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Summary of Impacts of Changes in Various Variables on FOREX Rates
Grand Summary of Short-Run, Medium-Term and Long-Run Impact of Various Shocks on FOREX
Rates[Document title]
Causes
Time Horizon
(Second
Round)
E↑
MediumTerm
(transition to
the new
Long-run eq.)
Trade
Trade
FOREX
FOREX rate
Note
Balance
1) External Real Shocks to Domestic Economy: International Demand for X falls (due to Yf↓)
Internation Short-Run
X↓
X-M↓
Supply
E↑
al Economy Trade
Down
Down
(a)
X ↑,
X-M ↑
Supply Up E starts ↓
M↓
(if
MarshallLerner
Conditio
n holds)
Note that at (b) may partially offset (a) with “Cushioning Effect”.
2) Domestic Money Market Shocks: Expansionary Monetary Policy (MS ↑)
MS ↑ and
S-R
M↑
X-M ↓ or
Excess
E↑
thus Y ↑
Trade
Trade
Demand
Account↓(c)
(b)
*A secondary
Rebounding/
Cushioning
Effect
i ↓due to
S-R
Capital
Financial
Excess
E↑
Liquidity
International Outflows Account↓(d) Demand
Effect
Investment
Above-the- S-R
Sum of (c )
E↑ ↑
line BP
Combined
and (d)
(c ) +(d)
(c ) + (d) = Above-the-line Balance of Payment; Note that both (c ) and (d) deteriorate.
(Second
M-T to new
X ↑, M↓
X-M ↑
Supply Up E starts↓
Round)
LR eq.
iff
A secondary/
E↑
MarshallCushioning
Lerner
Effect
Conditio
n holds
Note that at the beginning, (b) <(a); and then in the Long-run, (b) may partially offset (a) with
“Cushioning Effect”.
P↑
LR
Unchang Unchanged
E↑ due to
In MV = P y (PPP)
ed X or
X-M
E = P/Pf :
for M(S) ↑
M
Absolute
Version of
,or
Purchasing
π↑
in
π=%M-%
y + %V
for
continuous
Money
Creation
In L-R, i ↑ due
to Inflation
Expectations
Effect;
i>if but No
Capital
Inflows;
Interest Parity
Theorem
saying i-if
merely
reflects %Ee
(+ve or ↑)
Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the
same reasoning.
3) Domestic Goods Market Shocks: Expansionary Fiscal Policy
G ↑ and
S-R
M↑
X-M ↓
Demand
thus Y ↑
Trade
Trade
↑
E↑
Account(e) ↓
i ↑due to
S-R
Capital
Domestic
CrowingInternational Inflows
Financial
Supply ↑ E↓
Investment ↓
Out Effect
Investment
↑
Account (f)
due to
↑
Crowding Out
BP ( e+ f)
Sum of (e )
E?
and (f) = ?
S↑-D ↑
uncertain
uncertain
=?
uncertain
Note that in the Above-the-Line BP, (e ) and (f) work against each other on E; Net impact of G on E is
ambiguous.
Secondary
MT to new LR uncertain uncertain
uncertain uncertain
adjustment eq.
E ↑ or ↓
P↑
LR
E↑ due to
iff  G is
E = P/Pf
‘monetized’:
Absolute
when Bonds
Version of
are sold to
Purchasing
Central Bank:
Power
iff G = M
or
Parity
π↑
LR
%E ↑ =
iff G = M
↑– f
Relative
Version of
Purchasing
LR
(PPP)
Unchangi
ng
X or M
Unchanging
X-M
Power
Parity
%E ↑ due
to relative
version of
Purchasing
Power
Parity
Purchasing
Power
Parity
Power
Parity
Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the
same reasoning.
Causes
Time Horizon
Trade
Trade
FOREX
FOREX rate
Note
Balance
4) International Money Market Shocks: U.S. Expansionary Monetary Policy (MSf↑)
MSf ↑ and
S-R
X↑
X-M ↑ or
Excess
E↓
thus Yf ↑
Trade
Trade
Supply
Account↑(c)
If due to
Liquidity
Effect
S-R
International
Investment
Capital
Inflows
Above-theline BP
(c ) +(d)
(Second
Round)
E↓↓
S-R
Combined
M-T to new
LR eq.
X↓ , M↑
Financial
Account↑
(d)
Excess
Supply
E↓
(c ) + (d) ↑↑
Excess
Supply
E↓↓
Supply
down
E starts ↑
X-M ↓
A secondary/
Cushioning
Effect
Note that at the beginning, (b) <(a); and then in the Long-run, (b) may partially offset (a) with
“Cushioning Effect”.
Pf ↑
LR
Unchang Unchanged
E↓ due to
In Mf Vf = Pf Trade
ed X or
X-M
E = P/Pf :
yf for M(S)f
PPP
M
Absolute
↑
Version of
Purchasing
Power
or
Parity
πf ↑
Unchangi Unchanging
%E ↓due In L-R, if ↑
in
LR
ng
X-M
due to
to relative
X or M
Inflation
πf=%Mf-% Trade
version of
PPP
Expectations
Purchasing
yf + %Vf
Effect; LR
Power
for
I<if but No
Parity
continuous
Capital
Purchasing
Money
Outflows;
Power
Creation
Interest Parity
Parity
Theorem
saying i-if
merely
reflects %Ee
(-ve, or ↓)
Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the
same reasoning.
5) Inrternational Money Market Shocks: U.S. Expansionary Fiscal Policy
Gf ↑ and
S-R
X↑
X-M ↑
Supply↑
thus Yf ↑
Trade
Trade
E↓
Account(e) ↑
If ↑due to
S-R
Capital
U.S.
International Outflows Financial
Demand
E↑
CrowingInvestment
Account (f)
↑
Out Effect
↓
BP ( e+ f)
E?
uncertain
Note that in the Above-the-Line BP, (e ) and (f) work against each other on E; Net impact of Gf on E is
ambiguous.
Secondary
MT to new LR uncertain uncertain
uncertain uncertain
adjustment eq.
E ↑ or ↓
Pf ↑
LR
E ↓due to
iff  Gf is
Trade
E = P/Pf
‘monetized’:
PPP
Absolute
when Bonds
VersPurchas are sold to
ing Power
Central Bank:
or
Parity
iff  Gf = Mf
πf ↑
LR
%E ↓ due iff  Gf is
Trade
to relative
‘monetized’:
PPP
version of
when Bonds
Purchasing
are sold to
Power
Central Bank:
Parity
iff  Gf = Mf
Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the
same reasoning.
6) Real Factor Theory: Technical Innovations in Tradable Sector Only
Price of Tradable goods↓
(PT↓)
PPP
X↑
FOREX
Supply↑
E↓
holds
→
Technical Innovation
only in Tradable
Sector
EPfT/PT=1
Price of Non-Tradable
goods↑
PPP does
not hold
(PNT↑)
No change in Overall
Price Level Ratio, or small
fall
(P = PT + PNT)
Pf/P
more or
less
constant,
or small
fall
Partial
PPP
q=E*Pf/P
↓