What happens in the Monetary Model when the economy experiences a growth spurt or a drastic economic crash? These cases may occur in the event of natural disasters, major leaps in technological development, or the discovery of large deposits of raw materials. The Monetary Model provides a clear answer: if the domestic economy grows faster than the foreign economy – and no expansive monetary policy measures are taken – then the price level falls and the currency appreciates (per domestic currency unit you can buy more goods, which includes foreign money).
To better distinguish the effects of the different stimuli, we analyze the GDP shock under the ceteris paribus assumption, i.e. apart from the exogenous economic growth shock, only endogenous changes in the variables are considered. In particular, the money supply remains constant in the graphical analysis.
n this graph, the slider regulates the growth impulse. The straight line of the long-term production level . shifts accordingly. When the economy grows, the price level falls from to , because more goods are available but the money supply is constant. (There is a constant number of banknotes but there are more goods available, i.e. for each good there are fewer banknotes and this means the price falls). In the case of a recession the opposite occurs and prices rise.
With a decreasing price level, the economy would gain a competitive advantage, if the exchange rate remained constant. Domestic goods become cheaper in the foreign country and, therefore, net exports increase significantly. The demand for domestic currency increases. Whereupon, the domestic currency appreciates until purchasing power parity is restored. However, since foreign exchange markets react very quickly, the exchange rate adjusts to the new equilibrium before the goods arbitrage can take effect.
Accommodating monetary policy
In reality, neither the central bank nor the government would allow prices to fall (deflation). The central bank would simply increase the money supply according to the economic growth and so keep the price level constant. The profits from printing the new money go to the government as so-called seigniorage profits. The government thus experiences a double positive effect: the economy grows and it receives additional billions in taxes and seigniorage profits.
Recession and accommodating monetary policy
Of course, in the event of a recession, the opposite holds true: in order to prevent inflation, the central bank must apply a restrictive monetary policy, i.e. reduce the money supply. This results in a double negative effect: in addition to the recession, potential seigniorage gains are lost, since the reduction of the money supply reduces the profits of the central bank.