How the Exchange Rate Will Respond When the Domestic Money Supply Decrease Happened Permanently and Anticipated

How the Exchange Rate Will Respond When the Domestic Money Supply Decrease happened Permanently and Anticipated

Since the post-second World War, an enormous capital markets have been developing rapidly, in this condition, more and more international investors would like to switch a huge amount of currency into another based on the expected rate of return of being in one currency compared to another (Pilbeam K, 2006:148). Nowadays, the exchange rate is among the most active of all financial markets and the speculators buy low and sell high their activity ensures that exchange rates reflect the fundamental or long-run determinants of currency values(Froot K.A & Thaler R.H, 1990). However, it is not easy to explain the exchange rates movements simply by the "changes in the supply and demand for national money stock" (Pilbeam K, 2006:148), so with building the monetary models, the exchange rate movements will be analyzed more successfully.

According to Levich, as the foreign exchange market is a forward-looking market, once a news item has occurred, traders need to concern whether the news represents a permanent change or only a transitory phenomenon (Levich R.M, 2001:186), so this paper will focus on how the exchange rates will react in related to the negative shock to the domestic money supply, when the shock is considered permanent and when the shock is expected respectively by outlined a monetary model-the sticky price model.

The sticky-price model, also called "overshooting model", which was introduced by Dornbush in 1976. Basically, the sticky price model implies that the prices in the good market and wages in the labour market only "tend to change slowly over time in response to various shocks such as changes in the money supply" (Pilbeam K, 2006:155) with the UIP condition holding continuously as assuming the estimate of future exchange rate changes provided by the interest differential, should be unbiased (Froot K.A & Thaler R.H, 1990).

According to Levich, it is said that "the speed of adjustment of goods prices is slow relative to the speed of adjustment of asset price" (Levich, 2001:200). For instance, when the BoE announces its money supply's changes, the traders and investors in financial markets will response quickly, adjusting the prices of securities and their portfolio positions until a new equilibrium is achieved. However, the managers of the stores might just ignore the money supply changes, and the prices will keep the same after the BoE announcement, but slowly, the prices will change due to the general inflation pressures. In this case, the shocks of the money supply will lead to the "exchange rate changes in the short run, but it returns to the original level in the long run" (Levich R.M, 2001:201). The figures below will show what happened to exchange rate over time in response to an anticipated, permanent decrease in the money supply of the domestic currency.

In such condition, suppose that the PPP hold in the long run and the economy is in full equilibrium, which means the domestic interest rates i and foreign interest rates i* are equal (Levich R.M, 2001:202), and the domestic money stock is given by M which gives a domestic price level P and exchange rate S.

Supposing that in the long run, a money supply decreasing takes place unanticipated at time T' from M to M', as "the domestic money supply determines the domestic price level, and hence, the exchange rate is determined by the relative money supplies" (Macdorald R & Taylor M.P, 1992),so the negative shock in money supply leads to an unexpected drop in price level from P0 to P', the decreasing price level causes to a rise in interest rate "in order to clear the money market" (Macdorald R & Taylor M.P, 1992) and then leads to money appreciation, therefore eventually the exchange rate appreciates by going from S0 down to S' to maintain PPP. However in terms of short run, Dornbush model shows very differently. If there is a decrease in the money supply, relative to the equation S = (m-m*) – ?(y-y*) + ?(r-r*), where S is the log of the exchange rate defined as domestic currency units per unit of foreign currency; m-m* is the money supply differential between domestic and foreign stock; y-y* is the income differential between domestic and foreign money stock and r-r* interest rate differential between two countries (Pilbeam K, 2006:153), will lead to a fall in S, that is to say a rise in the value of domestic currency in terms of the foreign currency. However, because the domestic price are sticky remaining at P0 , which means that the decrease in money supply at price P0 will cause a lack of