Partial Detail

The increase in the money supply causes the first upward shift of the AA curve, shown as step 1 in the diagram. Since exchange rates adjust much more rapidly than gross national product (GNP), the economy will quickly adjust to the new A′A′ curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E¹ to E², representing a depreciation of the U.S. dollar.

The second effect is caused by changes in investor expectations. Investors generally track important changes in the economy, including money supply changes, because these changes can have important implications for the returns on their investments. Investors who see an increase in money supply in an economy at full employment are likely to expect inflation to occur in the future. When investors expect future U.S. inflation, and when they consider both domestic and foreign investments, they will respond today with an increase in their expected future exchange rate (E_$/£^e). There are two reasons to expect this immediate effect:

1. Investors are very likely to understand the story we are in the process of explaining now. As we will see below, the long-run effect of a money supply increase for an economy (initially, at full employment) is an increase in the exchange rate (E_$/£)—that is, a depreciation of the dollar. If investors believe the exchange rate will be higher next year due to today’s action by the Fed, then it makes sense for them to raise their expected future exchange rate in anticipation of that effect. Thus the average E_$/£^e will rise among investors who participate in the foreign exchange (Forex) markets.
2. Investors may look to the purchasing power parity (PPP) theory for guidance. PPP is generally interpreted as a long-run theory of exchange rate trends. If PPP holds in the long run, then E_$/£ = P_$/P_£. In other words, the exchange rate will equal the ratio of the two countries’ price levels. If P_$ is expected to rise due to inflation, then PPP predicts that the exchange rate (E_$/£) will also rise and the dollar will depreciate.

The timing of the change in E_$/£^e will depend on how quickly investors recognize the money supply change, compute its likely effect, and incorporate it into their investment plans. Since investors are typically very quick to adapt to market changes, the expectations effect should take place in the short run, perhaps long before the inflation ever occurs. In some cases, the expectations change may even occur before the Fed increases the money supply, if investors anticipate the Fed’s action.

The increase in the expected exchange rate (this means a decrease in the expected future dollar value) causes a second upward shift of the AA curve, shown as step 2 in the diagram. Again, rapid exchange rate adjustment implies the economy will quickly adjust to the new A″A″ curve at point H directly above. The exchange rate will now increase from E² to E³, representing a further depreciation of the U.S. dollar.

Once at point H, aggregate demand, which is on the DD curve to the right of H, exceeds aggregate supply, which is still at Y^F. Thus GNP will begin to rise to get back to G&S market equilibrium on the DD curve. However, as GNP rises, the economy moves above the A″A″ curve that forces a downward readjustment of the exchange rate to get back to asset market equilibrium on A″A″. In the end, the economy will adjust in a stepwise fashion from point H to point I, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the A″A″ curve. This process will continue until the economy reaches the temporary superequilibrium at point I.

The next effect occurs because GNP, now at Y² at point I, has risen above the full employment level at Y^F. This causes an increase in U.S. prices, meaning that P_$ (the U.S. price level) begins to rise. The increase in U.S. prices has two effects as shown in Figure 10.4 "Expansionary Monetary Policy in the Long Run, Continued". An increase in P_$ is both a DD left-shifter and an AA down-shifter.

In step 3, we depict a leftward shift of DD to D′D′. DD shifts left because higher U.S. prices will reduce the real exchange rate. This makes U.S. G&S relatively more expensive compared with foreign G&S, thus reducing export demand, increasing import demand, and thereby reducing aggregate demand.

In step 4, we depict a downward shift of A″A″ to A′″A′″. AA shifts down because a higher U.S. price level reduces real money supply. As the real money supply falls, U.S. interest rates rise, leading to an increase in the rate of return for U.S. assets as considered by international investors. This in turn raises the demand for U.S. dollars on the Forex, leading to a dollar appreciation. Since this effect occurs for any GNP level, the entire AA curve shifts downward.

Steps 3 and 4 will both occur simultaneously, and since both are affected by the increase in the price level, it is impossible to know which curve will shift faster or precisely how far each curve will shift. However, we do know two things. First, the AA and DD shifting will continue as long as GNP remains above the full employment level. Once GNP falls to Y_F, there is no longer upward pressure on the price level and the shifting will cease. Second, the final equilibrium exchange rate must lie above the original exchange rate. This occurs because output will revert back to its original level, the price level will be higher, and according to PPP, eventually the exchange rate will have to be higher as well.

The final equilibrium will be at a point like J, which lies to the left of I. In this transition, the exchange rate will occasionally rise when DD shifts left and will occasionally fall when AA shifts down. Thus the economy will wiggle its way up and down, from point I to J. Once at point J, there is no reason for prices to rise further and no reason for a change in investor expectations. The economy will have reached its long-run equilibrium.

Note that one cannot use the iso-CAB line to assess the long-run effect on the current account balance. In the final adjustment, although the final equilibrium lies above the original iso-CAB line, in the long run the P_$ changes will raise the iso-CAB lines, making it impossible to use these to identify the final effect.

However, in adjusting to the long-run equilibrium, the only two variables affecting the current account that will ultimately change are the exchange rate and the price level. If these two rise proportionally to each other, as they would if purchasing power parity held, then there will be no long-run effect on the current account balance.

The final long-run effect of an increase in the U.S. money supply in a floating exchange rate system is a depreciation of the U.S. dollar and no change in real GNP. Along the way, GNP temporarily rises and unemployment falls below the natural rate. However, this spurs an increase in the price level, which reduces GNP to its full employment level and raises unemployment back to its natural rate. U.S. inflation occurs in the transition while the price level is increasing.