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Chapter 17: Basic Theories of the Balance of PaymentsThe monetary approach to the exchange rate suggests that "other things equal" an increase in domestic money supply growth should be associated with a depreciation of the domestic currency. Let's examine some data on U.S. money growth and the U.S. dollar-British pound exchange rate to see if there is an obvious relationship between the two. We will take money supply and exchange rate data from the internet and then compute the percentage changes which will be plotted to serve as our tool of investigation. Data may be found on the Federal Reserve Bank of St. Louis site: http://research.stlouisfed.org/fred2/. After reaching this web page, click on Monetary Aggregates. Click on M1 Money Stock and download or print out the data. Next, click back to the main FRED page and click on Exchange Rates, . Click on Exchange Rates. Then find U.S./U.K Foreign Exchange Rate (you may have to click "Next" to find it). Download or print out the monthly exchange rate data. Compute annual percentage changes from the 1980s on by calculating the percentage change from January of each year (starting from January 1980) for both money and the exchange rate (this may be quickly done by taking the natural logarithm of each series and then taking the change in the logs of the series). Create a graph, with either a software program or by hand, with the percentage change on the vertical axis and year on the horizontal axis. Then plot two lines for the percentage change in the exchange rate and the money supply. Using your graph, answer the following questions:

This activity contains 4 questions. (use Korean won per 1 US dollar)

1.  Is it obvious that the higher the U.S. money supply growth rate, the more the dollar depreciates against the pound?


2. If there is no obvious contemporaneous relationship between U.S. money growth and the dollar/pound exchange rate, could there be a lagged relationship where changes in money this year lead to exchange rate changes next year?

3. Which is more variable: money growth or exchange rate changes?

4. What "other things" could account for the exchange rate changes that are missing from this simple analysis of the effects of money growth on exchange rates?