CHAPTER 14 (Part 2) Money, Interest Rates, and the Exchange Rate

Demand for Money: Total demand for money by all firms and individuals in the economy Money is an asset. Holding money balances a portfolio. Individuals wish to keep a certain amount of money on hand. Money is a good substitute for all goods and services. The Demand for Money The Demand for Money

 Why is money held? 1)Transactions demand for money  Individuals hold money to buy goods and services.  Varies directly with nominal GDP 2)Hold money in case of emergencies that require purchases above normal spending levels The Demand for Money

3)Changes in the interest rate  Opportunity cost to holding money b/c it as no explicit rate of return.  Less is held :  Interest rate is high, opportunity cost of holding money is high  More is held:  Interest rate is low, opportunity cost of holding money is low  Demand for money inversely related to the interest rate. The Demand for Money

 Three motivations for holding money combine to create the aggregate demand for money (relative to 3 factors): 1)Inversely related to the interest rate 2)Directly related to the price level  Rising price level requires more money to make purchases  Holding of money must increase to maintain real level of spending The Demand for Money

3)Directly related to real level of economic activity or real income  Real income increases mean consumers buy more goods and services.  More purchases mean more money is held.  Aggregate demand related to interest rate, price level and real income as: MD = f(-i, +P, +Y) i = Interest rate P = Price level Y = Real GDP The Demand for Money

 Money Supply:  Central bank determines it  Completely inelastic with respect to interest rates  Does not respond to interest rate changes  Central bank can determine its level at some arbitrary level  Increases: are rightward shifts of the money supply curve.  Declines: are leftward shifts of the money supply curve. The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

Figure 14.1: Changes in the Supply of Money Interest Rate (i) Money (M) MS 2 MS 1 Money Supply (MS)

 Demand for money slopes downward  Interest rates increase, quantity of money demanded decreases  Interest rates decrease, quantity of money demanded increases  Changes in interest rates cause individuals and firms to adjust by moving along the demand curve. The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

Figure 14.2: The Demand for Money Interest Rate (i) Money (M) Demand for Money (MD)

 Real income and the price level are held constant along the demand curve.  If real income or the price level increases, the demand for money will shift to the right (MD 1 ).  If real income or the price level decreases, the demand for money will shift to the left (MD 2 ). The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

Figure 14.3: Change in the Demand for Money Interest Rate (i) Money (M) Demand for Money (MD) MD 1 MD 2

 Intersection of money demand and money supply determines the equilibrium interest rate (i).  Shifts in money demand or supply will change the equilibrium interest rate. The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

i Figure 14.4: The Equilibrium Interest Rate Interest Rate (i) Money (M) Demand for Money (MD) Supply for Money (MS)

 Real income declines  Associated with a recession  Individuals willing and able to hold less money  Demand for money declines from MD to MD 1.  Equilibrium interest rate would fall.  Price level increases  More money is needed to purchase same real volume of goods and services.  Demand for money increases from MD to MD 2.  Equilibrium interest rate would rise to i 2. The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

i Figure 14.4: The Equilibrium Interest Rate Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) MD 2 MD 1 i2i2 i1i1 G E F

 Increases in money supply will shift from MS to MS 1.  Equilibrium interest rate will fall to i 1.  Central bank decreases money supply will shift from MS to MS 2  Equilibrium interest rate will rise to i 2. The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

i Figure 14.4: The Equilibrium Interest Rate Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) i2i2 i1i1 MS 1 MS 2

The Interest Rate And the Exchange Rate in the Short Run  Interest Arbitrage:  Relationship between interest rates and the exchange rate in the short run  Firms must decide how to invest.  Goal is to maximize the short-run rate of return on cash.  Highest short-term rate may be in a different country.

 Moving money to another country requires exchanging money into foreign currency.  Exchange rate risk:  Even if better rate, changes in exchange rate over time could affect rate of return on investment  Must look at exchange rates and interest rates  Currency appreciation or depreciation will affect the rate of return  Rate of return: d ifference between annual interest rate in foreign and the depreciation of foreign currency (or plus an appreciation of the foreign currency). The Interest Rate And the Exchange Rate in the Short Run

 Example:  You own a company in U.S. looking to invest $10,000 cash.  Assume U.K. has the best rate of 12%.  You must first buy pounds in the foreign exchange market, then invest pounds in U.K. market.  If spot exchange rate is $2/pound, which gives you 5,000 pounds to invest. The Interest Rate And the Exchange Rate in the Short Run

 Example (continued):  In 3 months the money will be worth 5,150 pounds.  If the exchange rate is the same, you can exchange the pounds for $10,300  If pound drops to $1.975/pound (5% depreciation), end up with $10,  Total return is difference between annual interest rate in U.K. (12%) and depreciation of the pound (5%) = approx. 7%. The Interest Rate And the Exchange Rate in the Short Run

 Example (continued):  The pound could appreciate  If exchange goes to $2.025/pound (5% appreciation), end up with $10,  Total return is sum of annual interest rate in U.K. (12%) and appreciation of the pound (5%) = approx. 17% The Interest Rate And the Exchange Rate in the Short Run

 To eliminate exchange-rate risk  Buy foreign currency in spot exchange market  At same time sell pound in forward exchange market delivering on date of investment’s maturity  If forward rate  current spot rate, more profitable to invest in U.K.  If pound is selling at forward discount, must compare the gain in favorable interest rate to loss suffered by exchange rate The Interest Rate And the Exchange Rate in the Short Run

 Interest rate differential < forward discount  less profitable to invest in U.K.  Interest Parity: Movement of funds continues until forward premium or discount equals the interest rate differential  If interest parity exists between U.S. and U.K. and U.S. central bank decreases the money supply:  U.S. interest rates rise relative to U.K.  U.S. and U.K. investors have incentive to purchase short–term financial assets in U.S.  Sell pounds and buy dollars  Supply of pounds increases in foreign exchange market The Interest Rate And the Exchange Rate in the Short Run

 Tightening of money  higher interest rates  Selling pounds to buy U.S. financial assets increases supply of pounds  Dollar appreciates until interest parity is achieved.  Larger supply of pounds causes exchange rate to decline.  U.S. investor demand for pounds would also fall as investments in U.S. increase. The Interest Rate And the Exchange Rate in the Short Run

Figure 14.7: Effect of a Decrease in the U.S. Money Supply on the Dollar- Pound Exchange Rate F E E’ F’

 U.S. interest rates would fall.  British and U.S. investors buy pounds and sell dollars.  Demand for pounds increases.  Exchange rate rises – dollar depreciates. The Interest Rate And the Exchange Rate in the Short Run

Figure 14.8: Effect of an Increase in the U.S. Money Supply on the Dollar-Pound Exchange Rate G E E’ G’

 Changes in Interest Rates:  Increasing a country’s interest rate:  Causes capital inflow  Appreciation of a country’s currency  Decreasing a country’s interest rate:  Causes capital outflow  Depreciates a country’s currency  Movement of capital causes change exchange rates  Interest rate volatility  exchange rate volatility Interest Rates, the Exchange Rate, and the Balance of Payments

 Balance of Payments:  Country’s inflows and outflows of money balance overtime.  Current account and balance of capital flows are inverse signs.  Changes in the money supply and interest rates affect capital flows.  Changes in capital flows change exchange rates. Interest Rates, the Exchange Rate, and the Balance of Payments

 Balance of Payments (continued):  If capital flows are zero:  Demand and supply of foreign exchange are country’s exports and imports of goods and services.  Current account is balanced at equilibrium exchange rate  Exports equal imports Interest Rates, the Exchange Rate, and the Balance of Payments

Figure 14.9: The Foreign Exchange Market With and Without Capital Flows E

 What happens if there are now capital flows between countries?  Assume U.S. interest rates increase  Capital moves into US.  Supply of pounds increases and dollar appreciates (pound depreciates). Interest Rates, the Exchange Rate, and the Balance of Payments

 New equilibrium balances current account and capital flows.  Capital inflows mean the current account must be in a deficit.  Deficit shown in next slide.  New $/£ 1  Total imports of goods/services at D and S 1  Total exports of goods/services at $/£ 1 and S Interest Rates, the Exchange Rate, and the Balance of Payments

Figure 14.9: The Foreign Exchange Market With and Without Capital Flows E F G Capital Inflow

 Appreciation of exchange rate causes total exports to fall.  At new exchange rate:  Imports of goods and services > exports  Creates current account deficit  Overall balance of payments “balances”  Current account deficit  Capital flow surplus Interest Rates, the Exchange Rate, and the Balance of Payments

 Interest rates in real terms are relatively high.  High interest rates attract foreign capital creating capital account surplus.  Surplus causes appreciation of dollar leading to current account deficit. Interest Rates, the Exchange Rate, and the Balance of Payments

 Interest rates decline in Japan  Capital is moved from Japan to U.S.  Demand for dollars increases  Exchange rate rises - Yen depreciates, dollar appreciates  Exports of goods/services increase, imports decrease  Capital account in deficit, current account in surplus Interest Rates, the Exchange Rate, and the Balance of Payments

Figure 14.10: The Foreign Exchange Market With and Without Capital Flows E G F

 As interest rates change:  Capital flows adjust.  Exchange rate moves to new equilibrium.  Movement in capital affects exchange rate and size of current account deficit.  Money is an asset that acts as a:  Medium of exchange  Unit of account  Store of value Summary

 Individuals’ and businesses’ demand for money is:  Inversely related to the interest rate  Positively related to the price level  Positively related to the level of real income  Interest rates and exchange rates are interrelated though interest arbitrage.  The Foreign Exchange market equates the total inflow of foreign exchange with the total outflow of foreign exchange. Summary

 The balance of payments:  A record of a country’s economic transactions with all other countries.  Identifies economic transactions as current account transactions, capital account transactions, or financial account transactions. Summary