Text From Video:
The model tells us the domestic currency will depreciate when there is an increase in the money supply, a decrease in income, or an increase in the inflation level.
Conversely, the domestic currency will appreciate when there is a decrease in the money supply, an increase in income, or a decrease in the inflation level.
Followers of this model therefore see the growth of a nation’s money supply in relation with inflation and inflation expectations.
They sustain that, for the most part, a currency increases in value if there is a stable monetary policy and decreases if the monetary policy is erratic or unstable.
———-
The Monetary Model assumes the PPP to be true.
In other words, if domestic prices rise, meaning inflation goes up, the currency will fall in value as money flows out of the country into countries with cheaper prices.
If domestic prices fall, the currency will rise in value as more money flows in from countries with higher prices.
The model also tells us that there is a proportional relationship between the money supply and the exchange rate, meaning that a 10 cent rise in the money supply leads to a 10 cent rise in the exchange rate.
________________________________________________
The monetary model is a hybrid of the quantity theory of money and the PPP, both of which follow the property of proportionality.
The quantity theory of money states that an increase in the money supply leads to a proportional increase in the price level.
The PPP tells us that an increase in the price level leads to a proportional increase in the exchange rate.
Let’s break all this down piece by piece.
______________
If the money supply goes up:
The country will experience inflation- in other words, prices will go up.
The currency will get weaker following the PPP as money flows out of the country seeking cheaper prices elsewhere.
If the money supply goes down:
Prices will go down
The currency will get stronger following the PPP as more money flows into the country from countries with higher prices.
—————-
If income levels rises:
Following the PPP, prices go down. This is because it now takes a smaller percentage of income to purchase the same basket of goods and services used in the PPP.
Again following PPP, lower prices means the currency will get stronger.
If the income level drops, prices will rise in proportion to income, because it now takes a larger percentage of income to buy the same basket of goods.
Therefore, following PPP, the currency will get weaker.
———————-
If interest rates goes up:
Prices will go up as it now costs more to borrow.
Following the PPP, the currency will get weaker.
If the interest rates go down:
Prices will go down as it now costs less to borrow.
Following the PPP, the currency will get stronger.___________________________________________
There are 2 variations of the Monetary Model- the Flexible Price Model and the Sticky Price Model.
The Flexible Price model basically states that the PPP is continuous.
In other words, prices have an immediate reaction to economic changes.
However, since the PPP only seems to work in longer time frames, and not shorter ones, it stands to reason that the Monetary Model only works in longer time frames as well.
——————————
This is where the “sticky-model” comes in.
The stick model basically states that price levels for goods and services are sticky in the short term.
In other words, when the money supply, income, inflation rates, or interest rates change, price levels take awhile to react to it.
This slows down the effect it has on the currency, and can cause the currency value to overshoot what would have happened if prices had reacted instantaneously.
——–
Like all economic theories, the Monetary Model has its problems when applied to real life.
For instance, when interest rates are changed, the Monetary Model ignores the vast increases and decreases of capital flowing into and out of a country for investment purposes.
This usually outweighs changes in price, and causes a currency to appreciate from interest rate hikes, and depreciate from interest rate cuts.
——
So that’s the monetary model. This now concludes the section on fundamental theories and models.
I’ve only touched on the most common theories, and only the basics of those.
This is an area that traders may want to consider studying further on their own; however, by now you should have a basic understanding of what moves price in the long term.
In the next section, we will look at fundamental data, such a various economic reports, to apply to these theories.
See you then.
Music:
Danse Macabre – Low Strings Finale (Theme)
Kevin MacLeod
incompetech.com
The Lonesome Death of Jonas Grumby- DRAUDETTE4web
Manolo Camp – Arabian Chupito
