Chapter 14. Money, Interest Rates, and Exchange Rates

Slide 14-2Copyright © 2003 Pearson Education, Inc. Chapter Organization  Introduction  Money Defined  The Demand for Money by Individuals & Aggregate Money Demand  The Equilibrium Interest Rate: The Interaction of Money Supply and Demand  The Money Supply and the Exchange Rate in the Short Run  Money, the Price Level, and the Exchange Rate in the Long Run  Inflation and Exchange Rate Dynamics

Slide 14-3Copyright © 2003 Pearson Education, Inc. Introduction  Ch 13 showed how the exchange rate depends on two factors; interest rate & expected future exchange rate. Next questions are how interest rate is determined & how expected future exchange is formed. (next 3 chapters)  In this context, factors affecting a country’s money supply or demand are among the determinants of its currency’s exchange rate (against foreign currencies).  This chapter combines foreign-exchange market with money market to determine the exchange rate in the SR. It also analyzes the long-term effects of monetary changes on output prices and expected future exchange rates.

Slide 14-4Copyright © 2003 Pearson Education, Inc. 1. Money Defined: A Brief Review  Money as a Medium of Exchange A generally accepted means of payment  Money as a Unit of Account A widely recognized (standardized) measure of value  Money as a Store of Value Ground for medium of exchange A transfer of purchasing power from the present into the future  What Is Money? An asset widely used and accepted as a means of payment. Money is the most liquid, but pays little or no return. –All other assets are less liquid, but pay higher return.

Slide 14-5Copyright © 2003 Pearson Education, Inc.  Money Supply (M s ) or narrow money M s (M1)= Currency + Checkable Deposits (Demand deposits)  How the Money Supply Is Determined An economy’s money supply is controlled by its central bank. –The central bank: –Directly controls the amount of currency (base money) in existence. –Indirectly controls the amount of checkable deposits issued by private banks Money Defined: A Brief Review

Slide 14-6Copyright © 2003 Pearson Education, Inc.  Three factors influence money demand (amount of money wishing to hold as a form of asset): Expected return, risk, and liquidity.  Expected Return The interest rate measures the opportunity cost of holding money rather than interest-bearing bonds (or savings deposit). –A rise in the interest rate raises the cost of holding money and causes money demand to fall. 2. The Demand for Money by Individuals

Slide 14-7Copyright © 2003 Pearson Education, Inc.  Risk Holding money is risky. –An unexpected increase in the prices of goods and services (inflation) reduce the value of money in terms of the commodities consumed. However, changes in the risk of holding money need not cause individuals to reduce the relative demand for money. –Any change in the riskiness of money causes an equal change in the riskiness of bonds (or some other assets). The Demand for Money by Individuals

Slide 14-8Copyright © 2003 Pearson Education, Inc.  Liquidity The main benefit of holding money comes from its liquidity. –Households and firms hold money because it is the easiest way of paying their everyday purchases. A rise in the average value (amount) of transactions carried out by a household causes its demand for money to rise. –Eg. when a college graduate get a job. The Demand for Money by Individuals

Slide 14-9Copyright © 2003 Pearson Education, Inc. 3. Aggregate Money Demand  Aggregate money demand The total demand for money by all households and firms in the economy. It is determined by three main factors: –Interest rate –It reduces the demand for money. –(overall) price level –The price of a broad reference basket of goods and services –It raises the nominal demand for money (no change in real demand). –Real national income –It raises the demand for money.

Slide 14-10Copyright © 2003 Pearson Education, Inc.  The aggregate demand for money can be expressed by: M d = P x L(R,Y) (14-1) where: P is the price level Y is real national income L(R,Y) is the aggregate real money demand  Equation (14-1) can also be written as: M d /P = L(R,Y) (14-2) Aggregate Money Demand

Slide 14-11Copyright © 2003 Pearson Education, Inc. Figure 14-1: Aggregate Real Money Demand and the Interest Rate L(R,Y)L(R,Y) Interest rate, R Aggregate real money demand Aggregate Money Demand

Slide 14-12Copyright © 2003 Pearson Education, Inc. Figure 14-2: Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income L(R,Y2)L(R,Y2) Increase in real income L(R,Y1)L(R,Y1) Interest rate, R Aggregate real money demand Aggregate Money Demand

Slide 14-13Copyright © 2003 Pearson Education, Inc.  Equilibrium in the Money Market The condition for equilibrium in the money market is: M s = M d (14-3) The condition can be expressed in terms of aggregate real money demand as: M s /P = L(R,Y) (14-4) Suppose a disequilibrium point, eg. point 2 or 3 in Figure The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

Slide 14-14Copyright © 2003 Pearson Education, Inc. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-3: Determination of the Equilibrium Interest Rate Aggregate real money demand, L(R,Y) Interest rate, R Real money holdings Real money supply MS PMS P ( = Q 1 ) R2R2 Q2Q2 2 R1R1 1 R3R3 Q3Q3 3

Slide 14-15Copyright © 2003 Pearson Education, Inc.  the Money Supply and Interest Rates An increase (fall) in the money supply lowers (raises) the interest rate, given the price level and output. –The effect of increasing the money supply at a given price level is illustrated in Figure –Start with the initial equilibrium point before the change in money supply. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

Slide 14-16Copyright © 2003 Pearson Education, Inc. M2 PM2 P R2R2 2 M1 PM1 P Real money supply Real money supply increase The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-4: Effect of an Increase in the Money Supply on the Interest Rate L(R,Y1)L(R,Y1) R1R1 1 Interest rate, R Real money holdings

Slide 14-17Copyright © 2003 Pearson Education, Inc.  Output and the Interest Rate An increase in real output(Y) raises the interest rate, given the price level and the money supply. –A decrease in Y lowers the interest rate, if other conditions are given. –Figure 14-5 shows these effects. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

Slide 14-18Copyright © 2003 Pearson Education, Inc. Q2Q2 1'1' The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-5: Effect on the Interest Rate of a Rise in Real Income L(R,Y1)L(R,Y1) L(R,Y 2 ) Increase in real income Real money supply MS PMS P ( = Q 1 ) R2R2 2 R1R1 1 Interest rate, R Real money holdings

Slide 14-19Copyright © 2003 Pearson Education, Inc. 5. The Money Supply and the Exchange Rate in the Short Run  Combine the analysis of the previous chapter and the money market analysis. Interest rate parity condition (for exchange rate determination) linked with interest rate determination in the money market. (We will see) increase in a country’s money supply causes the depreciation of its currency.  Short run analysis: The price level is assumed to be given (fixed)- sticky price.  Long run analysis allows for the complete adjustment of the price level (which may take a long time). Equivalent to perfectly flexible price (price immediately adjusts) The LR analysis also assume full employment of all factors, because price is adjusted flexibly.

Slide 14-20Copyright © 2003 Pearson Education, Inc. The Money Supply and the Exchange Rate in the Short Run  Linking Money, the Interest Rate, and the Exchange Rate U.S. money market determines the dollar interest rate, which in turn affects the exchange rate that maintains the interest parity. –Figure 14-6 links the U.S. money market (bottom) and the foreign exchange market (top).

Slide 14-21Copyright © 2003 Pearson Education, Inc. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-6: Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market Return on dollar deposits Expected return on euro deposits L(R $, Y US ) U.S. real money holdings Rates of return (in dollar terms) Dollar/euro exchange Rate, E $/€ 0 (increasing) Foreign exchange market Money market E 1 $/€ 1'1' R1$R1$ 1 U.S. real money supply M S US P US

Slide 14-22Copyright © 2003 Pearson Education, Inc. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-7: Money-Market/Exchange Rate Linkages European money market United States money market Europe European System of Central Banks United States Federal Reserve System (US money supply) M S US MSEMSE (European money supply) R $ (Dollar interest rate) R € (Euro interest rate) Foreign exchange market E $/€ (Dollar/Euro exchange rate)

Slide 14-23Copyright © 2003 Pearson Education, Inc.  U.S. Money Supply and the Dollar/Euro Exchange Rate An increase in a country’s money supply causes its currency to depreciate in the foreign exchange market, –Thru decrease in Dollar interest rate.  Europe’s Money Supply and the Dollar/Euro Exchange Rate An increase in Europe’s money supply causes a depreciation of the euro (* appreciation of the dollar). –Thru decrease in Euro interest rate. Changes in the European money supply does not disturb the U.S. money market equilibrium –No change in dollar interest rate. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

Slide 14-24Copyright © 2003 Pearson Education, Inc. Increase in U.S. real money supply Expected return on euro deposits The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 14-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply E 2 $/€ 2'2' U.S. real money holdings Rates of return (in dollar terms) Dollar/euro exchange Rate, E $/€ 0 Return on dollar deposits L(R $, Y US ) E 1 $/€ 1'1' R1$R1$ 1 M 1 US P US R2$R2$ 2 M 2 US P US

Slide 14-25Copyright © 2003 Pearson Education, Inc. Figure 14-9: Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate Increase in European money supply U.S. real money holdings Rates of return (in dollar terms) Dollar/euro exchange Rate, E $/€ 0 Expected euro return L(R $, Y US ) U.S. real money supply M S US P US R1$R1$ 1 E 1 $/€ 1'1' Dollar return The Equilibrium Interest Rate: The Interaction of Money Supply and Demand E 2 $/€ 2'2'

Slide 14-26Copyright © 2003 Pearson Education, Inc. 6. Money, the Price Level, and the Exchange Rate in the Long Run  Long-run equilibrium Prices are perfectly flexible and adjusted fully to preserve full employment. <cf: Our SR analysis assumed price level fixed even with change in money supply, while it cannot hold in the LR.  Money and Money Prices The money market equilibrium (Equation 14-4) can be rearranged to give the long-run equilibrium price level: P = M s /L(R,Y) (14-5) An increase in a country’s money supply causes a proportional increase in its price level. –R & Y are at their long-run equilibrium level of full-employment.

Slide 14-27Copyright © 2003 Pearson Education, Inc.  The Long-Run Effects of Changes in Money Supply A change in the money supply has no effect on the long-run values of the interest rate or real output. –Consider currency reform of 1 to 10 (or equivalent change in money supply)- no effect on real output, interest rate & relative prices of goods. –The full-employment output level is determined at the equilibrium level of labor & capital inputs, and interest rate will not change either by the change in money supply in the LR. Permanent increase in the money supply causes proportional increase in long-run price level. –This prediction is based on the money market equilibrium condition: M s /P = L(R,Y) or P = M s /L(R,Y). Money, the Price Level, and the Exchange Rate in the Long Run

Slide 14-28Copyright © 2003 Pearson Education, Inc.  Empirical Evidence on Money Supplies and Price Levels In a cross-section of countries, long-term changes in money supplies and price levels show a clear positive correlation. Refer to the Figure (p. 356). Money, the Price Level, and the Exchange Rate in the Long Run

Slide 14-29Copyright © 2003 Pearson Education, Inc.  Money and the Exchange Rate in the Long Run A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies. –The domestic currency price of foreign currency (namely, the exchange rate) is one of the many prices rising due to the increase in the money supply. –(eg. Consider currency reform again). Money, the Price Level, and the Exchange Rate in the Long Run

Slide 14-30Copyright © 2003 Pearson Education, Inc. 7. Inflation and Exchange Rate Dynamics  Combine the SR and LR analysis of the effects of monetary changes. What would happen between SR equil’m to LR equil’m.  Inflation: a situation where an economy’s price level rises.  Deflation: a situation where an economy’s price level falls.  Short-Run Price Rigidity versus Long-Run Price Flexibility The SR price stickiness is applicable to some goods (eg. wages) which are subject to long-term contracts, while not applicable to other goods (eg. food prices). – “controversial”. The short-run price “stickiness” is illustrated in Figure –Exchange rate is much more volatile than relative prices.

Slide 14-31Copyright © 2003 Pearson Education, Inc. Figure 14-11: Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, Inflation and Exchange Rate Dynamics

Slide 14-32Copyright © 2003 Pearson Education, Inc.  An increase in the money supply (albeit short run price rigidity) creates demand and cost pressures that eventually lead to increases in the price level from the following three sources: Excess demand for output and labor: –Increase in money supply has expansionary effect on the economy, raising the demand for output & consequently for labor –Wage & price increase expected. Inflationary expectations: Raw materials prices: –Prices of some of these adjust rapidly even in the SR. Inflation and Exchange Rate Dynamics

Slide 14-33Copyright © 2003 Pearson Education, Inc.  Permanent Changes in Money Supply and the Exchange Rate  How does the dollar/euro exchange rate adjust to a permanent increase in the U.S. money supply? Figure shows both the short-run and long-run effects of the increase in the U.S. money supply. The key difference here is that exchange rate expectation is changed responding to the permanent increase of money supply. –People expect increases in dollar prices of all things, including the exchange rate (dollar price of euro). –This leads to the change in the exchange rate. (recall the interest parity condition.) Inflation and Exchange Rate Dynamics

Slide 14-34Copyright © 2003 Pearson Education, Inc. Figure 14-12: Effects of an Increase in the U.S.Money Supply Dollar return M 1 US P 1 US M 2 US P 1 US U.S. real money supply M 2 US P 2 US M 2 US P 1 US Dollar/euro exchange Rate, E $/€ Rates of return (in dollar terms) U.S. real money holdings 0 (a) Short-run effects 0 (b) Adjustment to long- run equilibrium Dollar/euro exchange Rate, E $/€ U.S. real money holdings E 2 $/€ 2' E 3 $/€ 4' R1$R1$ 4 R2$R2$ 2 R1$R1$ 1 Inflation and Exchange Rate Dynamics 3' 2' E 2 $/€ Expected euro return Expected euro return L(R $, Y US ) R2$R2$ 2 E 1 $/€ 1'

Slide 14-35Copyright © 2003 Pearson Education, Inc. Figure 14-13: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply Inflation and Exchange Rate Dynamics P 2 US E 3 $/€ E 1 $/€ t0t0 (a) U.S. money supply, M US Time (c) U.S. price level, P US Time (b) Dollar interest rate, R $ Time M 1 US t0t0 t0t0 R1$R1$ M 2 US P 1 US t0t0 R2$R2$ E 2 $/€ (d) Dollar/euro exchange rate, E $/€ Time

Slide 14-36Copyright © 2003 Pearson Education, Inc.  Exchange Rate Overshooting The exchange rate is said to overshoot when its immediate response to a disturbance is greater than its long-run response. It helps explain why exchange rates move so sharply form day to day. It is a direct result of sluggish short-run price level adjustment and the interest parity condition. –Foreign exchange market is in equilibrium under interest rate parity during the adjustment period (R & P). Inflation and Exchange Rate Dynamics

Slide 14-37Copyright © 2003 Pearson Education, Inc. Summary  Money is held because of its liquidity.  Aggregate real money demand depends negatively on the opportunity cost of holding money and positively on the volume of transactions in the economy.  The money market is in equilibrium when the real money supply equals aggregate real money demand.  By lowering the domestic interest rate, an increase in the money supply causes the domestic currency to depreciate in the foreign exchange market.

Slide 14-38Copyright © 2003 Pearson Education, Inc.  Permanent changes in the money supply push the long-run equilibrium price level proportionally in the same direction. These changes do not influence the long-run values of output, the interest rate, or any relative prices.  An increase in the money supply can cause the exchange rate to overshoot its long-run level in the short run. Summary