchange rate, we obtained:
∞
1 X η j−t
st = ( ) Et (mj − φyj + ηi∗j+1 − p∗j ).
1 + η j=t 1 + η
Assuming the money supply process:
mt − mt−1 = ρ(mt−1 − mt−2 ) + t
,
where 0 ≤ ρ ≤ 1 and is a serially uncorrelated mean-zero shock such that Et−1 (t ) = 0.
Illustrate how sensitive the exchange rate can be to expectations. To simplify, assume that y,
i∗ and p∗ are all zero.
Solution guidance: Make use of the simplification assumptions, we have:
∞
1 X η j−t
st = ( ) Et (mj ).
1 + η j=t 1 + η
Lead the above equation one period forward and take the expectation, we have:
∞
1 X η j−t
Et [st+1 ] = ( ) Et (mj+1 ).
1 + η j=t 1 + η
Take the difference of the exchange rate to get:
∞
1 X η j−t
Et [st+1 ] − st = ( ) Et (mj+1 − mj ).
1 + η j=t 1 + η
Substitute the money supply process into the above equation and make use of the assumption
that Et−1 (t ) = 0, we have:
ρ
Et [st+1 ] − st = (mt − mt−1 ).
1 + η − ηρ
Recall that the demand for money is given by:
mt − pt = −ηit+1 + φyt ,
with PPP and UIRP
pt = st + p∗t ,
it+1 = i∗t+1 + Et (st+1 ) − st ,
together with some algebra, we can derive the following results:
−η(Et (st+1 ) − st ) = mt − p∗t − φyt + ηi∗t+1 − st
Remember that −p∗t − φyt + ηi∗t+1 = 0 by assumption, we have:
1
Et (st+1 ) − st = (mt − st )
−η
ECON3066 International Money and Macroeconomics
Tutorial 1 Solution
Substitute the above equation into the expected exchange rate change to get:
ηρ
st = mt + (mt − mt−1 ).
1 + η − ηρ
This equation shows that an unanticipated shock to mt may have two impacts. It always
raises the exchange rate directly by raising the current nominal money supply. When ρ > 0,
it also raises expectations of future money growth, thereby pushing the exchange rate even
higher. Thus, the simple monetary model provides us with some insight on how instability in
the money supply could lead to proportionally greater variability in the exchange rate.
