Chapter 14 Supplementary Notes

What is Money? Medium of Exchange –A generally accepted means of payment A Unit of Account –A widely recognized measure of value A Store of Value –A transfer of purchasing power from the present into the future

Money includes assets widely used and accepted as a means of payment. Money is very liquid, but pays little or no return. –All other assets are less liquid but pay higher return. Money Supply (M s ) M s = Currency + Checkable Deposits Money Supply

How the Money Supply Is Determined –An economy ’ s money supply is controlled by its central bank. –The central bank: Directly regulates the amount of currency in existence Indirectly controls the amount of checking deposits issued by private banks Money Supply

Demand for money is about why individuals choose money instead of other assets. Other assets include stocks, bonds, real estate, etc. These nonmonetary assets are collectively called “ bonds. ” Three factors influence money demand: –Expected return –Risk –Liquidity The Demand for Money by Individuals

Money vs. Bonds Money Pay no interest.  Expected return is zero. Liquidity is higher. Bonds Pay interest.  Expected return is higher. Liquidity is lower.

Expected Return Money is held for liquidity purposes. The interest rate measures the opportunity cost of holding money rather than interest- bearing bonds. –A rise in the interest rate raises the cost of holding money and causes money demand to fall.

Riskiness Holding money is risky. –Unexpected increase in the price level reduces the value of money. Changes in riskiness equally affect both money and bonds. Thus, risk is not an important factor in money demand.

Liquidity Money is held for liquidity. The value of holding liquidity increases with transactions. The magnitude of transactions is positively related to income. When income rises, transaction volume increases and the demand for money rises. If the price level increases, nominal transaction volume increases and the demand for nominal money balance increases.

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 Is negatively related to money demand. –Real national income Is positively related to money demand. –Price level Is positively related to money demand.

Aggregate Money Demand The aggregate demand for money can be expressed by: M d = P x L(R,Y) where: P is the price level Y is real national income R is a measure of interest rates L(R,Y) is the aggregate real money demand Alternatively: M d /P = L(R,Y) Aggregate real money demand is a function of national income and interest rates.

Aggregate Money Demand For a given level of income, real money demand decreases as the interest rate increases.

Increase in Money Demand When income increases, real money demand increases at every interest rate.

The Money Market The condition for equilibrium in the money market is: M s = M d or M s /P = M d /P  M s /P = L(R,Y) This equilibrium condition will yield an equilibrium interest rate.

Money Market Equilibrium

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

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

Linking the Money Market to the Foreign Exchange Market

Changes in the Domestic Money Supply

Changes in the Foreign Money Supply

Money, Prices and the Exchange Rates in the Long Run Money is neutral in the long run. –It has no effects on real variables. (Neutral) –A permanent increase in a country’s money supply causes a proportional increase in the price level. –The domestic currency depreciates proportionately.

Short Run and Long Run In the short run (with fixed P), an increase in money supply Leaves P unaffected Lowers R In the long run (with flexible P), an increase in money supply Raises P proportionately Has no effect on R

Goods Prices in the Short Run and Long Run Observation: Prices are sticky. They move slowly. Theory (abstraction): We assume that prices are fixed in the short run but flexible in the long run. In the long run, nominal variables (M, P, and E) change proportionately. Individuals have rational expectations. They expect E and P to move according to the long- run rule. In other words, as M increases, E e and P e move in the same proportion as the increase in M now in the short run!

Money, Prices and the Exchange Rates in the Short Run In the short run, when money supply increases, –The price level (P) is fixed and the interest rate (R) declines to clear the money market. –The expected future exchange rate rises (E e  ). (A) How would the exchange rate move? –Because, the domestic interest is now lower than the foreign interest rate, according to the interest parity condition, R-R* = (E e -E)/E, the expected rate of depreciation must be negative. –I.e., the domestic currency must be expected to appreciate! (B) –(A) and (B) are simultaneously true only if the exchange rate (E) rises more in the short run than it would in the long run (as indicated by E e ). –The exchange rate (E) overshoots its long-run level (E e ). –After the overshooting, the exchange rate declines (appreciates) to its long-run level.

Money, Prices, the Exchange Rates, and Expectations 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.

Money, Prices and the Exchange Rates in the Long Run Original return on dollar deposits As prices increases, the real money supply decreases and the domestic interest rate returns to its long run rate.

Exchange Rate Overshooting 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 people change their expectations about inflation immediately after a change in the money supply. 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.

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.