Comparative Statics: Money and FOREX Markets Combined

Comparative statics is any exercise examining how the endogenous variables will be affected when one of the exogenous variables is presumed to change, while holding all other exogenous variables constant. Holding other variables constant at their original values is the "ceteris paribus" assumption. We will do several such exercises here using the combined money market and FOREX market diagram.

An Increase in the US Money Supply

Suppose the US money supply increases, ceteris paribus. The increase in MS causes an increase in the real money supply, M^S/P_$ which causes the real money supply line to shift "down" from M^S'/P_$ to M^S"/P_$ (step 1) in the adjacent FOREX/Money diagram. (Don't get confused here: down in the diagram means an increase in the real money supply). This causes a decrease in the equilibrium interest rate from i_$' to i_$" (step 2). The decrease in the US interest rate causes a decrease in the rate of return on dollar assets: RoR_$ shifts from RoR_$' to RoR_$" (step 3). Finally, the reduction in the dollar rate of return causes an increase in the exchange rate from E'_$/£ to E"_$/£ (step 4). This exchange rate change corresponds to an appreciation of the British pound and a depreciation of the US$. In summary, an increase in the US money supply, ceteris paribus, causes a decrease in US interest rates and a depreciation of the dollar.

An Increase in US GDP

Suppose there is an increase in US GDP, ceteris paribus. This will increase real money demand causing a "downward" shift in the real money demand curve from L(i_$, Y_$') to L(i_$, Y_$") (step 1) in the adjacent FOREX/Money diagram. (Remember, real money increases as you move down on the rotated money diagram) This causes an increase in the US interest rate from i_$' to i_$" (step 2). The increase in the interest means that the rate of return on dollar assets increases from RoR_$' to RoR_$" (step 3). Finally, the increase in the US RoR causes a decrease in the exchange rate from E'_$/£ to E"_$/£ (step 4). The exchange rate change corresponds to an appreciation of the US dollar and a depreciation of the British pound. In summary, an increase in real US GDP, ceteris paribus, causes an increase in US interest rates and appreciation (depreciation) of the US dollar (British pound).

International Finance Theory and Policy - Chapter 40-13: Last Updated on 1/15/05