1. Slide 14-1Copyright © 2003 Pearson Education, Inc. Money, Interest, and the Exchange Rate MONEY Medium of Exchange A generally accepted means of payment Unit of Account A widely recognized measure of value Express prices, keep records,… write contracts ! Store of Value Transfer purchasing power from the present to the future

2. Slide 14-2Copyright © 2003 Pearson Education, Inc.  What Is Money? Asset used and accepted as means of payment. A liquid asset with little or no return. –All other assets are less liquid but pay higher return. Money Supply (M s ) M s = Currency + Checkable Deposits  How Is Economy’s Money Supply Determined? Controlled by central bank that –Directly regulates the amount of currency in existence –Indirectly controls the amount of checking deposits issued by private banks Money Defined: A Brief Review

3. Slide 14-3Copyright © 2003 Pearson Education, Inc. Demand for money: a function of … Expected return – interest earnings forgone Risk – money loses value if prices increase unexpectedly –A change in the inflation risk of holding money causes an equal change in the riskiness of holding bonds that are denominated in money. Liquidity –Money is the easiest way to pay for everyday purchases –More transactions  increased demand for money The Demand for Money by Individuals

4. Slide 14-4Copyright © 2003 Pearson Education, Inc.  The aggregate demand for money: M d = P x L(R,Y) where: P = price level Y = real national income R = interest rate L(R,Y) is the aggregate real money demand  The demand for money can also be expressed as the demand for real balances: M d /P = L(R,Y) Aggregate Money Demand

5. Slide 14-5Copyright © 2003 Pearson Education, Inc. Aggregate Real Money Demand and the Interest Rate L(R,Y)L(R,Y) Interest rate, R Aggregate real money demand Aggregate Money Demand

6. Slide 14-6Copyright © 2003 Pearson Education, Inc. Effect on the Aggregate Real Money Demand 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

7. Slide 14-7Copyright © 2003 Pearson Education, Inc. Equilibrium in the Money Market: M d = M s or M s /P = L(R,Y) Determination of the Equilibrium Interest Rate: Equate M d to M s 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

8. Slide 14-8Copyright © 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 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

9. Slide 14-9Copyright © 2003 Pearson Education, Inc. Q2Q2 1'1' The Equilibrium Interest Rate: The Interaction of Money Supply and Demand 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

10. Slide 14-10Copyright © 2003 Pearson Education, Inc. The Money Supply and the Exchange Rate in the Short Run Short run analysis: The price level and real output are given. Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment. Linking Money, the Interest Rate, and the Exchange Rate The US money market determines the dollar interest rate which, together with the foreign interest rate, determines the exchange rate that maintains the interest rate parity.

11. Slide 14-11Copyright © 2003 Pearson Education, Inc. Money Market and Exchange Market Interaction 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

12. Slide 14-12Copyright © 2003 Pearson Education, Inc. Equilibrium Interest Rates and Exchange Rates Money-Market/Exchange Rate Linkages European money market United States money market Europe European System of Central Banks United States Federal Reserve System (United States 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)

13. Slide 14-13Copyright © 2003 Pearson Education, Inc. Increase in U.S. real money supply Expected return on euro deposits Equilibrium Interest Rates and Exchange Rates 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

14. Slide 14-14Copyright © 2003 Pearson Education, Inc. 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 Equilibrium Interest Rates and Exchange Rates E 2 $/€ 2'2'

15. Slide 14-15Copyright © 2003 Pearson Education, Inc. Money, the Price Level, and the Exchange Rate in the Long Run  Long-run equilibrium: Prices are perfectly flexible and adjust to preserve full employment.  Money and Money Prices From the money market equilibrium condition, M s /P = L(R,Y) P = M s /L(R,Y) An increase in a country’s money supply causes a proportional increase in its price level. A change in the supply of money has no effect on the long-run values of the interest rate or real output. This long-run equilibrium condition implies that  P/P =  M s /M s -  L/L. The inflation rate equals the monetary growth rate less the growth rate of the demand for money (real balances).

16. Slide 14-16Copyright © 2003 Pearson Education, Inc. Monetary Growth and Price-Level Change in the Seven Main Industrial Countries, 1973-1997 Money, the Price Level, and the Exchange Rate in the Long Run

17. Slide 14-17Copyright © 2003 Pearson Education, Inc. Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, 1974-2001 Inflation and Exchange Rate Dynamics: The short-run “stickiness” of price levels

18. Slide 14-18Copyright © 2003 Pearson Education, Inc. A change in the money supply creates demand and cost pressures that lead to future increases in the price level from three main sources: –Excess demand for output and labor –Inflationary expectations –Raw materials prices Inflation and Exchange Rate Dynamics

19. Slide 14-19Copyright © 2003 Pearson Education, Inc.  Permanent Money Supply Changes and the Exchange Rate How does the dollar/euro exchange rate adjust to a permanent increase in the U.S. money supply? –Figure 14-12 shows both the short-run and long-run effects of the increase in the U.S. money supply. nflation and Exchange Rate Dynamics

20. Slide 14-20Copyright © 2003 Pearson Education, Inc. Short-run and Long-run 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 Permanent Money Supply Changes and the Exchange Rate 3' 2' E 2 $/€ Expected euro return Expected euro return L(R $, Y US ) R2$R2$ 2 E 1 $/€ 1'

21. Slide 14-21Copyright © 2003 Pearson Education, Inc. Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply Permanent Money Supply Changes and the Exchange Rate 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

22. Slide 14-22Copyright © 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. “Overshooting” helps explain why exchange rates move so sharply form day to day. “Overshooting” is a direct result of sluggish short-run price level adjustment and the interest parity condition. Inflation and Exchange Rate Dynamics

23. Slide 14-23Copyright © 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.

24. Slide 14-24Copyright © 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