How to Graphically Analyze Exchange Rates This Monetary Model can be used to analyze the effect of domestic and foreign events on the spot value of one’s own currency exchange rate GO to next

S tep 2: What do they want? e RET we focus on their choice of which asset to obtain the highest expected returns: domestic &/or foreign ? e RET S tep 3: What is the PRICE of the thing? * cost per $ asset (to foreigners )) E* $ S tep 1: Who is in the market for foreign currencies? savers: mainly major financial intermediaries go to next To buy a dollar-denominated asset, foreigners have to pay E*/$ (the indirect quote of the $). An appreciation of the dollar is measured up. The higher E is, the more dollar assets cost to foreigners. To buy a foreign-currency denominated asset, Americans pay 1/E (= e, the direct quote of the $, or the dollar cost of one unit of foreign currency). An appreciation of the foreign currency is measured down. The lower E is the more foreign assets cost to Americans. cost per foreign asset to Americans 

S tep 5: Add the Liquidity Preference graph to show i$ determination. e RET E S tep 4: What is the return on domestic assets? e RET($) = i$ go to next =i$ M1 MdMd MSMS This is the return on $ assets (to Americans) no matter what E is (so it is a vertical line). i$

since it is positively related to E, it is an upward sloping line e RET E S tep 6: What is the return on foreign assets? e R* = (1+i*)E/ e E - 1 go to next on domestic or foreign assets, both in terms of dollars M1 MdMd MSMS Step 7. Indicate the equilibrium exchange rate i$ EoEo The expected return on foreign assets is positively related to E because the stronger the dollar currently is, the cheaper foreign assets are relative to their long run value. Buying them cheap and selling them later earns the holder capital gains.

Step 8. What are the effects of the event on the expected returns on dollar and/or foreign assets? Example Event: What will be the effect of the Fed’s expansion of the money supply on the value of the dollar? Does  M s affect R D (i$)? Yes: an expansion of the money supply, all else equal, causes interest rates to fall in the short run (Ch5: liquidity effect), and interest rates to rise in the long run (Ch5: expected inflation and price level effects). Does  M s affect R F ( e R*) ? Not directly, but indirectly. From PPP, the increase in the U.S. price level due to M s growth will force a depreciation of the dollar in the long run, so, expect depreciation of the dollar now. This increases e R* now. Step 9: Illustrate these effects on your graph,go to next

1. expand the money supply e RET E e R* = (1+i*)E/ e E expect inflation: by PPP, expect dollar depreciation  e R* increases M1 M d =f(i; Y, e , P ) MSMS 3. Get inflation (long run Price level effect)  Md Md increases and i$ rises i$ EoEo liquidity effect: i$ falls in the short run short run i$ long run i$ E long run overshooting: the initial depreciation due to the MS MS expansion exceeds the ultimate depreciation of the dollar. go to next

Step 10. SUMMARIZE: Expansion of the dollar money supply leads to short run depreciation that overshoots a long run depreciation of the dollar. back to Kilkenny’s 353 web page start over