Money, the Price Level, and the Exchange
Rate in the Long Run
Our short-run analysis of the link between countries’ money markets and the foreign exchange
market rested on the simplifying assumption that price levels and exchange rate
expectations were given. To extend our understanding of how money supply and money
demand affect exchange rates, we must examine how monetary factors affect a country’s
price level in the long run.
An economy’s long-run equilibrium is the position it would eventually reach if no
new economic shocks occurred during the adjustment to full employment. You can think
of long-run equilibrium as the equilibrium that would be maintained after all wages and
prices had had enough time to adjust to their market-clearing levels. An equivalent way of
CHAPTER 15 Money, Interest Rates, and Exchange Rates 369
thinking of it is as the equilibrium that would occur if prices were perfectly flexible and
always adjusted immediately to preserve full employment.
In studying how monetary changes work themselves out over the long run, we will examine
how such changes shift the economy’s long-run equilibrium. Our main tool is once
again the theory of aggregate money demand.
Money and Money Prices
If the price level and output are fixed in the short run, the condition (15-4) of money market
equilibrium,
determines the domestic interest rate, R. The money market always moves to equilibrium,
however, even if we drop our “short-run” assumption and think of periods over which P and
Y, as well as R, can vary. The above equilibrium condition can therefore be rearranged to give
(15-5)
which shows how the price level depends on the interest rate, real output, and the domestic
money supply.
The long-run equilibrium price level is just the value of P that satisfies condition (15-5)
when the interest rate and output are at their long-run levels, that is, at levels consistent
with full employment. When the money market is in equilibrium and all factors of production
are fully employed, the price level will remain steady if the money supply, the aggregate
money demand function, and the long-run values of R and Y remain steady.
One of the most important predictions of the above equation for P concerns the relationship
between a country’s price level and its money supply, : All else equal, an increase
in a country’s money supply causes a proportional increase in its price level. If, for example,
the money supply doubles (to 2 ) but output and the interest rate do not change, the
price level must also double (to 2P) to maintain equilibrium in the money market.
The economic reasoning behind this very precise prediction follows from our observation
above that the demand for money is a demand for real money holdings: Real money demand
is not altered by an increase in that leaves R and Y (and thus aggregate real money demand
) unchanged. If aggregate real money demand does not change, however, the
money market will remain in equilibrium only if the real money supply also stays the same.
To keep the real money supply constant, P must rise in proportion to .
The Long-Run Effects of Money Supply Changes
Our theory of how the money supply affects the price level given the interest rate and output is
not yet a theory of how money supply changes affect the price level in the long run. To develop
such a theory, we still have to determine the long-run effects of a money supply change
on the interest rate and output. This is easier than you might think. As we now argue, a change
in the supply of money has no effect on the long-run values of the interest rate or real output.6
Ms/P Ms
L(R, Y)
Ms
Ms
Ms
P = Ms/L(R, Y),
Ms/P = L(R, Y),
6 The preceding statement refers only to changes in the level of the nominal money supply and not, for example,
to changes in the rate at which the money supply is growing over time. The proposition that a one-time change in
the level of the money supply has no effects on the long-run values of real economic variables is often called the
long-run neutrality of money. In contrast, changes in the money supply growth rate need not be neutral in the
long run. At the very least, a sustained change in the monetary growth rate will eventually affect equilibrium real
money balances by raising the money interest rate (as discussed in the next chapter).
370 PART THREE Exchange Rates and Open-Economy Macroeconomics
The best way to understand the long-run effects of money supply on the interest rate and
output is to think first about a currency reform, in which a country’s government redefines the
national currency unit. For example, the government of Turkey reformed its currency on
January 1, 2005, simply by issuing “new” Turkish lira, each equal to 1 million “old” Turkish
lira. The effect of this reform was to lower the number of currency units in circulation, and all
lira prices, to of their old lira values. But the redefinition of the monetary unit had no
effect on real output, the interest rate, or the relative prices of goods: All that occurred was a
one-time change in all values measured in lira. A decision to measure distance in half-miles
rather than miles would have as little effect on real economic variables as the Turkish government’s
decision to chop six zeros off the end of every magnitude measured in terms of money.
An increase in the supply of a country’s currency has the same effect in the long run as
a currency reform. A doubling of the money supply, for example, has the same long-run
effect as a currency reform in which each unit of currency is replaced by two units of
“new” currency. If the economy is initially fully employed, every money price in the economy
eventually doubles, but real GNP, the interest rate, and all relative prices return to
their long-run or full-employment levels.
Why is a money supply change just like a currency reform in its effects on the economy’s
long-run equilibrium? The full-employment output level is determined by the economy’s
endowments of labor and capital, so in the long run, real output does not depend on the
money supply. Similarly, the interest rate is independent of the money supply in the long run.
If the money supply and all prices double permanently, there is no reason why people previously
willing to exchange today for a year from now should not be willing afterward
to exchange today for a year from now, so the interest rate will remain at
10 percent per annum. Relative prices also remain the same if all money prices double, since
relative prices are just ratios of money prices. Thus, money supply changes do not change
the long-run allocation of resources. Only the absolute level of money prices changes.7
When studying the effect of an increase in the money supply over long time periods, we
are therefore justified in assuming that the long-run values of R and Y will not be changed
by a change in the supply of money. Thus, we can draw the following conclusion from
equation (15-5): A permanent increase in the money supply causes a proportional increase
in the price level’s long-run value. In particular, if the economy is initially at full employment,
a permanent increase in the money supply eventually will be followed by a proportional
increase in the price level.
Empirical Evidence on Money Supplies and Price Levels
In looking at actual data on money and prices, we should not expect to see an exactly
proportional relationship over long periods, partly because output, the interest rate, and the
aggregate real money demand function can shift for reasons that have nothing to do with
the supply of money. Output changes as a result of capital accumulation and technological
advance (for example, more powerful computers), and money demand behavior may
change as a result of demographic trends or financial innovations such as electronic cashtransfer
facilities. In addition, actual economies are rarely in positions of long-run equilibrium.
Nonetheless, we should expect the data to show a clear-cut positive association
between money supplies and price levels. If real-world data did not provide strong evidence
$2 $2.20
$1 $1.10
1
1,000,000
7To understand more fully why a one-time change in the money supply does not change the long-run level of the
interest rate, it may be useful to think of interest rates measured in terms of money as defining relative prices of
currency units available on different dates. If the dollar interest rate is R percent per annum, giving up $1 today
buys you next year. Thus, is the relative price of future dollars in terms of current dollars,
and this relative price would not change if the real value of the monetary units were scaled up or down by the
same factor on all dates.
$(1 + R) 1/(1 + R)
CHAPTER 15 Money, Interest Rates, and Exchange Rates 371
that money supplies and price levels move together in the long run, the usefulness of the
theory of money demand we have developed would be in severe doubt.
The wide swings in Latin American rates of price level increase in recent decades make
the region an ideal case study of the relationship between money supplies and price levels.
Price level inflation had been high and variable in Latin America for more than a decade,
when efforts at macroeconomic reform began to bring inflation lower by the mid-1990s.
On the basis of our theories, we would expect to find such sharp swings in inflation
rates accompanied by swings in growth rates of money supplies. This expectation is confirmed
by Figure 15-10, which plots annual average growth rates of the money supply
against annual inflation rates. On average, years with higher money growth also tend to be
years with higher inflation. In addition, the data points cluster around the 45-degree line,
along which money supplies and price levels increase in proportion.
The main lesson to be drawn from Figure 15-10 is that the data confirm the strong
long-run link between national money supplies and national price levels predicted by
economic theory.
Money and the Exchange Rate in the Long Run
The domestic currency price of foreign currency is one of the many prices in the economy
that rise in the long run after a permanent increase in the money supply. If you
think again about the effects of a currency reform, you will see how the exchange rate
moves in the long run. Suppose, for example, that the U.S. government replaced every
pair of “old” dollars with one “new” dollar. Then if the dollar/euro exchange rate had
been 1.20 old dollars per euro before the reform, it would change to 0.60 new dollars
Percent increase in
price level
Percent increase in
money supply
1 10 100 1000
1
10
100
1000
2001
1990
1989
1988
1993
1992
1991
1994
1987
1995
1996
2007 2005
2000
2004
2003
2002
1997
1999 1998
2006
45°
Figure 15-10
Average Money Growth and
Inflation in Western Hemisphere
Developing Countries, by Year,
1987–2007
Even year by year, there is a strong
positive relation between average
Latin American money supply
growth and inflation. (Both axes
have logarithmic scales.)
Source: IMF, World Economic Outlook,
various issues. Regional aggregates are
weighted by shares of dollar GDP in total
regional dollar GDP.
372 PART THREE Exchange Rates and Open-Economy Macroeconomics
per euro immediately after the reform. In much the same way, a halving of the U.S.
money supply would eventually lead the dollar to appreciate from an exchange rate of
1.20 dollars/euro to one of 0.60 dollars/euro. Since the dollar prices of all U.S. goods
and services would also decrease by half, this 50 percent appreciation of the dollar
leaves the relative prices of all U.S. and foreign goods and services unchanged.
We conclude that, all else equal, a permanent increase in a country’s money supply
causes a proportional long-run depreciation of its currency against foreign currencies.
Similarly, a permanent decrease in a country’s money supply causes a proportional longrun
appreciation of its currency against foreign currencies.
Rate in the Long Run
Our short-run analysis of the link between countries’ money markets and the foreign exchange
market rested on the simplifying assumption that price levels and exchange rate
expectations were given. To extend our understanding of how money supply and money
demand affect exchange rates, we must examine how monetary factors affect a country’s
price level in the long run.
An economy’s long-run equilibrium is the position it would eventually reach if no
new economic shocks occurred during the adjustment to full employment. You can think
of long-run equilibrium as the equilibrium that would be maintained after all wages and
prices had had enough time to adjust to their market-clearing levels. An equivalent way of
CHAPTER 15 Money, Interest Rates, and Exchange Rates 369
thinking of it is as the equilibrium that would occur if prices were perfectly flexible and
always adjusted immediately to preserve full employment.
In studying how monetary changes work themselves out over the long run, we will examine
how such changes shift the economy’s long-run equilibrium. Our main tool is once
again the theory of aggregate money demand.
Money and Money Prices
If the price level and output are fixed in the short run, the condition (15-4) of money market
equilibrium,
determines the domestic interest rate, R. The money market always moves to equilibrium,
however, even if we drop our “short-run” assumption and think of periods over which P and
Y, as well as R, can vary. The above equilibrium condition can therefore be rearranged to give
(15-5)
which shows how the price level depends on the interest rate, real output, and the domestic
money supply.
The long-run equilibrium price level is just the value of P that satisfies condition (15-5)
when the interest rate and output are at their long-run levels, that is, at levels consistent
with full employment. When the money market is in equilibrium and all factors of production
are fully employed, the price level will remain steady if the money supply, the aggregate
money demand function, and the long-run values of R and Y remain steady.
One of the most important predictions of the above equation for P concerns the relationship
between a country’s price level and its money supply, : All else equal, an increase
in a country’s money supply causes a proportional increase in its price level. If, for example,
the money supply doubles (to 2 ) but output and the interest rate do not change, the
price level must also double (to 2P) to maintain equilibrium in the money market.
The economic reasoning behind this very precise prediction follows from our observation
above that the demand for money is a demand for real money holdings: Real money demand
is not altered by an increase in that leaves R and Y (and thus aggregate real money demand
) unchanged. If aggregate real money demand does not change, however, the
money market will remain in equilibrium only if the real money supply also stays the same.
To keep the real money supply constant, P must rise in proportion to .
The Long-Run Effects of Money Supply Changes
Our theory of how the money supply affects the price level given the interest rate and output is
not yet a theory of how money supply changes affect the price level in the long run. To develop
such a theory, we still have to determine the long-run effects of a money supply change
on the interest rate and output. This is easier than you might think. As we now argue, a change
in the supply of money has no effect on the long-run values of the interest rate or real output.6
Ms/P Ms
L(R, Y)
Ms
Ms
Ms
P = Ms/L(R, Y),
Ms/P = L(R, Y),
6 The preceding statement refers only to changes in the level of the nominal money supply and not, for example,
to changes in the rate at which the money supply is growing over time. The proposition that a one-time change in
the level of the money supply has no effects on the long-run values of real economic variables is often called the
long-run neutrality of money. In contrast, changes in the money supply growth rate need not be neutral in the
long run. At the very least, a sustained change in the monetary growth rate will eventually affect equilibrium real
money balances by raising the money interest rate (as discussed in the next chapter).
370 PART THREE Exchange Rates and Open-Economy Macroeconomics
The best way to understand the long-run effects of money supply on the interest rate and
output is to think first about a currency reform, in which a country’s government redefines the
national currency unit. For example, the government of Turkey reformed its currency on
January 1, 2005, simply by issuing “new” Turkish lira, each equal to 1 million “old” Turkish
lira. The effect of this reform was to lower the number of currency units in circulation, and all
lira prices, to of their old lira values. But the redefinition of the monetary unit had no
effect on real output, the interest rate, or the relative prices of goods: All that occurred was a
one-time change in all values measured in lira. A decision to measure distance in half-miles
rather than miles would have as little effect on real economic variables as the Turkish government’s
decision to chop six zeros off the end of every magnitude measured in terms of money.
An increase in the supply of a country’s currency has the same effect in the long run as
a currency reform. A doubling of the money supply, for example, has the same long-run
effect as a currency reform in which each unit of currency is replaced by two units of
“new” currency. If the economy is initially fully employed, every money price in the economy
eventually doubles, but real GNP, the interest rate, and all relative prices return to
their long-run or full-employment levels.
Why is a money supply change just like a currency reform in its effects on the economy’s
long-run equilibrium? The full-employment output level is determined by the economy’s
endowments of labor and capital, so in the long run, real output does not depend on the
money supply. Similarly, the interest rate is independent of the money supply in the long run.
If the money supply and all prices double permanently, there is no reason why people previously
willing to exchange today for a year from now should not be willing afterward
to exchange today for a year from now, so the interest rate will remain at
10 percent per annum. Relative prices also remain the same if all money prices double, since
relative prices are just ratios of money prices. Thus, money supply changes do not change
the long-run allocation of resources. Only the absolute level of money prices changes.7
When studying the effect of an increase in the money supply over long time periods, we
are therefore justified in assuming that the long-run values of R and Y will not be changed
by a change in the supply of money. Thus, we can draw the following conclusion from
equation (15-5): A permanent increase in the money supply causes a proportional increase
in the price level’s long-run value. In particular, if the economy is initially at full employment,
a permanent increase in the money supply eventually will be followed by a proportional
increase in the price level.
Empirical Evidence on Money Supplies and Price Levels
In looking at actual data on money and prices, we should not expect to see an exactly
proportional relationship over long periods, partly because output, the interest rate, and the
aggregate real money demand function can shift for reasons that have nothing to do with
the supply of money. Output changes as a result of capital accumulation and technological
advance (for example, more powerful computers), and money demand behavior may
change as a result of demographic trends or financial innovations such as electronic cashtransfer
facilities. In addition, actual economies are rarely in positions of long-run equilibrium.
Nonetheless, we should expect the data to show a clear-cut positive association
between money supplies and price levels. If real-world data did not provide strong evidence
$2 $2.20
$1 $1.10
1
1,000,000
7To understand more fully why a one-time change in the money supply does not change the long-run level of the
interest rate, it may be useful to think of interest rates measured in terms of money as defining relative prices of
currency units available on different dates. If the dollar interest rate is R percent per annum, giving up $1 today
buys you next year. Thus, is the relative price of future dollars in terms of current dollars,
and this relative price would not change if the real value of the monetary units were scaled up or down by the
same factor on all dates.
$(1 + R) 1/(1 + R)
CHAPTER 15 Money, Interest Rates, and Exchange Rates 371
that money supplies and price levels move together in the long run, the usefulness of the
theory of money demand we have developed would be in severe doubt.
The wide swings in Latin American rates of price level increase in recent decades make
the region an ideal case study of the relationship between money supplies and price levels.
Price level inflation had been high and variable in Latin America for more than a decade,
when efforts at macroeconomic reform began to bring inflation lower by the mid-1990s.
On the basis of our theories, we would expect to find such sharp swings in inflation
rates accompanied by swings in growth rates of money supplies. This expectation is confirmed
by Figure 15-10, which plots annual average growth rates of the money supply
against annual inflation rates. On average, years with higher money growth also tend to be
years with higher inflation. In addition, the data points cluster around the 45-degree line,
along which money supplies and price levels increase in proportion.
The main lesson to be drawn from Figure 15-10 is that the data confirm the strong
long-run link between national money supplies and national price levels predicted by
economic theory.
Money and the Exchange Rate in the Long Run
The domestic currency price of foreign currency is one of the many prices in the economy
that rise in the long run after a permanent increase in the money supply. If you
think again about the effects of a currency reform, you will see how the exchange rate
moves in the long run. Suppose, for example, that the U.S. government replaced every
pair of “old” dollars with one “new” dollar. Then if the dollar/euro exchange rate had
been 1.20 old dollars per euro before the reform, it would change to 0.60 new dollars
Percent increase in
price level
Percent increase in
money supply
1 10 100 1000
1
10
100
1000
2001
1990
1989
1988
1993
1992
1991
1994
1987
1995
1996
2007 2005
2000
2004
2003
2002
1997
1999 1998
2006
45°
Figure 15-10
Average Money Growth and
Inflation in Western Hemisphere
Developing Countries, by Year,
1987–2007
Even year by year, there is a strong
positive relation between average
Latin American money supply
growth and inflation. (Both axes
have logarithmic scales.)
Source: IMF, World Economic Outlook,
various issues. Regional aggregates are
weighted by shares of dollar GDP in total
regional dollar GDP.
372 PART THREE Exchange Rates and Open-Economy Macroeconomics
per euro immediately after the reform. In much the same way, a halving of the U.S.
money supply would eventually lead the dollar to appreciate from an exchange rate of
1.20 dollars/euro to one of 0.60 dollars/euro. Since the dollar prices of all U.S. goods
and services would also decrease by half, this 50 percent appreciation of the dollar
leaves the relative prices of all U.S. and foreign goods and services unchanged.
We conclude that, all else equal, a permanent increase in a country’s money supply
causes a proportional long-run depreciation of its currency against foreign currencies.
Similarly, a permanent decrease in a country’s money supply causes a proportional longrun
appreciation of its currency against foreign currencies.
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