(Dollar interest rate) (Dollar/Euro exchange rate) Equilibrium Interest Rates and Exchange Rates Money-Market/Exchange Rate Linkages United States Federal Reserve System Europe European System of Central Banks (United States money supply) MSUS MSE (European money supply) United States money market European money market Foreign exchange market R$ (Dollar interest rate) R€ (Euro interest rate) E$/€ (Dollar/Euro exchange rate)

Money, Interest, and the Exchange Rate Medium of Exchange Unit of Account Express prices, keep records,…write contracts! Store of Value … Low risk Other, riskier assets are less liquid but pay higher return. Money Supply (Ms) Ms = Currency + Checkable Deposits Controlled by central bank

Aggregate Money Demand Md = P x L(R,Y) where: P = price level Y = real national income R = interest rate The demand for money can be expressed as the demand for real balances: Md/P = L(R,Y)

Aggregate Money Demand Aggregate Real Money Demand and the Interest Rate Interest rate, R Aggregate real money demand Md/P = L(R,Y)

Effect on Aggregate Real Money Demand of Rise in Real Income Interest rate, R Aggregate real money demand L(R,Y2) L(R,Y1) Increase in real income

Equilibrium in the Money Market: Md = Ms or Ms/P = L(R,Y) Interest rate, R Real money holdings Real money supply Aggregate real money demand, L(R,Y) R2 Q2 2 1 R1 R3 Q3 3 MS P ( = Q1)

Money Supply and Exchange Rate Short run analysis: The price level and real output are given  sticky prices Assume real output (Y) starts at full-employment Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment. Short – run Long – run

Linking Money, the Interest Rate, and the Exchange Rate United States Federal Reserve System Europe European System of Central Banks (United States money supply) MSUS MSE (European money supply) United States money market European money market Foreign exchange market R$ (Dollar interest rate) R€ (Euro interest rate) E$/€ (Dollar/Euro exchange rate)

Money Market and Exchange Market Interaction: Our Elaborated Model Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market U.S. real money holdings Rates of return (in dollar terms) Dollar/euro exchange Rate, E$/€ (increasing) Return on dollar deposits Foreign exchange market E1$/€ 1' Expected return on euro deposits Money market R1$ 1 L(R$, YUS) U.S. real money supply MSUS PUS

Money, Price Level, & Exchange Rate: the Long Run Long-run equilibrium: Prices are perfectly flexible  adjust to preserve full employment. Money and Money Prices From the money market equilibrium condition, Ms/P = L(R,Y) P = Ms/L(R,Y) The Classical Dichotomy: Ms  proportional P A change in Ms has no effect on the long-run values of R (the relative price of money) or Y (full employment output). In order for E to remain stable, R must return to R* in the long-run. This long-run equilibrium condition implies that P/P = Ms/Ms - L/L. The inflation rate equals the growth rate of Ms minus the growth rate of the demand for money (real balances). In long-run, E adjusts to P, keeping relative prices (foreign and domestic) constant  purchasing power parity. If E in long-run, Ee right away. (We’ve read the textbook).

Permanent Money Supply Changes and the Exchange Rate Short-run and Long-run Effects of an Increase in the U.S.Money Supply Dollar/euro exchange Rate, E$/€ Rates of return (in dollar terms) U.S. real money holdings (a) Short-run effects (b) Adjustment to long- run equilibrium Dollar/euro exchange Rate, E$/€ U.S. real money holdings Dollar return Dollar return 2' E2$/€ Expected euro return Expected euro return E2$/€ 2' 3' 4' E3$/€ E1$/€ 1' R2$ 2 R1$ 1 R2$ 2 R1$ 4 M1US P1US L(R$, YUS) M2US P2US L(R$, YUS) U.S. real money supply M2US P1US M2US P1US

Permanent Money Supply Changes and the Exchange Rate Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply (a) U.S. money supply, MUS Time (b) Dollar interest rate, R$ Time M2US R1$ t0 t0 M1US R2$ (c) U.S. price level, PUS Time (d) Dollar/euro exchange rate, E$/€ Time E2$/€ t0 P2US E3$/€ P1US E1$/€ t0

Effect of an Increase in the European Money Supply on Dollar/Euro Exchange Rate: Short-run response Expected return on euro holdings declines both because R* falls and Ee declines (euro is expected to depreciate). U.S. real money holdings Rates of return (in dollar terms) Dollar/euro exchange Rate, E$/€ Dollar return Expected euro return 1' E1$/€ Increase in European money supply 2' E2$/€ R1$ 1 L(R$, YUS) U.S. real money supply MSUS PUS