CHAPTER - 5

International Finance
and Money
• Money functions mainly as a medium of
exchange, facilitating trade between
consumers and firms. We all trade our labor
for food and housing, using the medium of
money in the form of paychecks, bank
deposits, checks, and cash.
• We all know how it feels to have less of the
medium at our disposal than we would like.
This scarcity of money reflects the world's
scarcity of resources and the unavoidable
necessity of making choices.
• Income for an individual consumer or firm
may be greater during a particular year than
the desire to spend.
• Markets for loanable funds develop through
the interaction of potential lenders and
borrowers.
• The interest rate is the price or return of a
loan. Banks and other financial
intermediaries bring together those who
currently have either more or less cash than
they want to spend.
• A nation is composed of individual
consumers and firms and may as a whole
have more or less income than it wants to
spend during a given year.
• One nation can become a net lender and the
other a net borrower, with loans flowing
internationally.
• International banks are the mechanisms
through which these international loanable
funds flow.
• Each nation would have its own
loanable funds market in autarky, but
both nations benefit through an
international loanable funds market.

• International interest rates are

established when free international
lending and borrowing exist.
• Besides its role as a medium of
exchange, money functions as a unit of
account for the goods and services an
economy produces.
• Currencies effectively serve as a unit of
account for each other in the foreign
exchange market.
• International price comparisons must
be made through the exchange rate.
• Money also serves as a store of value. An
inflating currency loses value and is a poor
store of value.
• Currencies with relative high inflation rates
depreciate in the foreign exchange market.

• A large amount of currency trading takes

place as investors look for the currency that
will be the best store of value.
• International financial flows are reported in
the capital account of the balance of
payments.
• Interest payments on previously made
international loans are reported in net
investment income of the current account
because the funds are available for current
transactions.
• Borrowing nations experience cash inflow
and capital account surpluses but are
committed to future investment income and
current account deficits.
• Lenders experience cash outflows and
capital account deficits but enjoy future
investment income and current account
surpluses.
• International loans are used to
purchase productive machinery and
equipment or consumer goods and are
associated with balance of trade (BOT)
deficits.
• While often interpreted as bad news, a trade
deficit and international debt may be a signal
that a nation is expected to grow.
• Developing nations should be expected to
incur debt in order to acquire needed capital
goods. Investors will want to have interest in
an economy that is expanding because
ownership of a growing enterprise can create
sizeable gains. As output expands, a growing
country can repay its debt more easily.
• Students similarly take out loans (a capital
account surplus) and spend more than they
make (a current account deficit). Later, with a
good education and high-paying
employment, paying off the loan causes
relatively little strain.
• Income is higher over the person's lifetime
because the debt was assumed.
• There is an optimal amount of debt that a
nation should acquire for growth.
• Debt is harmful only if it is not managed well.
Some commentators argue that late1980s
U.S. borrowing is harmful, since it has been
carried out to finance current consumption
rather than investment for growth.
• The issue of concern is whether the United
States can manage its debt.
• Stocks, bonds, certificates of deposit, and
overnight paper are some the financial
instruments involved in international finance.
• If a firm in the United States wants to raise
money for a new building, it can offer new
stock or bonds on the market.
• Investors buy this paper to receive returns
over time.
• Investors give up cash in hand for more
cash later in the form of dividends on
stocks or premiums on bonds. When
such transactions occur internationally,
they typically clear the foreign
exchange market and affect exchange
rates.
• On the other hand, the exchange rate
influences international finance flows.
• Suppose the home currency
depreciates. Foreign lenders may then,
want to buy more home stocks and
bonds because they have become
cheaper in terms of the foreign
currency.
• The appreciating foreign currency
makes home assets cheaper in the
foreign country. A depreciation
immediately encourages a nation to
become more of a borrower. An
appreciation causes foreign financial
instruments to become cheaper and
immediately encourages the nation to
become a lender.
• The international market for loanable
funds and the foreign exchange market
are closely related.
• A tremendous amount of arbitrage
trading occurs internationally among
financial intermediaries (banks,
investment houses, and brokers).
• The primary positive role governments
should play in these international
financial markets is to control their
money supplies.
• A government central bank has the job
of controlling its country's money
supply.
• A nation whose money supply is
growing relative to the rest of the world
will experience currency depreciation.

• Both domestic and international

markets for loanable funds, as well as
the foreign exchange markets, are
affected by central bank action.
 Capital and International
Loanable Funds
• This section
– examines how markets for loanable funds
develop,
– considers the international market for
loanable funds, and
– describes the scheme of international
financial accounting.
 What is Capital?
i. The Two Senses of "Capital"
• Capital has different meanings in
microeconomics and finance.
• In micro economics, capital is a factor
of production, namely the machinery
and equipment combined in production
processes along with labor and natural
resources.
• In finance, capital refers to loanable
funds.
• When you read a newspaper or
magazine that refers to international
capital flows, it is referring to
international lending and borrowing.
• The word "capital" is most commonly
used in this financial sense
• The two uses of the word are closely
connected. When a firm borrows from a
bank, it is likely to invest in productive
capital equipment in order to increase future
production.
• A firm could try to borrow to pay current
labor or material expenses, but this would
indicate losses. A firm could not do this for
long because banks will not make loans to
firms with current losses.
• To receive a loan, a firm must convince a
bank that the loan will be repaid.
• By investing in new capital equipment,
a firm increases its earning potential.
• Since loans are most often used to
purchase new machinery and
equipment, the two senses of "capital"
go hand in hand.
• Economic agents are faced with the
dilemma of choosing between current
and future spending. This applies to
consumers, who can put off current
consumption by saving out of their
current income or increase current
consumption beyond current income
by borrowing.
• Governments can also increase their
current spending beyond tax revenues
by borrowing and selling new bonds.
• Government bond sales bring cash into
the government's coffers but represent
obligations for future payments.
• A government can also save by
spending less than its tax revenue.
• Firms can use a portion of current cash
profit for their own investment
spending, or they can become lenders
in the market for loanable funds.
• If a firm lacks cash to fund a worthwhile
investment project, it can borrow in the
loanable funds market.
• A firm deciding whether to invest in a project looks
at the project's rate of return. This is found by first
estimating the profit created by the project over its
lifetime. Suppose a new machine is expected to
create added revenue of $100,000 per year. Labor to
run the machine costs $40,000 per year,
maintenance $5,000, and material $15,000. The net
cash profit from the machine would be $40,000 per
year. For simplicity, suppose the machine has an
indefinitely long lifetime and there is no inflation.
The net benefit of the machine is the $40,000 per
year it adds to profits indefinitely. The machine costs
$1 million, and its rate of return is 4%.
• To determine whether installing the machine is
worthwhile, we must consider the opportunity cost
of $1 million. Suppose the current interest rate is 3%
in the loanable funds market. With no inflation, this
is a real rate of return. If our firm has $1 million cash
on hand, it can become a lender and earn $30,000
per year, which is less than the machine would add
to revenue. The benefit of buying the machine
outweighs the cost, and the firm will buy the
machine. If the market interest rate were 5%, the firm
could earn $50,000 yearly through becoming a lender
and would not buy the machine
• A general principle is that investment
spending varies inversely with the interest
rate.
• Firms examine the rate of return on potential
investment projects and compare it with the
market interest rate. Any firm is a potential
lender or borrower, depending on the rates
of return of its potential projects and the
interest rate.
• When there is inflation, investors calculate
the real interest rate, which discounts the
expected effect of inflation.
• Demand in the loanable funds market comes
largely from the investment opportunities of
firms.
• Financial capital is translated directly into
productive capital by firms borrowing to
invest in new projects. This is the link
between the two senses of the word capital
ii. The Loanable Funds Market
• If the real interest rate is 2 %, more money
will be borrowed than if the rate is 5%.
• As the cost of borrowing increases, the
quantity of loanable funds demanded
decreases.
• On the other hand, at higher real interest
rates more people are willing to save their
income and forgo current spending for future
spending.
• The quantity of loanable funds supplied
increases with the return to saving.
• These two market forces of demand
and supply in the loanable funds
market are illustrated in Figure 5.1. The
real interest rate r represents the price
of borrowing to demanders and the
return on a loan to lenders.
• The real interest rate equals the
nominal interest rate minus expected
inflation.
• The Fischer equation tells us the real interest
rate r is the difference between the nominal
interest rate and expected inflation. When r =
5 %, saving $100 today results in $105 of
purchasing power after one year. The
nominal interest rate might be 11 %, with an
expected inflation rate of 6%. From the
borrower's viewpoint, it costs $5 worth of
current goods and services to borrow $100
for a year. From the lender's viewpoint, $5
worth of goods and services can be gained
by giving up $100 for a year.
 Figure 5.1 The Domestic
Loanable Funds Market

6%
5%
4%

8 10 12 $ bil
• Figure 5.1. The Domestic Loanable Funds Market
The real interest rate r represents the expected
return of an investment after inflation. The demand
for loanable funds (LF) is based on the marginal
efficiency of various investment projects, which can
be lined up in order of decreasing expected returns.
When higher real interest rates must be paid, the
quantity of LF demanded falls. The supply of LF
comes from those with liquidity who must sacrifice
current spending to make a loan. With higher real
interest rates, the quantity of LF supplied rises.
Equilibrium occurs where the demand for LF equals
the supply of LF, at r = 5% with $10 billion of loans.
• Note that in Figure 5.1, at a real interest
rate of r = 4%, the quantity of loans
demanded ($12 billion) is greater than the
quantity supplied ($8 billion). Banks and
other financial intermediaries perceive this
excess demand of $4 billion for loans.
They respond to this excess demand or
shortage by rationing their loanable funds
and raising the interest rate from 4%
toward 5%.
• If the interest rate were 6%, there would be an
excess supply or surplus of loanable funds
amounting to $4 billion. Banks would not be able
to loan out their reserves. Idle excess reserves
would spur banks to lower interest rates to
encourage potential borrowers. The market
equilibrium interest rate in Figure 5.1 is 5%, the
rate at which the quantity supplied of loanable
funds just equals the quantity demanded and
$10 billion worth of loans are made.
 iii. The International Loanable
Funds
• Financial intermediation is becoming an
international activity.
• Lenders and borrowers in different nations
increase their interaction as banks become
more integrated internationally.
• In most nations it is possible to hold bank
accounts in foreign currencies. The United
States quietly began this practice in the
summer of 1989.
• The central issue in the international
loanable funds market is a comparison of the
level of real interest across nations.
• If the interest rate in the rest of the world is
4% and the nation in Figure 5.1 can acquire
as many loans as it wants at that rate, an
inflow of $12 billion - $8 billion = $4 billion
will occur. This inflow is recorded as a
capital account surplus. The nation as a
whole would be borrowing internationally.
• If the world interest rate is 6%, a
national excess supply of $4 billion of
loanable funds will be exported. This
outflow is recorded as a capital
account deficit, with the nation lending
internationally.
 iv. International Financial
Accounting
• Yearly estimates of the international flow of
loanable funds are made by governments
and by international agencies like the United
Nations, the IMF, and the World Bank. These
financial flows enter into the capital account
of the balance of payments as foreign
investment. For borrowing nations, the
capital account reports a surplus (a positive
number in the balance of payments).
• Lending nations report a deficit in their
capital account because cash is flowing out.
• Net investment income on foreign
investment also enters into the balance of
payments. When a Japanese investor buys
stock in General Motors, a yearly return is
expected. These dividend payments enter as
a negative amount in U.S. net interest
payments.
• When someone in the United States
holds a German government bond,
interest payments enter as a surplus
for the United States.
• Payments on international loans enter
into net interest payments in the
current account.
 International Finance and the
Foreign Exchange Market
• International financial transactions
involve the exchange of currencies
through the foreign exchange market.
• Exchange rates both affect and are
affected by international financial
transactions.
• When the exchange rate changes, the
prices of foreign financial assets
change.
• On the other hand, if international
investors start buying the stocks and
bonds of a particular currency, its
currency will appreciate.
• This section examines the links
between the exchange rate and
international financial transactions
 i. International Portfolios
• A large volume of international
financial transactions occurs daily.
• Wealth holders trade the financial
assets of other countries.
• These international transactions for the
most part are carried out electronically
between large international banks and
financial intermediaries.
• Wealth holders want to adjust their portfolios
or asset holdings to avoid overexposure in a
particular currency.
• Consider the position of an international
bank that keeps deposits of numerous
currencies. If the international bank
exchanged all of its cash for one currency
and that currency depreciates on the foreign
exchange market, the bank loses.
• International financial transactions
occur because of international trade
(forward exchange rate hedging),
international investment spending by
firms, and international portfolio
diversification (wealth holders buying
the stocks and bonds of another
country).
• Banks and other financial
intermediaries perform arbitrage across
credit and exchange markets, looking
for profitable transactions involving
foreign currencies and international
interest rates.
• Close links naturally develop between
the international financial market and
the foreign exchange market.
• Changes in the exchange rate
immediately affect the price of one
nation's stocks, bonds, and other
financial assets in other nations.
• Suppose the nominal interest rate is 20% in a
foreign nation that has pesos as its currency.
• The present value of a perpetuity bond
paying 100,000 pesos per year indefinitely
would be 100,000/0.20 = 500,000 pesos.
• A perpetuity bond pays a yearly premium
indefinitely. If you had 500,000 pesos in the
bank in that country, you could earn 100,000
pesos interest every year, leaving the
principal intact.
• Suppose the current spot exchange
rate is e = $/peso = 0.002, and both the
dollar and peso have the same inflation
rate. The dollar price of this perpetuity
bond would then be 0.002 X 500,000 =
$1,000. An unexpected dollar
appreciation to e = 0.0015 would
decrease the price of the bond to
0.0015 X 500,000 = $750 (if no more
appreciation is expected).
 ii. Discounting International
Earnings by Expected Depreciation
• The issue on an international investor's
mind is what the 100,000 peso premium
will be worth at the end of each year as
the perpetuity bond pays off. Suppose
the market expects the inflation rate in
pesos to remain at its historical level of
20%, while the dollar's inflation rate is
expected to be 8 %. The peso, in other
words, is expected to lose 12 % of its
value every year against the dollar.
• The 100,000 peso yearly earning from
the bond will be worth $200 at today's
exchange rate of e = 0.002.
• One year from now the 100,000 peso
premium is expected to be worth only
88% as much, or $176.
• Two years from now, the 100,000 peso
premium is expected to be worth only
88% of that, or $176 X 0.88 = $154.88.
• The value of the bond to an investor
interested in a dollar return must be
discounted by the additional 12% per year.
The present value of the bond is thus only
100,000/(0.20 + 0.12) = 312,500 pesos.
• At the current exchange rate of $/pesos =
0.002, this peso bond would sell in the United
States for $625.
• If the peso and the dollar had the same
inflation rate, the peso bond would sell for
$1,000.
• Higher discounts of the peso cause the
dollar price of the foreign bond to fall.
• Risk discount may also be associated with
the peso bond. Suppose peso bonds have a
history of defaulting 12% of the time,
whereas dollar bonds default an average of
only 4% of the time. An additional 8% risk
discount would be placed on the value of the
peso bond relative to U.S. bonds.
• The present value of the peso would be
100,000/(0.20 + 0.12 + 0.08) = 250,000
pesos.
• At the current exchange rate, the peso
bond would sell for $500.
• International differences in risk
premiums help investors arrange their
international portfolio.
• While the degree of risk in international
portfolios can be high when they
contain foreign stocks or bonds, the
returns are high.
• Levels of international investment have
increased substantially during the past
two decades.
iii. The Foreign Exchange Market
and International Investment
• The effect international financial
markets have on the foreign exchange
market is pictured in the market for
Korean won in Figure 5.2. Demand for
won is based in part on domestic
investors who are potential buyers of
Korean financial assets, stocks, and
bonds.
• Part of the demand for won comes from U.S.
investors who are potential buyers of Korean
financial assets.
• As the exchange rate $/won rises, the price
of Korean assets in the United States rises,
the quantity of Korean assets demanded in
the United States falls, and the quantity of
won demanded falls. The demand for won
thus slopes downward.
Figure 5.2 International Finance and
the Foreign Exchange Market
S Foreign
$/won International
Investors

0.0015 D Domestic
International
Investors
Q won
• Figure 5.2. International Finance and the Foreign
Exchange Market Demand for won slopes downward
partly because a lower $/won exchange rate creates
cheaper Korean assets in the United States. The
quantity of won demanded to buy Korean assets
increases. Supply of won slopes upward partly
because a higher $/won exchange rate creates
cheaper U.S. assets in Korea. The quantity of won
supplied to buy U.S. assets increases. Changes in
investment opportunities in the United States or
Korea shift the supply and demand for foreign
exchange, causing exchange rate adjustment.
• The supply of won comes from Korean
investors who are potential buyers of
U.S. assets. As $/won rises, the price of
domestic assets in Korea falls, the
quantity of U.S. assets demanded in
Korea rises, and the quantity of won
supplied rises. The supply of won thus
slopes upward.
• International investment contributes to the
structure of supply and demand in the
foreign exchange market.
• Suppose the expected return on Korean
investments rises because of an announced
policy of more liberalized trade in Korea.
Investors in the United States will want to
buy more Korean stocks and bonds because
Korean exporting firms are expected to
prosper under the new economic policy.
• A higher expected return on Korean
stocks and bonds will increase their
price because of increased demand.
The demand for won also rises,
causing the won to appreciate and
further raising the price of Korean
assets to U.S. investors.
• This type of change in the exchange
rate complements adjustment in the
financial markets. Changes in the
exchange rate work in the same
direction as changes in the price of the
assets, complementing the underlying
forces in the international asset
markets.
• Suppose the expected return on U.S.
investments rises because of spending
on new plant and equipment by U.S.
firms and forecasts of a coming
expansion. Korean investors will want
to buy more U.S. assets, increasing the
supply of won. This depreciates the
won, which in turn raises the price of
U.S. assets in Korea
• The foreign exchange market works in
the same direction as the underlying
asset market.
• This is a fundamental lesson in
international financial economics.
• Government exchange rate policy is
not required to balance international
financial markets and will hinder this
complementary adjustment process.
 International Money
• Money is a vital commodity for economic
activity.
• The high degree of specialization in modern
society would be impossible without a
medium of exchange. This section examines
the link between money and the price level.
• Inflation occurs when the price level (the
average price of all goods) rises, causing the
value of money to fall.
• International commerce depends on a
reliable monetary system.
 i. What is Money
• Money is anything which performs the
basic functions of money:
– medium of exchange,

– store of value, and

– unit of account.
• Money as a medium of exchange makes commerce
possible. Imagine how difficult it would be to barter
or trade directly for everything you wanted. Only the
most primitive societies get by completely with
barter, with families trading hides for corn, meat for
labor, and so on. Money allows people in an
economy to specialize more and to trade with one
another. International trade and finance requires an
international mechanism for trading the mediums of
exchange. There must be a medium of exchange
across borders, some mechanism to exchange
different mediums of exchange. The foreign
exchange market performs this vital function.
• Money as a store of value allows economic agents
(consumers and firms) to put off purchases until a
later date. If you are paid every Friday, some money
must be kept through the following Thursday. During
this time, money acts as a store of value,
representing potential purchases through the week.
If you are paid once a month, your money has to
store value that much longer. A currency that is
inflating quickly acts as a poor store of value. In
countries suffering hyperinflation, tremendously
high inflation rates, people scramble to spend cash
before it loses value.
• Money also serves as a unit of account
or a unit for measuring the value of the
vast array of goods and services. This
car is worth $20,000, that shirt $25, a
night on the town $50, and so on. In a
particular society, people become
accustomed to valuing goods and
services in their currency. They are
ready to make and accept payment in
their currency.
• Only things that can perform money's
functions are able to serve as money.
• Bricks would be a good of value but are
too heavy to act as a practical medium
of exchange. Ice cream would be easier
to carry but would not work well as a
store of value.
• While money can be created by private banks and financial
intermediaries, money today is universally controlled by
government central banks. A government's monetary policy
controls the monetary base. The banking system in market
economies is made up of private commercial financial
intermediaries that accept deposits and make loans. Financial
intermediation facilitates lending and borrowing and effectively
expands the money supply. Still, the monetary base is
controlled by the central bank: the Federal Reserve Bank in the
United States, the Bank of England in the United Kingdom,
Bundesbank in Germany, National Bank of Ethiopia in Ethiopia,
Reserve Bank of India in India, and so on. The link between the
money supply and the price level determines how well a
currency can perform its basic functions. Money that does not
maintain its value becomes useless for both domestic and
international transactions.
• Paper clips would be good money if
their supply could be controlled.
• There has to be some mechanism to
limit the supply of money.
• If people could make their own money,
they would spend little time in other
pursuits and soon money would be
worthless.
 ii. Money and Prices
• The demand for money depends on its
value, or the goods and services that it
can potentially purchase.
• The price level P represents the
average value of all goods and services
in terms of the currency: P = $/good.
• The inverse of P, 1/P = goods/$,
represents the value or purchasing
power of money.
• As P rises, the purchasing power of money
falls in that less goods can be exchanged for
each dollar.
• When P rises, people want to hold less
money and switch to holding other assets
like stocks, bonds, gold, jewelry, and real
estate.
• Money that is losing its value or purchasing
power through inflation will not be demanded
as a store of value.
• The money market illustrates the quantity
theory of money, based on the quantity
equation
MV = PQ
• M is the supply of money and V is its velocity
(number of times on average a dollar
changes hands per year). The product MV is
the value of all transactions in the economy
for the year. On the other side, P is the price
level and Q is the quantity of output. The
product PQ is the value of all output or gross
national product.
• If M increases by 20% and both V and Q
are constant, P must increase by 20%
(like from 1.25 to 1.5). Velocity V is
generally constant.
• Real output is not greatly affected by
money growth as long as monetary
policy is stable and reliable. If M falls
by 20% and Q is unchanged, P would
then also fall by 20%.
• The quantity equation shows the strong
link between the supply of money and
the price level.
• Currencies whose supply is increasing
rapidly will, ceteris paribus, experience
more inflation than currencies whose
money supply is stable or growing
slowly.
Money and International Finance
• What exactly is the link among the
various money supplies of different
nations and international financial
flows? This section concentrates on
the exchange market as the
international transmitter of monetary
signals and on the effect of money on
international finance.
 i. Government Bonds and the
Money Supply
• A government creates debt with its
deficits when it spends more than its
tax revenue.
• Governments with deficits raise funds
by selling government bonds, which
are promises to pay the bondholder the
face value of the bond at maturity.
• A government with debt is a demander
in the loanable funds market.
• When the government enters the
loanable funds market, demand for
loanable funds rises, causing the
interest rate (the price of a loan) to rise.
• With the increase in the supply of
bonds, bond prices fall.
• Higher interest rates and lower bond
prices attract foreign investors.
• Demand for the domestic currency
rises, causing it to appreciate. This
currency appreciation can lead to a
current account deficit.
• This theoretical link between the
government deficit and the trade deficit
has been difficult to isolate empirically.
• Government deficits in the United
States during the 1980s and early 1990s
have been associated with current
account deficits, but the dollar has both
appreciated and depreciated and the
current account has both risen and
fallen.
• It should be stressed again that capital
account surpluses (current account
deficits) are typical for a nation with the
desire and potential for growth.
• This potential for future prosperity
most likely explains why foreign wealth
holders remain willing to invest in the
United States.
• The U.S. government finances its deficit
operations through expanding the money
supply.
• This monetary expansion is carried out
predominantly through open market
operations.
• The Treasury prints new bonds, selling them
to acquire cash to pay the government's
payroll and bills. Meanwhile, the Federal
Reserve Bank buys the new bonds, paying
for them with new money, which enters the
economy.
• The government is not compelled to
limit spending to its tax revenue.
• The Gramm-Rudman Act is an attempt
to get the U.S. government to operate
with a balanced budget. Many states in
the United States operate under
balanced budget requirements.
• International Money Supplies and the Price
Level
• In the late eighteenth century, David Hume
studied the long-run relationship among
national money supplies, prices, and trade.
The theory of the price specie flow
mechanism summarizes this relationship.
• When the money supply in one nation is
increased, the price level in that nation rises
and the value of that money falls.
• Higher prices cause the nation to
export less (since exports become
more expensive abroad) and import
more (since imports become cheaper at
home).
• The trade deficit creates an outflow of
money to the rest of the world.
• The increased supply of money spills
over into the rest of the world through a
trade deficit.
• Money supplies are internationally
interdependent in this way. Through
the influence of price, specie (currency)
flows internationally.
• The close link between the supply of
money and the rate of inflation is
illustrated by the quantity equation, MV
= PQ.
• Suppose $1 trillion is the nation's total
supply of money and $4 trillion the
level of real output of goods and
services. This is the approximate level
of money (Ml) and gross national
product in 1990 for the United States.
• On average, each dollar in the money
supply changes hands four times
during the year, since $4 trillion worth
of transactions are made. In the
quantity equation, GNP of $4 trillion is
equal to PQ. Using consumer price
index 1.25 as P (1982 = 1) the level of
real output is $4 trillion/1.25 = 3.2
trillion. This is the real output in 1990 in
terms of 1982 dollars.
• If the government increases the supply of
money while real output Q and money
velocity V remain constant, P must rise.
Suppose M rises to $1.1 trillion.
• By the quantity equation, MV = 4.4 and PQ =
3.2P Then P will be 4.4/3.2 = 1.375, a 10%
increase for both M and P.
• Milton Friedman, a leading U.S. economist,
has consistently argued since the 1950s that
an indisputable empirical link exists between
high money supply growth and inflation.
• Evidence of a positive relationship between the growth of the money
supply and inflation is overwhelming. When the money supply grows
faster, inflation will be higher.
• 3. Purchasing Power Parity and the Real Exchange Rate
• A direct link between the money supply and the foreign exchange
market can be seen when it is realized that prices are linked
internationally through trade. Some goods are not traded (such as
haircuts in Iowa), but most goods and services can be traded. This
means that purchasing power parity (PPP) should generally hold.
PPP is stated
• P = eP*
• where P is the home level, p* is the foreign price level, and e is the
exchange rate.
• There is solid empirical evidence supporting PPP, at least approximately over long periods. As
more non traded goods are excluded from the price indices P and P*, the PPP relationship
becomes stronger. Strictly, PPP says that traded goods cost the same across nations. When all
goods are freely traded, PPP is the law of one price, which simply says that arbitrage will equalize
the price of the same good across locations.
• Suppose P = 1.25 and p* = 1,250 lira. These are hypothetical price indices or average prices of all
traded goods and services in the United States and Italy. The real exchange rate comes from the
PPP relation:
• The real exchange rate in this example is er = $Ilira = 1.25/1,250 = 0.001. The real exchange rate
is used by currency traders in the exchange market to anticipate the fundamental direction the
market exchange rate is likely to take in the future. Suppose for instance the market exchange
rate is $Ilira = 0.002. The lira is then fundamentally overvalued in the market and can be expected
to depreciate. Using the market exchange rate, the U.S. price level 1.25 is less than eP* = 2.50.
Italian goods and services are overvalued by the market exchange rate. Italy will run current
account deficits at the market exchange rate, and the lira should depreciate. The Italian
government may try to delay this depreciation, which makes the job of predicting the time of a
devaluation difficult. Being able to successfully predict exchange rate changes would result in
large speculative profits in the forward exchange market.
• EXAMPLE 12.13 Purchasing Power Parity in the 1930s between the United States and the
United Kingdom
• A unique episode occurred in 1931 when the United Kingdom gave up the gold standard.
Speculation turned against the British pound, and its exchange value $/£ dropped by 30 %. The
U.S. dollar remained on the
• gold standard and appeared a safe haven for investors. Meanwhile, PIP*
rose by 10% as described by S.N. Broadberry (1987). PPP was thus 40%
out of line between the United States and the United Kingdom in 1932 and
1933. Finally, the United States dropped the gold standard, the pound
appreciated, and PIP* fell. By 1934 PPP held once again. In this instance,
PPP was a reliable guide to long·run movement in the exchange rates.
• 4. Relative Money Supplies and the Real Exchange Rate
• Figure 12.7 illustrates the theoretical relationship between the relative
money supplies MIM* of two nations and their real exchange rate PIP*. If M*
= 76 billion Swiss francs and M = $1,000 billion, MIM* = 13.2.
Corresponding to this relative money supply, PIP* = 1.12/1.07 = 1.05.
These are in fact the 1989 money supplies and consumer price indices
(1985 = 1) for Switzerland and the United States. If M increases by 10% to
$1.1 trillion with all outputs and M constant, P will rise by 10% to 1.232,
MIM* will rise to 1,100/76 = 14.5, and the real exchange rate PIP* will rise to
1.15. The Swiss franc, whose relative supply has fallen, would increase in
real value.
• The schedule in Figure 12.7 is upward sloping, illustrating the long· run
relationship among money supplies, price levels, and the exchange
• Figure 12.7. Money Supplies and the Real Exchange
Rate This schedule illustrates the theoretical link
between relative money supplies MIM* and the real
exchange PIP*. Purchasing power parity (P = eP*)
implies that the relative price PIP* is the real exchange
rate e,. Increasing the home money supply M relative to
the foreign money supply M* will raise MIM* and create
higher home prices relative to foreign prices. The real
exchange rate rises, which causes a real depreciation of
the home currency. If the exchange market value of the
dollar has not fallen, it can be expected to fall in the
future.
• rate. Nations with relatively high growth rates in their money supply will experience higher than
average inflation and currency depreciation when the growth of real output is constant. Higher
inflation creates a depreciating currency.
• The relationship in Figure 12.7 is empirically well established. A few of the nations with the highest
inflation rates and fastest depreciating currencies in recent history have been Brazil, Mexico, and
Israel. Nations that have had the lowest rates of inflation and have seen their currencies appre-
ciating relative to others are Germany, Japan, and Switzerland.
• If inflation jumps unexpectedly, as it did in the 1970s, debtors paying off fixed-term loans benefit
while creditors are hurt. Unexpected deflation has exactly the opposite effect, redistributing
income from debtors to creditors. If economic agents are able to anticipate the inflation rate, its
level has no real effect.
• When rates of inflation are steady and predictable, exchange rate changes will be consistent and
have little impact on international trade and finance.
• Economic variables can be reduced to real terms, and people learn quickly to think in real terms.
Businesses in Israel and along the Mexican border quote prices in U.S. dollars. This practice is
common in nations where the inflation rate is so high and erratic that daily or weekly price
changes are necessary just to keep up with generally rising prices.
• Central banks may be able to support temporarily the value of a currency that is rapidly inflating,
but they cannot do so indefinitely. Looking at the history of inflating currencies is the same as
looking at the history of depreciating currencies. Inflation rates value the currency against goods,
while exchange rates value the currency against other currencies.
• The Economist presents a yearly comparison of Big Mac prices in
various countries and uses this as a proxy measure of the real
exchange rate (PIP*). This may sound ridiculous, but Big Macs are
produced and priced locally and include a wide range of labor,
capital, and local intermediate inputs. In April 1989 the average price
of a Big Mac in the United States was $2.02. The figures below
indicate the dollar was undervalued against the won, yen, franc,
mark, and pound, while it was overvalued against the Canadian
dollar, Hong Kong dollar, Singapore dollar, and Yugoslavian dinar.
The dollar subsequently rose in value against the won, the yen, and
the European currencies, exactly as Big Mac PPP suggested it
would. In Singapore and former Yugoslavia the local currencies are
vastly overvalued at the official exchange rate. Black markets arise
accepting dollars at close to the real exchange rate.
• Controlling the Money Supply
• What makes a nation choose a particular growth rate for its money supply, price level, and
exchange rate? As Akira Takayama and other monetary economists consistently argue, the
money supply is an endogenous economic variable. This means money supply growth is the
result of economic processes, including central bank activity, commercial bank lending, private
spending, and so on.
• The primary job of the Federal Reserve Bank and other central banks is to control their nations'
money supplies. This is no trivial task. The Great Depression of the 1930s has been labeled the
Great Contraction by monetary experts. The money supply of the United States fell suddenly and
dramatically by 25%, an unprecedented event. There was little money, as anyone who was
around then would tell you. Add to this the Smoot-Hawley Tariff Act, which raised tariffs to an
average of 60 %, and the recipe for economic disaster is complete.
• Optimal control of the money supply is one of the central and most difficult problems of economic
policy. Economists at the frontier of the science wrestle with the problem of optimal money supply
control using theoretical and empirical tools. Comparative studies of the different growth rates of
money and economic processes influencing money supply growth across nations should help
supply clues about how to control the supply of money more successfully. A strong competitive
system of banking and financial intermediation is essential. The link between government deficits
and an increased money supply suggests that a government wanting to control the inflation of its
currency should control its spending.
• Hume's price specie flow mechanism emphasizes the point that no nation's money supply and
prices will be entirely independent of money growth and inflation in the rest of the world. In other
words, high inflation
• in developing nations will influence prices in the
industrial nations. A decline in the money supply
of developed nations will be felt through a
reduction in prices and money supply in the
developing nations. Issues of money supply and
demand are among the most elusive and difficult
in economics. As economists sharpen their
focus and policymakers use the improving tools,
the international monetary system will improve.
 The Determination of Exchange
Rates
• Exchange rates are determined under one of
the three major types of exchange rate
systems:
– Freely fluctuating
– Managed fixed, and
– Automatic fixed
• Factors that affect exchange rates include:
– Inflation
– Interest rate differentials, and
– Technical factors
 i. Freely Fluctuating Currencies
• Currencies that freely fluctuate respond to
supply and demand conditions relatively free
from government intervention.
• Demand for a country’s currency is a
function of the demand for that country’s
goods and services and financial assets.
• This concept can be illustrated using a two-
country model involving the United States
and Japan.
• Figure 5.3 shows the equilibrium
exchange rate in the market and then a
movement to a new equilibrium level as
the situation changes.
• The demand for yen in this example is a
function of U.S demand for Japanese
goods and services, such as
automobiles, and yen denominated
financial assets, such as securities.
• The supply of yen, which in this illustration is
tied to the demand for dollars, is a function
of Japanese demand for U.S. goods and
services and dollar - denominated financial
assets.
• Initially, the supply of and demand for yen in
Figure 5.3 meet at the equilibrium exchange
rate e0 (for example, 0.009 dollars per yen, or
111 yen per dollar) and the quantity of yen
Q1.
 Figure 5.3 Equilibrium Exchange Rate
Equilibrium exchange rate
Exchange rate moves from $0.009 per yen at
(US dollar/yen) e0 to $0.00917 per yen at e1 S’

S
e1
e0

D’
D

Q2 Q1 Q3 Quantity of yen
• Assume demand for U.S. goods and services
by Japanese consumers drops because of,
say, relatively high U.S. inflation. This would
result in reduced supply of yen in the foreign
– exchange market, causing the supply curve
to shift to S’.
• Simultaneously, the increasing prices of U.S.
goods might lead to an increase in demand
for Japanese goods and services by U.S.
consumers.
• This in turn will lead to an increase in
demand for yen in the market, causing the
demand curve to shift to D’ and finally
leading to an increase in the quantity of yen
and an increase in the exchange rate.
• Thus, the new equilibrium exchange rate
would be at e1 (for example, 0.00917 dollars
per yen, or 109 yen per dollar).
• From a dollar standpoint, the increased
demand for Japanese goods would
lead to an increase in supply of dollars
as more consumers tried to trade their
dollars for yen, and the reduced
demand for U.S. goods would result in
a drop in demand dollars. This would
result in a reduction in the dollar’s
price, indicating a devaluation of the
dollar.
 ii. Managed Fixed Exchange Rate
System
• In the preceding example, Japanese and U.S.
authorities allowed changes in the exchange
rates between their two currencies to occur
in order for currencies to reach a new
exchange-rate equilibrium.
• In fact, however, one or both countries might
not want exchange rates to change. For
example, assume the United States and
Japan decide to manage their exchange
rates.
• The U.S. government might not want its
currency to weaken because its
companies and consumers would have
to pay more for Japanese products,
which would lead to more inflationary
pressure in the United States.
• The Japanese government might not want
the yen to strengthen because it would mean
unemployment in its export industries.
• But how can the government keep the values
from changing when the United States is
earning too few yen? Somehow the
difference between yen supply and demand
must be neutralized.
• In a managed fixed exchange-rate system,
the New York Federal Reserve Bank would
hold foreign-exchange reserves, which it
would have built up through the years for
this type of contingency.
• It could sell enough of its yen reserves (make
up the difference between Q1 and Q3 in
Figure 5.3) at the fixed exchange rate to
maintain that rate.
• Or the Japanese central bank might be
willing to accept dollars so that U.S.
consumers can continue to buy Japanese
goods. These dollars would then become
part of Japan’s foreign-exchange reserves.
• The fixed rate could continue as long as the
United States had reserves and / or as long
as the Japanese were willing to add dollars
to their holdings.
 iii. Automatic Fixed Exchange
Rate System.
• As with the managed fixed exchange
rate-system, assume that Japan and
the United States agreed to maintain
fixed exchange rates by setting their
domestic money supplies on the basis
of the amount of reserves held by their
central banks and by denominating
their currency values in terms of their
reserve assets.
• Now suppose the United states has a
shortage of yen. Under an automatic fixed-
exchange rate system, the United States
hypothetically would sell gold to get the
needed yen.
• However, unlike with the managed system,
there would be automatic adjustments to
prevent the United States from running out of
gold.
• As the United States sold off some of its
gold, its money supply, which is tied to the
amount of gold it holds, would fall.
• This would lead to higher interest rates and
lower investment in the United States,
followed by increased unemployment and
lower prices.
• Meanwhile, the increase in gold in Japan
would have the opposite effect.
• The higher U.S. interest rates and the
decrease in U.S. prices relative to the
Japanese rate and prices would cause an
increase in the supply of yen in the United
States as funds flowed in for investment and
to purchase U.S. goods and services.
• This would result in a strengthening of
the dollar and a weakening of the yen.
• This system differs from the others in
that the adjustment of exchange rates
does not depend on government
intervention but rather on changes in
the domestic money supply.
• A change in exchange rate for a freely
fluctuating currency is more a function of the
supply and demand of the currency in the
foreign-exchange market than in the
domestic money market. Thus, although the
law of supply and demand can determine
exchange rates in an open market, many
governments intervene in the market to
influence exchange rate movements.
• Although the automatic fixed exchange
rate system is possible, it is not widely
used as freely fluctuating currencies
and managed fixed exchange-rate
system.
 Purchasing Power Parity
• Purchasing power parity (PPP) is the
key theory that explains the
relationships between currencies.
• In essence, it claims that a change in
relative inflation must result in a
change in exchange rates in order to
keep the prices of goods in two
countries fairly similar.
• According to the PPP theory, if for example,
Japanese inflation were 2 percent and U.S.
inflation were 3.5 percent, the dollar would
be expected to fall by the difference in
inflation rates.
• Then the dollar would be worth fewer yen
than before the adjustment, and the yen
would be worth more dollars than before the
adjustment.
• The following formula can be used to
relate inflation to exchange-rate changes:
et – e0 ih,t – if,t
=
e0 1 + if,t
• Where,
– e the exchange rate quoted in terms of the
number of units of the domestic (home)
currency for one unit of the foreign
currency (the direct rate)
– i the inflation rate
– h indicates the home country (in these
examples, the United States
– f indicates the foreign country (in these
examples, Japan)
– 0 indicates the beginning of the period.
– t indicates the end of the period.
• The anticipated future exchange rate is
given by

e (1 + ih,t )
et = 0
( 1 + if,t )
• For example, assume the consumer
price index (CPI) went from 100 to 103.5
in the United States and from 100 to
102 in Japan during a period when the
exchange rate at the beginning of the
period was 125 yen to the dollar, or
0.008 dollar per yen. The inflation rates
are:
• ih,t = (103.5 – 100)/100 = 0.035

• i f,t = (102 – 100)/100 = 0.02

• Now the formula above gives

• et = 0.008(1 + 0.035)/(1 + 0.02) = 0.00812

• The exchange rate at the end of the
period is 0.00812 dollars per yen or
123.2 yen per dollar.
• Thus the yen is worth more dollars, and
the dollar is worth fewer yen when
inflation is higher in the United States
than in Japan.
 Interest rates
• Although inflation is the most
important long run influence on
exchange rates, interest rates are also
important.
• To see the impact of interest rates it is
important to know two key theories of
finance:
– Fisher Effect, and
– International Fisher Effect
• The first links inflation and interest rates,
and the second links interest rates and
exchange rates.
• The Fisher Effect:
• Is the theory that the nominal interest
rate r in a country is determined by the
real interest rate R and the inflation rate
i as follows:

(1 + r) = (1 + R) (1 + i)
• According to this theory, if the real
interest rate is 5 percent, the U.S.
inflation rate is 2.9 percent, and the
Japanese inflation rate is 1.5 percent,
then the nominal interst rates for the
United States and Japan are computed
as follows:
r us = (1.05)1.029) – 1 = 0.08045 or 8.045
%
r J = (1.05)(1.015) - = 0.06575, or 6.575 %
 The International Fisher Effect (IFE)

• The theory that the interest rate differential is

an unbiased predictor of future changes in
the spot exchange rate.
• For example, the IFE predicts that if nominal
interest rates in the United States are higher
than those in Japan, the dollar’s value
should fall in the future by that interest rate
differential, which would be an indication of a
weakening, or depreciation of the dollar.
• The PPP attempts to deal with the
relationship of Inflation rate and Exchange
rate
• The Domestic Fisher effect deals with the
relationship between Inflation rate and
nominal interest rate
• The International Fisher Effect deals with
the relationship between Nominal Interest
Rate and the Exchange Rate
• (1+rh)t/(1+rf)t = et /e0
• Where et refers to the expected
exchange rate in period t
• For single period analogue (one year)
• (1+rh)1/(1+rf)1 = e 1/e0
• (1+rh) /(1+rf) = e1/e0
• Example, Forecast US$ and SFr Rates.
– In July, the one year interest rate is 4% on
Swiss Francs and 13% on US dollars.
– A) If the current exchange rate is SFr =
$0.63, what is the expected future
exchange rate in one year? 3 years?
– B) If a change in expectations regarding
future one year US inflation causes the
expected future spot rate to rise to $0.70,
what should happen to the US interest
rate?
• Exercise
– Br/$ = 10.12
– Interest rate in Ethiopia is 15%
– Interest rate in US is 12%
– Determine ER after 1 and 3 years
 Other Factors
• Various other factors can cause
exchange rate changes.
• One important determinant in a world
of political and economic uncertainty is
confidence. During times of turmoil
people prefer to hold currencies that
considered safe-haven ones.
• For example, during the political
uncertainty in Russia in 1996 because
of worsening health of President
Yeltsin, money flowed into the United
States and out of Germany because of
the concern over the safety of Western
Europe if a true crisis were to occur in
Russia.
• In addition to basic economic forces
and confidence in leadership, exchange
rates are also influenced by a number
of technical factors, such as
– The release of national economic
statistics,
– Seasonal demands for a currency,
– Slight strengthening of a currency
following a prolonged weakness, or vice
versa