One last time…wtf is it? Can someone direct me to a good example?
If a country increase their money supply, their currency will depreciate on the short run. However the effects reverse and currency will revert to long term level implied by PPP in the long run.
adding to it: think of it as: when a country increase their money supply, the interest rates will drop (loose policy) and people will take their money out of there because it earns less than somewhere else. Then over the long run, said country will become more competitive in international markets thus leading to an appreciating currency. I don’t know if it’s the right logic but it does work in my head
initially the short run move is too much…oveshoots… thus it later on moves towards the PPP in the long run…but overall effect is still a depreciation
Ok…So … I’m going to try doing this without a numerical example… Here’s all the information you need. 1. What is the current spot rate 2. What is the increase in money supply/inflation 3. How many years is that going to materialize in 4. What are the respective country interest rates. Note: For the country that announced the change in monetary policy - they should give you the new interest rate at t=0 Step 1. Take the Spot exchange rate and forecast your future expected exchange rate using your inflation/change in money supply percentage - Simple relative purchasing power parity formula of E(S1) = S0 * (1 + i dc)/ (1 + i fc) Note: Do not raise this to the power of the number of years unless they give you an annual inflation rate . Most likely it will say something like "Money Supply will grow at 5% over the next 3 years - that’s not 5% each year…it’s 5% over the next 3 years) Step 2. With the new Expected Exchange Rate - you back into the Current spot rate given the two interest rates of the respective countries. Basically - Interest Rate Parity formula here…except since you’re BACKING into the current (new) spot rate you’d put the (1 + Rfc) term in the numerator and the (1 + Rdc) term in the denominator, assuming your exchange rate is in DC/FC. In this case you raise it to the power of the number of years…because this is an annual rate… And viola!! You now have the new spot exchange rate at t=0 (which is now). This is the exchange rate that will occur when the announcement is made. The expected rate that you calculated earlier will happen in n numbers of years. Remember: If its an expansionary policy - You will see BIG depreciation in your new spot rate which will eventually appreciate to E(S1). E(S1) however will be lower than the spot exchange rate before the expansionary policy… does that make sense???
woww thanks !!! mumu good luck