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2014 | OriginalPaper | Chapter

11. Incorporating Inflation into the Model

Authors : Farrokh Langdana, Peter T. Murphy

Published in: International Trade and Global Macropolicy

Publisher: Springer New York

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Abstract

We now add inflation into our ISLM-BOP model and explore in greater detail the relationship between exchange rates and interest rates.

We see how inflation can manifest itself not only in the consumer price index, but in asset prices, as we explore speculative asset price (SAP) bubbles. We move on to explore how currency pegs can “explode” when the pegging Country A has lashed itself to the currency of a Country B whose economic cycle is out of synch with Country A, with devastating consequences. We see how this played out in Southeast Asia in 1997–1998. The Impossible Trinity tells us that we cannot have a pegged exchange rate, control over interest rates, and perfectly mobile capital. We see that one of the three variables must give. Can a pegged-exchange rate country escape the cycle of boom and bust? We follow the actions of Singapore in the late 1990’s and find an answer.

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previous chapter Exports and Imports, Real Exchange Rates

next chapter Capital Flows: Perfectly and Imperfectly Mobile Capital

We can contrast the inflationary effect of monetary (↑M) versus fiscal (↑G) stimulus here. Recall that with a floating exchange rate, a strengthening of the exchange rate will mitigate the effects of government spending, by (a) reducing exports, returning GDP back to where it started, and (b) making imports cheaper, which works against inflation.

This is a manifestation of the “Fisher Effect,” named for economist Irving Fisher, whose formula for long-term rates is expressed as r = i_LT − π^e, where r = real interest rate, i_LT = long-term interest rate, and π^e = inflation expectations. This can be rearranged as i_LT = r + π^e, i.e., long-term interest rates are equal to the real interest rate plus expected inflation.

Shiller RJ (2000) Irrational exuberance. Princeton University Press, Princeton

This remarkable book is still a compelling read today and is available for free download from many sites on the Internet.

The best examination of social mood and its relation to bubbles and depressions is found in Robert Pretcher’s The Wave Principle of Human Social Behavior and the New Science of Socionomics, New Classics Library, 2002.

William McChesney Martin, Jr., Federal Reserve Chairman from 1951 to 1970, famously said that the job of a central banker is “to take away the punch bowl just as the party gets going.”

The S&P 500 opened 1987 at 246 and peaked in at 1565 on October 9, 2007. In the interim, the market fell by −33 % from August to December 1987 and by −46 % from September 2000 to October 2002.

We use the term “easy money” to refer to a climate of low interest rates and plentiful credit.

Asset-Price “Bubbles” and Monetary Policy. Remarks by Governor Ben S. Bernanke before the New York Chapter of the National Association for Business Economics, New York, New York, October 15, 2002. Source: Federal Reserve Bank of New York.

Ben Bernanke, “The Economic Outlook,” Speech before the Joint Economic Committee, US Congress, March 28, 2007. Source: New York Fed.

Source: International Monetary Fund.

Eichengreen B (1999) Toward a New International Financial Architecture: apractical Post-Asia Agenda. Peterson Institute for International Economics, Washington, D.C.

Recall that the central bank, in order to maintain the peg in the face of FX determined to exit the domestic economy, would need to buy domestic currency with its reserves of foreign exchange.

Title: Incorporating Inflation into the Model
Authors: Farrokh Langdana
Peter T. Murphy
Publisher: Springer New York
Book: International Trade and Global Macropolicy
Print ISBN: 978-1-4614-1634-0

Electronic ISBN: 978-1-4614-1635-7

Copyright Year: 2014
DOI: https://doi.org/10.1007/978-1-4614-1635-7_11