1. U6018International Finance & Monetary TheoryRecitation 8 - 4/1/10Prof. richardclarida TA: Doug Dowson Email: dd2440@columbia.edu

2. Contents 2 Permanent Monetary and Fiscal Policy in the AA-DD Model Policy Choices in the AA-DD Model Open Economy IS-TR Model Is Bad News About Inflation Good News for the Exchange Rate?

3. Permanent Monetary and Fiscal Policy in the AA-DD Model 3 A permanent policy shift affects not only value of the government’s policy instrument (the money supply, government spending, or taxes) but also the long-run exchange rate which in turn affects the expected future exchange rate, Ee

4. Permanent increase in the money supply 4 A permanent increase in the money supply shifts the AA curve upward but it also causes the expected future exchange rate Ee to rise

5. Permanent increase in the money supply 5 In the short term, interest rates fall and aggregate demand increases  AA schedule shifts to the right (more than it would for a temporary increase in the money supply) Over time, prices rise  DD curve shifts to the left Rise in P also reduces the real money supply (Ms/P)  AA curve shifts to the left Eventually, the economy returns to full employment with a permanent domestic currency depreciation Theoretically, the exchange rate, E, and the price level, P, should rise in proportion to the increase in the money supply

6. Permanent increase in the money supply 6

7. Overshooting 7 Exchange rate overshooting is the tendency for an exchange rate to respond more in the short-run than the long-run to a change in the money supply

9. Policy Choices in the AA-DD Model In response to a recession, the central bank can lower interest rates causing a depreciation of the domestic currency, an increase in aggregate demand, and an expansion of output back to its full employment level 10

10. Policy Choices in the AA-DD Model 11 If central bank does nothing, domestic prices will eventually fall and both the AA and DD curves will shift to the right

11. Open Economy IS-TR Model 12 The IS-TR model explains how economic conditions influence monetary policy and the real exchange rate

12. Open Economy IS-TR Model 13 A central bank following a Taylor rule will raises real interest rate when the economy is booming and inflation is rising TR (Taylor Rule) schedule slopes up because ↑Y  ↑P  ↑R IS (Investment Saving) schedule slopes down because ↑R  ↓I  ↓Y UIP (Uncovered Interest Parity) schedule represents the relationship ↑R  ↓Q Recall that Q is the real exchange rate E(P*/P)

13. IS-TR Model: Inflation Shock 14 In response to an inflation shock, the central bank raises interest rates, GDP falls, and the real exchange rate appreciates

14. IS-TR Model: Fall in World Demand 15 In response to a fall in world demand, the central bank lowers interest rates and the real exchange rate depreciates

15. Is Bad News About Inflation Good News for the Exchange Rate? 16 According to PPP, in the long run, a country’s nominal exchange rate should depreciate in response to an inflation shock What about the short run? The textbook model says that an inflation shock will cause the nominal exchange rate to depreciate on impact

16. Is Bad News About Inflation Good News for the Exchange Rate? 17 The truth is that the nominal exchange rate can either depreciate or appreciate on impact, depending upon how aggressively the central bank raises real interest rates to bring inflation back to target The expectation of credible and sufficient monetary policy can cause a currency to appreciate in response to an inflation shock ↑π  ↑R  ↓E

17. Is Bad News About Inflation Good News for the Exchange Rate? 18 Clarida-Waldman find that for non-inflation targeting countries, there is no significant impact of inflation announcements on the nominal exchange rate For inflation targeting countries, higher than expected inflation can cause nominal exchange rate appreciation

18. Is Bad News About Inflation Good News for the Exchange Rate? 19 Conclusions: Higher than expected inflation can cause nominal exchange rate appreciation if the central bank has an inflation target that it implements with a Taylor Rule Inflation credibility matters for asset prices including exchanges rates and bond yields