The money supply and monetary policy in an open economy

Overview

Increase in the money supply affect inflation, change in the money supply affect the exchange rate and competitive depreciation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   How does an increase in the money supply affect inflation, and on what does the size of the effect depend?

   Model answer

   An increase in the money supply raises the spending power in the hands of households and firms and lowers the return on holding money rather than goods or other assets, so spending rises. If output can expand to meet the extra spending, prices need not rise much; if it cannot, the extra spending bids up prices. The size of the effect therefore depends on how much spare capacity exists, on whether the extra money is spent or held, which is the question of what happens to velocity, and on whether people expect the increase to be permanent, since an expansion believed to be temporary and reversible changes behaviour far less. In the long run, when output is determined by the supply side, a sustained increase in money growth in excess of real growth shows up as inflation and nothing else.

2. 2

   Analyse the effect of a tightening of monetary policy in an open economy on inflation, output, unemployment and the balance of payments.

   Model answer

   Higher interest rates raise the cost of borrowing and the return on saving, so households postpone purchases of housing and durable goods and firms shelve investment projects that no longer cover their cost of capital; asset prices fall, reducing wealth and collateral. Capital is also attracted from abroad by the higher return, so the currency appreciates. Output therefore falls from both the domestic and the external side, and unemployment rises as firms cut production and hiring, with the loss concentrated in construction, durables and exporting sectors. Inflation falls for two reasons: domestic demand weakens relative to capacity, so wages and prices are bid up less, and the appreciation lowers the domestic price of imported goods and components, which acts quickly and directly. On the balance of payments the effects conflict: weaker domestic income cuts import volumes, which improves the current account, while the appreciation makes exports dearer and imports cheaper, which worsens it, so the net outcome depends on how responsive trade volumes are to price. The financial account records an inflow of capital attracted by the higher return.

3. 3

   Why does a contraction of the money supply reduce output before it reduces inflation?

   Model answer

   Prices and wages are not reset continuously. Wages are fixed by contracts and custom for periods of a year or more, and firms reprice at intervals because changing prices carries costs and risks losing customers. When spending is reduced, firms therefore meet the weaker demand first by producing less and employing fewer people, because their prices are already set. Only as contracts come up for renewal, and as sustained weak demand and rising unemployment weaken bargaining power, do wage settlements and prices adjust downwards. Expectations reinforce the delay, since workers and firms who still expect the previous rate of inflation continue to build it in. The consequence is a sequence rather than a simultaneous adjustment: output and employment fall within months, while the full effect on inflation appears only after a year or more, which is the short-run cost of disinflation.

4. 4

   How does a change in the money supply affect the exchange rate, and why does that matter for inflation?

   Model answer

   An increase in the money supply lowers domestic interest rates and raises the domestic supply of money relative to foreign currencies, so holding domestic assets becomes less attractive; investors sell the currency and it depreciates. The depreciation matters for inflation because it raises the domestic price of everything bought from abroad, and that effect is direct and quick rather than working through the long chain of demand, output and wages. Imported food, fuel and components become dearer at once, and firms pass the higher input costs on. There is a second, slower effect through demand, since cheaper exports and dearer imports raise net exports and therefore add to spending. This is why an expansion of the money supply raises inflation faster in a small open economy than in a large closed one.

5. 5

   Why do the effects of a monetary expansion on unemployment fade while the effects on inflation persist?

   Model answer

   An expansion works in the short run because prices and wages have not yet adjusted: firms see higher money receipts, take them partly as higher real revenue, and expand output and hiring, and workers accept existing wage contracts whose real value has not yet been eroded. As prices rise, the real wage falls back to its previous level and firms discover that their costs have risen along with their revenue, so the incentive to produce more disappears and employment returns to the rate the economy can sustain given its labour market and capacity. What does not reverse is the price level, and if the faster money growth is sustained, the rate of inflation settles higher as well, because expectations adjust to it. The lasting result is therefore higher inflation with unemployment back where it started, which is why monetary expansion cannot be used to hold unemployment permanently below its sustainable rate.

6. 6

   Evaluate the claim that in a global economy a country's own monetary policy determines its rate of inflation.

   Model answer

   There is a solid core to the claim. Over the long run a sustained inflation requires sustained growth in the money supply in excess of real growth, and the central bank determines the conditions under which that money is created, so a determined central bank can always bring inflation down eventually, whatever its source, by restraining demand far enough. The credibility of its target also anchors expectations, which is a large part of what determines wage and price setting. The qualifications are substantial. A great deal of what enters a country's price index is set abroad: energy, food and industrial commodities are priced in world markets, and no domestic decision changes them. The exchange rate transmits those prices and is itself moved by capital flows and by the policies of much larger economies, so a small open economy can import an inflation it did not create and cannot prevent. Global competition and integrated supply chains restrain the prices of traded manufactures independently of domestic conditions. And capital mobility limits how far a country can hold its interest rate away from world rates before currency movements dominate the intended effect. The reasonable conclusion is that a central bank controls the trend rate of inflation over a period of years, because it can always choose to squeeze demand hard enough, but that in any given year a substantial part of measured inflation is imported and outside its control, so it is judged fairly on whether expectations stayed anchored rather than on whether the target was hit in every month.

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