Ch. 15: Money, Interest Rates, and Exchange Rates Udayan Roy ECO41 International Economics

What is Money? Money is any asset that is widely used and accepted as a means of payment. So, a countrys quantity of money (M s ) includes – All currency with the public and – The value of all checking accounts bank deposits in a foreign currency are excluded from this definition. M1 and M2 are two well-known periodically published measures of the quantity of money M1M2

Properties of Money: No Return We can classify all assets into: – Money, which earns no return Currency with the public, checking accounts – Assets that earn a return Stocks, bonds, real estate, etc.

Properties of Money: Liquid Money is very liquid: – that is, it can easily and quickly be used to purchase goods and services. Assets that earn a return are less liquid

Money Supply The quantity of money is also called the money supply Who controls the money supply? Central banks determine the money supply. – In the US, the central bank is the Federal Reserve. – The Federal Reserve directly regulates the amount of currency in circulation. – It indirectly controls the amount of checking deposits issued by private banks.

Money Demand Money demand is the amount of their wealth that people are willing to hold in the form of money … – (… instead of other assets that are less liquid but earn a higher return).

Money Demand: Individual 1.Interest rate (on interest-earning assets): this is the cost (or, downside) of holding money. 2.Risk: the risk of holding money principally comes from unexpected inflation, thereby unexpectedly reducing the purchasing power of money. – but many other assets have this risk too, so this risk is not very important in money demand 3.Liquidity: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought in transactions increases.

Money Demand: Aggregate Interest rate Average level of prices Income

Money Demand: Aggregate Money pays little or no interest. So, the interest rate on interest-earning assets (such as bonds) is the opportunity cost of holding money (instead of non-money assets). A higher interest rate means a higher opportunity cost of holding money lower money demand Therefore, aggregate money demand (M d ) is inversely related to the interest rate (R)

Money Demand: Aggregate The overall level of prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. A higher overall price level means a greater need for liquidity to buy the same amount of goods and services higher money demand Therefore, aggregate money demand (M d ) is directly related to the overall level of prices (P)

Money Demand: Aggregate Higher income implies more goods and services are being produced and bought So, more money would be needed to conduct transactions. A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity higher money demand Therefore, aggregate money demand (M d ) is directly related to GNP (Y)

Money Demand: Aggregate

Equilibrium

THE AA CURVE This topic is actually in Chapter 17. But lets do it now anyway.

Two Markets: Foreign Exchange and Money So far, we have seen the equilibrium conditions for the two asset markets – The foreign exchange market (Ch. 14), and – The money market (this chapter)

Equilibrium in Asset Markets

This gives us the AA Schedule (or the AA Curve) of Chapter 17.

Fig. 17-7: The AA Schedule

Shifting the AA Curve AA 2 3

Shifting the AA Curve The AA curve shifts right if: – M s increases – P decreases – E e rises – R* rises – L decreases for some unknown reason Y E E0E0 Y0Y0 Y1Y1 E1E1