1 Ch. 14: Money, Interest Rates, and Exchange Rates

2 The Outline We learned that exchange rates depend on interest rates on the deposits of currencies and the expected future exchange rate. We learned that exchange rates depend on interest rates on the deposits of currencies and the expected future exchange rate. What affects interest rates and expectations is our next concern. What affects interest rates and expectations is our next concern.

3 Money Nominal interest rate in a country is closely related to the supply and demand of money. Nominal interest rate in a country is closely related to the supply and demand of money. Future price level in a country is closely related to the supply and demand of money. Future price level in a country is closely related to the supply and demand of money. Future prices of products affect the expected exchange rate. Future prices of products affect the expected exchange rate. Since supply and demand of money is so influential in determining exchange rates, we start with it. Since supply and demand of money is so influential in determining exchange rates, we start with it.

4 What Is Money? Money is anything that is accepted in a society in return for goods and services and settlements of debts. Money is anything that is accepted in a society in return for goods and services and settlements of debts. Money fulfills three functions. Money fulfills three functions. Money is a unit of account. Money is a unit of account. Money is a medium of exchange. Money is a medium of exchange. Money is a store of value. Money is a store of value.

5 What Is Money? Currency and checking deposits fulfill all three functions. Currency and checking deposits fulfill all three functions. Saving deposits are not a medium of exchange, although the ease with which they can be transferred to checking deposits make them closer to money. Saving deposits are not a medium of exchange, although the ease with which they can be transferred to checking deposits make them closer to money. For simplicity, we will define money as currency plus demand deposits. For simplicity, we will define money as currency plus demand deposits.

6 Money Supply The amount of money supplied to the economy, therefore, depends on the available currency outside of the banks and the holdings of checking deposits. The amount of money supplied to the economy, therefore, depends on the available currency outside of the banks and the holdings of checking deposits. The Federal Reserve, the Central Bank of US, controls the money supply by manipulating the reserves available for banks. The Federal Reserve, the Central Bank of US, controls the money supply by manipulating the reserves available for banks.

7 Money Demand Currency and demand deposits are assets for holders. Currency and demand deposits are assets for holders. The theory of asset demand says three factors determine the demand for an asset. The theory of asset demand says three factors determine the demand for an asset. Expected return of an asset compared to returns from other assets. Expected return of an asset compared to returns from other assets. Riskiness of an asset’s returns. Riskiness of an asset’s returns. Liquidity of an asset. Liquidity of an asset.

8 Expected Return Currency has no return. In the absence of inflation, $1 bill is worth the same a year from now as today. Currency has no return. In the absence of inflation, $1 bill is worth the same a year from now as today. Checking deposits may or may not pay interest. Typically, the interest paid is lower than saving deposits or bonds. The difference in interest paid between checking deposits and bonds is the opportunity cost of holding money. Checking deposits may or may not pay interest. Typically, the interest paid is lower than saving deposits or bonds. The difference in interest paid between checking deposits and bonds is the opportunity cost of holding money. When interest rates rise, the opportunity cost of holding money rises and people hold less money. When interest rates rise, the opportunity cost of holding money rises and people hold less money. The demand for money falls. The demand for money falls.

9 Riskiness The riskiness of money is the unexpected loss of its value due to inflation. The riskiness of money is the unexpected loss of its value due to inflation. Bonds and saving accounts lose their value with inflation, too. Bonds and saving accounts lose their value with inflation, too. Inflation, therefore, will not change a person’s portfolio between money and bonds. Inflation, therefore, will not change a person’s portfolio between money and bonds.

10 Liquidity In order to carry out purchases, people need to hold an inventory of money. In order to carry out purchases, people need to hold an inventory of money. The higher the value of transactions a person expects to conduct per period, the higher is the demand for money. The higher the value of transactions a person expects to conduct per period, the higher is the demand for money.

11 Additional Variables for the Demand for Money Income of the individual Income of the individual The higher the income, the higher is the demand for money. The higher the income, the higher is the demand for money. Price level Price level Likewise, the higher is the price level, the higher is the demand for money. Likewise, the higher is the price level, the higher is the demand for money.

12 The Demand for Money The demand for money will fall as interest rates rise. The demand for money will fall as interest rates rise. The demand for money will rise as real income rises. The demand for money will rise as real income rises. The demand for money will be proportional to the price level, rising by the same percentage. The demand for money will be proportional to the price level, rising by the same percentage.

13 The Demand for Money M d = P L(R,Y) M d /P = L(R,Y) Real money demand depends on interest rate and real income.

14 The Demand for Money R M/P Increase in Y shifts demand right.

15 The Demand for Money R M/P If R and Y are kept constant, any % increase in P has to be matched by an equal % increase by M.

16 The Demand for Money R M/P If R is allowed to change but Y is kept constant, any increase in P will increase interest rates as well.

17 Equilibrium Interest Rate M/P R Real Money Supply Real Money Demand R 0 R 1 What happens at R 1 ? There is excess supply. People want to hold less money. They try to exchange their money for interest bearing assets, like bonds. Every one trying to buy bonds, raises the price of bonds and lowers the interest rate until equilibrium is reached.

18 Equilibrium Interest Rate If there is excess real money supply, interest rates fall. If there is excess real money supply, interest rates fall. If there is excess real money demand, interest rates rise. If there is excess real money demand, interest rates rise. If income (output=Y) increases, interest rates rise. If income (output=Y) increases, interest rates rise. If real money supply increases, interest rates fall. If real money supply increases, interest rates fall.

19 Changes in the Money Supply An increase in the money supply lowers the interest rate for a given price level. A decrease in the money supply raises the interest rate for a given price level.

20 Changes in National Income An increase in national income increases equilibrium interest rates for a given price level.

21 Linking the Money Market to the Foreign Exchange Market

22 Interaction of Monetary Sector and FX Market R R R M/P $/€ Return in $ Expected $ return on euro deposits E 0 R 0 E1E1 R 1

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25 Application In each following case assume that nothing else changes: ceteris paribus. In each following case assume that nothing else changes: ceteris paribus. What happens to USD exchange rate if the Fed raises the interest rate? What happens to USD exchange rate if the Fed raises the interest rate? What happens to USD exchange rate if US economy grows? What happens to USD exchange rate if US economy grows? In both cases USD appreciates.

26 Application What happens to the exchange rate between $ and €, if the ECB lowers the interest rate? What happens to the exchange rate between $ and €, if the ECB lowers the interest rate? If you said USD appreciates and € depreciates, you were right. How do you show this in the related markets of money and FX?

27 Interaction of Monetary Sector and FX Market R R R M/P $/€ Return in $ Expected $ return on euro deposits E0E0 R0R0 E 1

28 Changes in the Foreign Money Supply How would a change in the euro money supply affect the US money market and foreign exchange market? How would a change in the euro money supply affect the US money market and foreign exchange market? An increase in the EU money supply causes a depreciation of the euro (appreciation of the dollar). An increase in the EU money supply causes a depreciation of the euro (appreciation of the dollar). A decrease in the EU money supply causes an appreciation of the euro (a depreciation of the dollar). A decrease in the EU money supply causes an appreciation of the euro (a depreciation of the dollar).

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30 Short Run to Long Run In the short run, both output (Y) and price level (P) will remain constant. In the short run, both output (Y) and price level (P) will remain constant. In the medium run, output will change but price level will not. In the medium run, output will change but price level will not. Long run is when the price level is allowed for full adjustment. Long run is when the price level is allowed for full adjustment.

31 Long Run The long run position of an economy is when full employment is reached. The long run position of an economy is when full employment is reached. Full employment in an economy occurs when all markets clear and resources are allocated efficiently. Full employment in an economy occurs when all markets clear and resources are allocated efficiently. To have clearance in all markets means prices and wages have adjusted fully. To have clearance in all markets means prices and wages have adjusted fully. An economy with perfect flexibility in prices and wages always operates in full employment. An economy with perfect flexibility in prices and wages always operates in full employment.

32 Short Run In the short run equilibrium in the monetary sector happens with the adjustment of interest rates. In the short run equilibrium in the monetary sector happens with the adjustment of interest rates. M S = M D M S = M D M D = P L(Y,R) M D = P L(Y,R) P and Y are constant in the short run. P and Y are constant in the short run. M S increase will have to be matched by R decrease. M S increase will have to be matched by R decrease.

33 Short Run R M/P R1 (M/P)’(M/P) R2

34 Medium Run Lower interest rates spur more investment activities by firms. Lower interest rates spur more investment activities by firms. As firms expand operations, income (Y) increases. As firms expand operations, income (Y) increases. Higher Y pushes the demand for money outward. Higher Y pushes the demand for money outward. Interest rates rise. Interest rates rise.

35 Medium Run R M/P R1 (M/P)’(M/P) R2 R3

36 Long Run In the long run, prices adjust to the higher level of money supply. In the long run, prices adjust to the higher level of money supply. Long run is also characterized by actual inflation being equal to expected inflation. Long run is also characterized by actual inflation being equal to expected inflation. In the long run, interest rates will be equal to real interest rates plus actual inflation. In the long run, interest rates will be equal to real interest rates plus actual inflation. As price level rises, real demand for money will drop. As price level rises, real demand for money will drop.

37 Long Run R M/P R1, R3 (M/P)’(M/P) R2

38 Long Run Real interest rates are determined by the interaction of investments (demand for loanable funds) and savings (supply of loanable funds). Real interest rates are determined by the interaction of investments (demand for loanable funds) and savings (supply of loanable funds). Nominal interest rates are equal to real interest rates in the absence of inflation. Nominal interest rates are equal to real interest rates in the absence of inflation. Income (Y) in the long run is determined by available capital, labor, and technology, all fully employed. Income (Y) in the long run is determined by available capital, labor, and technology, all fully employed.

39 Long Run Changes in money supply will have no effect on real variables in the long run. Changes in money supply will have no effect on real variables in the long run. I=S will determine R. I=S will determine R. K, L, A will determine Y. K, L, A will determine Y. Rate of increase of M will be exactly matched by the rate of increase in P. Rate of increase of M will be exactly matched by the rate of increase in P.

40 Long Run and Short Run In the long run, there is a direct relationship between the inflation rate and changes in the money supply. In the long run, there is a direct relationship between the inflation rate and changes in the money supply. M s = P x L(R,Y) M s = P x L(R,Y) P = M s /L(R,Y) P = M s /L(R,Y)  P/P =  M s /M s -  L/L  P/P =  M s /M s -  L/L The inflation rate equals growth rate in money supply minus the growth rate for money demand. The inflation rate equals growth rate in money supply minus the growth rate for money demand.

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42 Money and Prices in the Long Run 1. Excess demand: an increase in the money supply implies that people have more funds available to pay for goods and services. To meet strong demand, producers hire more workers, creating a strong demand for labor, or make existing employees work harder. To meet strong demand, producers hire more workers, creating a strong demand for labor, or make existing employees work harder. Wages rise to attract more workers or to compensate workers for overtime. Wages rise to attract more workers or to compensate workers for overtime. Prices of output will eventually rise to compensate for higher costs. Prices of output will eventually rise to compensate for higher costs. Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the strong demand. Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the strong demand.

43 Money and Prices in the Long Run 2. Inflationary expectations: If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. And if producers expect the same, they are more willing to raise wages. And if producers expect the same, they are more willing to raise wages. Producers will be able to match higher costs if they expect to raise prices. Producers will be able to match higher costs if they expect to raise prices. Result: expectations about inflation caused by an expected money supply increase leads to actual inflation. Result: expectations about inflation caused by an expected money supply increase leads to actual inflation.

44 Exchange Rate in the Long Run When the amount of money doubles under full employment, we expect the price level to double, too. When the amount of money doubles under full employment, we expect the price level to double, too. The price of foreign currency, therefore, should double, too. The price of foreign currency, therefore, should double, too. If the price of euros were $1 per euro, it will become $2 per euro. If the price of euros were $1 per euro, it will become $2 per euro.

45 Money, Prices and the Exchange Rates and Expectations When we consider price changes in the long run, inflationary expectations will have an effect in the foreign exchange market. When we consider price changes in the long run, inflationary expectations will have an effect in the foreign exchange market. Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterwards. Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterwards.

46 Inflationary Expectations in the Long Run R R R M/P $/€ Return in $ Expected $ return on euro deposits E0E0 R0R0 E1E1 If M and P grow at the same rate, M/P will remain constant. However, inflation in the future should boost the expected appreciation of euro. USD depreciates.

47 Seeming Paradox In the short run, money supply increase lowers the interest rate and depreciates the currency. In the short run, money supply increase lowers the interest rate and depreciates the currency. An increase in the growth rate of money increases inflationary expectations and hence raises the nominal interest rate (Fisher effect). An increase in the growth rate of money increases inflationary expectations and hence raises the nominal interest rate (Fisher effect). This raises the expected appreciation of foreign currency and depreciates the spot value of domestic currency. This raises the expected appreciation of foreign currency and depreciates the spot value of domestic currency. An increase of money supply leads to exchange rate overshooting. An increase of money supply leads to exchange rate overshooting.

48 Short Run Effect of Money Supply Increase in US R R R M/P $/€ Return in $ Expected $ return on euro deposits E0E0 R0R0 Increase of M in US changes expectations about future exchange rates. Euro is expected to appreciate. E1E1 R1R1

49 Long Run Effect of Money Supply Increase in US R R R M/P $/€ Return in $ Expected $ return on euro deposits E0E0 R0R0 Price increases shift M/P to the left. Higher R in US appreciates USD. E1E1 R1R1 E2E2

50 Change in expected return on euro deposits The expected return on euro deposits rises because of inflationary expectations: The dollar is expected to be less valuable when buying goods and services and less valuable when buying euros. The dollar is expected to depreciate, increasing the return on deposits in euros.

51 Original (long run) return on dollar deposits As prices increases, the real money supply decreases and the domestic interest rate returns to its long run rate.

52 Money, Prices and the Exchange Rates in the Long Run A permanent increase in a country’s money supply causes a proportional long run depreciation of its currency. A permanent increase in a country’s money supply causes a proportional long run depreciation of its currency. However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation. However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation. A permanent decrease in a country’s money supply causes a proportional long run appreciation of its currency. A permanent decrease in a country’s money supply causes a proportional long run appreciation of its currency. However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation. However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

53 Overshooting A permanent increase in M first A permanent increase in M first lowered R $ lowered R $ raised E 0 to E 1 raised E 0 to E 1 In time, In time, price level rose. price level rose. R $ rose. R $ rose. E 1 dropped to E 2 E 1 dropped to E 2 Exchange rate overshooting refers to the movement of E away from its long run value. Exchange rate overshooting refers to the movement of E away from its long run value.

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55 Exchange Rate Overshooting The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response. The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response. We assume that changes in the money supply have immediate effects on interest rates and exchange rates. We assume that changes in the money supply have immediate effects on interest rates and exchange rates. We assume that people change their expectations about inflation immediately after a change in the money supply. We assume that people change their expectations about inflation immediately after a change in the money supply. Overshooting helps explain why exchange rates are so volatile. Overshooting helps explain why exchange rates are so volatile. Overshooting occurs in the model because prices do not adjust quickly, but expectations about prices do. Overshooting occurs in the model because prices do not adjust quickly, but expectations about prices do.

56 Exchange Rate Volatility Changes in price levels are less volatile, suggesting that price levels change slowly. Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.