Inflation and the exchange rate: The role of aggregate demand elasticity

It is rather well established in macroeconomic theory that domestic inflation results in domestic currency depreciation.  A rising price level ion the short-run, however, may be caused by either increased aggregate demand or decreased aggregate supply, with resulting opposite effects on real income and the exchange rate.  A concept mostly ignored in macroeconomics but which may prove of some significance here is the price level elasticity of aggregate demand.  The purpose of this paper, therefore, is to investigate the importance of aggregate demand elasticity for the effects of a rising price level on the exchange rate.

This paper employs a rather standard and short run model of the economy.  Aggregate demand is analyzed within an IS-LM framework with no government sector and is shown to be a negative function of the price level which can possess different price level elasticities.  Aggregate supply is assumed a positive function of the price level.  We assume also that the exchange rate is a positive function of both the price level and real income.

We reach two conclusions.  First, demand pull inflation results unambiguously in an increase of the exchange rate and the depreciation of the domestic currency is larger the more inelastic is aggregate demand with respect to the price level.  Second, and with cost push inflation, the effect on the exchange rate is ambiguos and depends on the price level elasticity of aggregate demand, i.e., if aggregate demand is inelastic the exchange rate will rise while if aggregate demand is elastic the exchange rate will decrease.