Inflation, interest rate and exchange rate
Continues a series of publications devoted to the study of fundamental analysis of the international currency market (FOREX).
In the previous issue, we examined the relationship between changes in interest rates by central banks and exchange rate changes using a simple model describing the mechanism of exchange rate changes in long and medium term.
Today we will examine the relationship of inflation, interest rates and exchange rate changes, using all the same simple model.
What is Inflation
In considering the theory of purchasing power parity (PPP), we have already addressed issues relating to inflation. Now propose to speak about inflation in more detail.
What, in fact, represents the phenomenon of inflation?
The answer seems obvious. This increase in the prices of various goods or, in more scientific language, the increase in the general price level. To measure inflation, there are various indices such as gross domestic product deflator, consumer price index, producer price index. Moreover, the growth of the value of an index made to explain in terms of its structural changes, as well as excluding them from the various product groups, such as cars or energy. Suppose an index grew due to growth of its components, associated with rising oil prices, etc.
This approach is really based on information about changes occurring in the economy, but he overlooked the most important: inflation is a phenomenon that primarily relates to the values used in the economy of means (money).
The general level of prices can be viewed from two perspectives. On the one hand, when the price level increases, the population is forced to pay for purchased goods and services to large amounts of money. On the other - raise the price decline means the value of money, because now one monetary unit allows the purchase fewer goods and services.
Suppose P - the price level, measured using an index. In this case the quantity of goods and services, which can be bought for 1 monetary unit will be equal to 1 / R. Thus, when the general price level increases, the value of money decreases.
Demand and supply of money
The cost of money, as well as the cost of ordinary goods and services is determined by supply and demand. Offer of money (money in circulation), as already mentioned in previous publications, is largely determined by the Central Bank conducted monetary policy. The demand for the same money (the amount of money that people wish to keep with them in liquid form - in the form of cash or current account) is determined by many factors, such as the credibility of the credit or interest income, which can be obtained by turning them into some sort financial assets. But the main factor determining the demand for money - this is the average price in the economy. The higher the price, the more money will need to commit each transaction, and the more people will keep in your purse or in current accounts. Thus, the increase in the price level (lower value of money) leads to an increase in the demand for money and vice versa.
In the long run the overall level of prices represents the value at which the demand for money equal to their proposal. Ie any deviation from the equilibrium level of prices over time should be eliminated.
Now look at the schedule.
Fig.1. Demand and supply of money
Offer of money is determined by the Central Bank policy, and therefore the value is fixed. The demand for money can act as a function of price and value of money, which, as we saw earlier are interconnected in the inversely proportional dependence.
In general, easy to notice that the schedule much like the timetable of the currency exchange market.
Now let's look at what is displayed on the price level and changing value of money of money from the Central Bank.
Fig.2. Increased availability of money
Suppose, to cover shortfalls in the budget CB starts machine and prints the required number of banknotes. Offer of money had increased, and the curve on the schedule shifted upward, ie, right. As a result of the excessive amount of money the general price level to rise and the cost of money in proportion to decrease.
Inflation and interest rate
Finally, we come to consider the relationship of inflation and interest rates.
For further considerations need to make a slight digression.
In economic theory, taken to separate all the variables into two groups. First make up the nominal variables, ie size, measured in monetary units, and the second - the real variables - size, measured in physical units. Using this classification can distinguish between real and nominal interest rate. Previously, we determined the real interest rate as a nominal (bank) net of inflation. Now you can extend some of these concepts.
Nominal interest rate - this is a nominal variable, as is the measure of income that you can get some money, investing it, say, to the bank. The real interest rate - is a real variable, because it shows the ratio of the real value of assets in the present and future, adjusted for inflation.
The importance of this approach is that in the long run monetary policy of the state (ie, decrease or increase the supply of money) has an impact only on the nominal value and the real will remain unchanged.
Explain this conclusion may be to non-economic example.
Suppose, the official length changed from 100 meters to 50 centimeters. All distances in this case nominally increased by half, and in fact will remain the same. Money is essentially a measure of value, as well as the meter - a measure of length.
Let us answer the question, what happens to the nominal interest rate, with an increase in the price level? It is obvious that in order to motivate people to make savings, but, quite simply, to borrow money to banks, state or other people at the same level as before, the nominal interest rate should be increased. And, at least so far as to cover the loss of population from inflation. This is the case, as bank interest rates, and the discount rate securities. Dependence, in which money from the Central Bank, inflation and nominal interest rate increases in proportion to be called the Fisher effect.
And now let us gather all the information obtained with the help of our well-known model.
So, the state has increased the money supply. This is the display for greater inflation and a corresponding increase in the price level and lowering the value of money.
Let us recall a little theory of PPP.
The nominal exchange rate of the two countries should reflect the ratio of price levels in these countries. We have an increase in domestic prices, which means reducing the nominal exchange rate.
In our model, it appears as follows.
Higher prices in the domestic market has meant that domestic products are less attractive than foreign ones, which should lead to higher imports and lower exports, ie reduction in net exports. The curve of net exports is moving in the direction of reduction, ie left.
Because net exports in our model determines the amount of demand for domestic currency, respectively, and decreased demand. Since the real interest rate, and hence the value of net foreign investment remained unchanged (remember the independence of the real values of monetary policy), the proposal of the currency remained at the same level. As a result, the real exchange rate fell from level Er1 to Er2 that has been displaying in the proportional reduction of the nominal exchange rate.
Thus, in the long run, we are reducing the nominal exchange rate with the increase of money from the state.
If you divide the period into shorter time intervals, we get a more complex picture.
The nominal interest rate does not immediately react to the acceleration (deceleration) of inflationary processes. Ie in the short term, we get a reduction in net exports and the decline in real interest rates. The last is to display an increase in net foreign investment and further reducing the nominal exchange rate, as compared with the base situation (I suggest to examine this process in the schedules themselves). After some time the Central Bank increased the discount rate, taking into account the increased level of inflation (the proportional increase in the nominal interest rate), and the real rate returns to its original level. Net foreign investment is falling again, and the nominal exchange rate slightly increased, but not enough to override a previous decline.
Thus, conclusions can be drawn. Accelerating inflation in the long run should lead to a reduction in the nominal exchange rate (the output of the theory of PPP). But the decline is as though in two stages: the first decline in more substantial than the decrease in the ratio of external and domestic prices, then some correction related to the increase in the nominal interest rate (increase in the discount rate) correction. That's why big speculators so closely followed the changes in inflation (in fact, for the output indexes of consumer and industrial prices and the GDP deflator) and link them to possible changes in interest rates in order to advance the right to take (long or short), long-term position or to determine the future direction of the main trend.
Continues a series of publications devoted to the study of fundamental analysis of the international currency market (FOREX).
In the previous issue, we examined the relationship between changes in interest rates by central banks and exchange rate changes using a simple model describing the mechanism of exchange rate changes in long and medium term.
Today we will examine the relationship of inflation, interest rates and exchange rate changes, using all the same simple model.
What is Inflation
In considering the theory of purchasing power parity (PPP), we have already addressed issues relating to inflation. Now propose to speak about inflation in more detail.
What, in fact, represents the phenomenon of inflation?
The answer seems obvious. This increase in the prices of various goods or, in more scientific language, the increase in the general price level. To measure inflation, there are various indices such as gross domestic product deflator, consumer price index, producer price index. Moreover, the growth of the value of an index made to explain in terms of its structural changes, as well as excluding them from the various product groups, such as cars or energy. Suppose an index grew due to growth of its components, associated with rising oil prices, etc.
This approach is really based on information about changes occurring in the economy, but he overlooked the most important: inflation is a phenomenon that primarily relates to the values used in the economy of means (money).
The general level of prices can be viewed from two perspectives. On the one hand, when the price level increases, the population is forced to pay for purchased goods and services to large amounts of money. On the other - raise the price decline means the value of money, because now one monetary unit allows the purchase fewer goods and services.
Suppose P - the price level, measured using an index. In this case the quantity of goods and services, which can be bought for 1 monetary unit will be equal to 1 / R. Thus, when the general price level increases, the value of money decreases.
Demand and supply of money
The cost of money, as well as the cost of ordinary goods and services is determined by supply and demand. Offer of money (money in circulation), as already mentioned in previous publications, is largely determined by the Central Bank conducted monetary policy. The demand for the same money (the amount of money that people wish to keep with them in liquid form - in the form of cash or current account) is determined by many factors, such as the credibility of the credit or interest income, which can be obtained by turning them into some sort financial assets. But the main factor determining the demand for money - this is the average price in the economy. The higher the price, the more money will need to commit each transaction, and the more people will keep in your purse or in current accounts. Thus, the increase in the price level (lower value of money) leads to an increase in the demand for money and vice versa.
In the long run the overall level of prices represents the value at which the demand for money equal to their proposal. Ie any deviation from the equilibrium level of prices over time should be eliminated.
Now look at the schedule.
Fig.1. Demand and supply of moneyOffer of money is determined by the Central Bank policy, and therefore the value is fixed. The demand for money can act as a function of price and value of money, which, as we saw earlier are interconnected in the inversely proportional dependence.
In general, easy to notice that the schedule much like the timetable of the currency exchange market.
Now let's look at what is displayed on the price level and changing value of money of money from the Central Bank.
Fig.2. Increased availability of moneySuppose, to cover shortfalls in the budget CB starts machine and prints the required number of banknotes. Offer of money had increased, and the curve on the schedule shifted upward, ie, right. As a result of the excessive amount of money the general price level to rise and the cost of money in proportion to decrease.
Inflation and interest rate
Finally, we come to consider the relationship of inflation and interest rates.
For further considerations need to make a slight digression.
In economic theory, taken to separate all the variables into two groups. First make up the nominal variables, ie size, measured in monetary units, and the second - the real variables - size, measured in physical units. Using this classification can distinguish between real and nominal interest rate. Previously, we determined the real interest rate as a nominal (bank) net of inflation. Now you can extend some of these concepts.
Nominal interest rate - this is a nominal variable, as is the measure of income that you can get some money, investing it, say, to the bank. The real interest rate - is a real variable, because it shows the ratio of the real value of assets in the present and future, adjusted for inflation.
The importance of this approach is that in the long run monetary policy of the state (ie, decrease or increase the supply of money) has an impact only on the nominal value and the real will remain unchanged.
Explain this conclusion may be to non-economic example.
Suppose, the official length changed from 100 meters to 50 centimeters. All distances in this case nominally increased by half, and in fact will remain the same. Money is essentially a measure of value, as well as the meter - a measure of length.
Let us answer the question, what happens to the nominal interest rate, with an increase in the price level? It is obvious that in order to motivate people to make savings, but, quite simply, to borrow money to banks, state or other people at the same level as before, the nominal interest rate should be increased. And, at least so far as to cover the loss of population from inflation. This is the case, as bank interest rates, and the discount rate securities. Dependence, in which money from the Central Bank, inflation and nominal interest rate increases in proportion to be called the Fisher effect.
And now let us gather all the information obtained with the help of our well-known model.
So, the state has increased the money supply. This is the display for greater inflation and a corresponding increase in the price level and lowering the value of money.
Let us recall a little theory of PPP.
The nominal exchange rate of the two countries should reflect the ratio of price levels in these countries. We have an increase in domestic prices, which means reducing the nominal exchange rate.In our model, it appears as follows.
Higher prices in the domestic market has meant that domestic products are less attractive than foreign ones, which should lead to higher imports and lower exports, ie reduction in net exports. The curve of net exports is moving in the direction of reduction, ie left.Because net exports in our model determines the amount of demand for domestic currency, respectively, and decreased demand. Since the real interest rate, and hence the value of net foreign investment remained unchanged (remember the independence of the real values of monetary policy), the proposal of the currency remained at the same level. As a result, the real exchange rate fell from level Er1 to Er2 that has been displaying in the proportional reduction of the nominal exchange rate.
Thus, in the long run, we are reducing the nominal exchange rate with the increase of money from the state.
If you divide the period into shorter time intervals, we get a more complex picture.
The nominal interest rate does not immediately react to the acceleration (deceleration) of inflationary processes. Ie in the short term, we get a reduction in net exports and the decline in real interest rates. The last is to display an increase in net foreign investment and further reducing the nominal exchange rate, as compared with the base situation (I suggest to examine this process in the schedules themselves). After some time the Central Bank increased the discount rate, taking into account the increased level of inflation (the proportional increase in the nominal interest rate), and the real rate returns to its original level. Net foreign investment is falling again, and the nominal exchange rate slightly increased, but not enough to override a previous decline.
Thus, conclusions can be drawn. Accelerating inflation in the long run should lead to a reduction in the nominal exchange rate (the output of the theory of PPP). But the decline is as though in two stages: the first decline in more substantial than the decrease in the ratio of external and domestic prices, then some correction related to the increase in the nominal interest rate (increase in the discount rate) correction. That's why big speculators so closely followed the changes in inflation (in fact, for the output indexes of consumer and industrial prices and the GDP deflator) and link them to possible changes in interest rates in order to advance the right to take (long or short), long-term position or to determine the future direction of the main trend.
Andrew Khamidullin
to Forex Magazine
fxtrade@tomsk.ru
to Forex Magazine
fxtrade@tomsk.ru
No comments:
Post a Comment