In the short run of a model with sticky prices, a reduction...

Name: Problem 15, Chapter 15: International Economics: Theory and Policy
Uploaded: 2023-05-21T00:24:44-08:00
Duration: 3 min 41 s
Channel: Jennifer Stoner
Description: In the short run of a model with sticky prices, a reduction in the money supply raises the nominal interest rate and appreciates the currency (see Chapter 14 ). What happens to the expected real interest rate? Explain why the subsequent path of the real exchange rate satisfies the real interest parity condition.

In the short run of a model with sticky prices, a reduction in the money supply raises the nominal interest rate and appreciates the currency (see Chapter 14 ). What happens to the expected real interest rate? Explain why the subsequent path of the real exchange rate satisfies the real interest parity condition.

Key Concepts

Real Exchange Rate

The real exchange rate adjusts the nominal exchange rate for differences in price levels between two economies, reflecting the true cost or purchasing power of one country's goods relative to another's. In a model with sticky prices, even if the nominal exchange rate suddenly appreciates due to a monetary contraction, the gradual adjustment in domestic and foreign prices brings about an evolution in the real exchange rate that aligns with the real interest parity condition, ensuring consistent international financing conditions over time.

Real Interest Parity Condition

The real interest parity condition is an economic theory which states that the real interest rate differentials between countries are offset by expected changes in the real exchange rate, assuming capital mobility. This condition implies that any deviation in real interest rates would eventually be counterbalanced by corresponding movements in the real exchange rate, thereby restoring equilibrium. It links monetary policy actions, expected inflation, and exchange rate movements in an internationally integrated economy.

Inflation Expectations

Inflation expectations represent the anticipated rate of inflation in the future. In the context of sticky prices, even when monetary policy tightens and nominal rates rise, the slow adjustment of prices leads to lower inflation expectations. As a result, although the nominal interest rate increases, the expected real interest rate—which deducts expected inflation from the nominal rate—remains relatively unchanged or less affected.

Money Supply Reduction

A reduction in the money supply is a contractionary monetary policy action designed to curb inflation or cool down an overheating economy. In models with sticky prices, this policy typically raises nominal interest rates as the central bank tightens liquidity. Even though prices adjust slowly, the immediate effect is a shock to the nominal variables which then sets in motion the adjustments in expectations and relative prices that influence the real exchange rate.

Sticky Prices

Sticky prices refer to the phenomenon where nominal prices do not adjust immediately to changes in economic conditions. Because prices are slow to change, adjustments in monetary policy, such as a reduction in the money supply, can lead to temporary mismatches between nominal variables (like nominal interest rates) and the underlying real economy. This delay is critical in short-run analysis of monetary policy effects, particularly with regard to interest rates and exchange rates.

Nominal vs Real Interest Rates

The nominal interest rate is the stated rate on loans and bonds, unadjusted for inflation, while the real interest rate adjusts for expected inflation. When a contractionary monetary policy increases the nominal rate, the real interest rate depends on the corresponding change in inflation expectations. In the short run, with sticky prices, inflation expectations adjust differently than nominal rates, meaning that the expected real interest rate might not move in tandem with the nominal rate.

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