Chapter 14 Money, Interest Rates, and Exchange Rates · 2014. 9. 26. · Chapter 14 Money, Interest...

Chapter 14Chapter 14Money, Interest Rates, and Exchange RatesMoney, Interest Rates, and Exchange Rates

Prepared by Iordanis Petsas

To AccompanyInternational Economics: Theory and PolicyInternational Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

Introduction

Money Defined: A Brief Review

The Demand for Money by Individuals

Aggregate Money Demand

The Equilibrium Interest Rate: The Interaction ofMoney Supply and Demand

Chapter Organization

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Introduction

Money Defined: A Brief Review

The Demand for Money by Individuals

Aggregate Money Demand

The Equilibrium Interest Rate: The Interaction ofMoney Supply and Demand

The Money Supply and the Exchange Rate in theShort Run

Money, the Price Level, and the Exchange Rate in theLong Run

Inflation and Exchange Rate Dynamics

Summary

Chapter Organization

Slide 14-3Copyright © 2003 Pearson Education, Inc.

The Money Supply and the Exchange Rate in theShort Run

Money, the Price Level, and the Exchange Rate in theLong Run

Inflation and Exchange Rate Dynamics

Summary

Introduction

Factors that affect a country’s money supply ordemand are among the most powerful determinants ofits currency’s exchange rate against foreigncurrencies.

This chapter combines the foreign-exchange marketwith the money market to determine the exchangerate in the short run.• It analyzes the long-term effects of monetary changes

on output prices and expected future exchange rates.

Slide 14-4Copyright © 2003 Pearson Education, Inc.

Factors that affect a country’s money supply ordemand are among the most powerful determinants ofits currency’s exchange rate against foreigncurrencies.

This chapter combines the foreign-exchange marketwith the money market to determine the exchangerate in the short run.• It analyzes the long-term effects of monetary changes

on output prices and expected future exchange rates.

Money Defined: A Brief Review

Money as a Medium of Exchange• A generally accepted means of payment

Money as a Unit of Account• A widely recognized measure of value

Money as a Store of Value• A transfer of purchasing power from the present into

the future

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Money as a Medium of Exchange• A generally accepted means of payment

Money as a Unit of Account• A widely recognized measure of value

Money as a Store of Value• A transfer of purchasing power from the present into

the future

What Is Money?• 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 (Ms)Ms = Currency + Checkable Deposits

Money Defined: A Brief Review

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What Is Money?• 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 (Ms)Ms = Currency + Checkable Deposits

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 byprivate banks

Money Defined: A Brief Review

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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 byprivate banks

Three factors influence money demand:• Expected return

• Risk

• Liquidity

Expected Return• 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.

The Demand forMoney by Individuals

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Three factors influence money demand:• Expected return

• Risk

• Liquidity

Expected Return• 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.

Risk• Holding money is risky.

– An unexpected increase in the prices of goods andservices could reduce the value of money in terms of thecommodities consumed.

• Changes in the risk of holding money need not causeindividuals to reduce their demand for money.

– Any change in the riskiness of money causes an equalchange in the riskiness of bonds.

The Demand forMoney by Individuals

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Risk• Holding money is risky.

– An unexpected increase in the prices of goods andservices could reduce the value of money in terms of thecommodities consumed.

• Changes in the risk of holding money need not causeindividuals to reduce their demand for money.

– Any change in the riskiness of money causes an equalchange in the riskiness of bonds.

Liquidity• The main benefit of holding money comes from its

liquidity.– Households and firms hold money because it is the

easiest way of financing their everyday purchases.

• A rise in the average value of transactions carried outby a household or firm causes its demand for money torise.

The Demand forMoney by Individuals

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Liquidity• The main benefit of holding money comes from its

liquidity.– Households and firms hold money because it is the

easiest way of financing their everyday purchases.

• A rise in the average value of transactions carried outby a household or firm causes its demand for money torise.

Aggregate Money Demand

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– It reduces the demand for money.

– Price level– It raises the demand for money.

– Real national income– It raises the demand for money.

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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– It reduces the demand for money.

– Price level– It raises the demand for money.

– Real national income– It raises the demand for money.

The aggregate demand for money can be expressed by:

Md = P x L(R,Y) (14-1)where:

P is the price level

Y is real national income

L(R,Y) is the aggregate real money demand

Equation (14-1) can also be written as:

Md/P = L(R,Y) (14-2)

Aggregate Money Demand

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The aggregate demand for money can be expressed by:

Md = P x L(R,Y) (14-1)where:

P is the price level

Y is real national income

L(R,Y) is the aggregate real money demand

Equation (14-1) can also be written as:

Md/P = L(R,Y) (14-2)

Figure 14-1: Aggregate Real Money Demand and the Interest Rate

Interestrate, R

Aggregate Money Demand

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L(R,Y)

Aggregate realmoney demand

Figure 14-2: Effect on the Aggregate Real Money Demand Schedule ofa Rise in Real IncomeInterestrate, R

Aggregate Money Demand

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L(R,Y2)

Increase inreal income

L(R,Y1)

Aggregate realmoney demand

Equilibrium in the Money Market• The condition for equilibrium in the money market is:

Ms = Md (14-3)

• The money market equilibrium condition can beexpressed in terms of aggregate real money demandas:

Ms/P = L(R,Y) (14-4)

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

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Equilibrium in the Money Market• The condition for equilibrium in the money market is:

Ms = Md (14-3)

• The money market equilibrium condition can beexpressed in terms of aggregate real money demandas:

Ms/P = L(R,Y) (14-4)

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

Figure 14-3: Determination of the Equilibrium Interest Rate

Interestrate, R

Real money supply

R2 2

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Aggregate realmoney demand,L(R,Y)

Real moneyholdings

MS

P( = Q1)

R2

Q2

R1 1

R3

Q3

3

Interest Rates and the Money Supply• An increase (fall) in the money supply lowers (raises)

the interest rate, given the price level and output.– The effect of increasing the money supply at a given

price level is illustrated in Figure 14-4.

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

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Interest Rates and the Money Supply• An increase (fall) in the money supply lowers (raises)

the interest rate, given the price level and output.– The effect of increasing the money supply at a given

price level is illustrated in Figure 14-4.

Real moneysupply Real money

supply increase

The Equilibrium Interest Rate: TheInteraction of Money Supply and DemandFigure 14-4: Effect of an Increase in the Money Supply on the Interest

RateInterestrate, R

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M2

P

R2 2

M1

P

Real moneysupply increase

L(R,Y1)

R1 1

Real moneyholdings

Output and the Interest Rate• An increase (fall) in real output raises (lowers) the

interest rate, given the price level and the moneysupply.

– Figure 14-5 shows the effect on the interest rate of a risein the level of output, given the money supply and theprice level.

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

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Output and the Interest Rate• An increase (fall) in real output raises (lowers) the

interest rate, given the price level and the moneysupply.

– Figure 14-5 shows the effect on the interest rate of a risein the level of output, given the money supply and theprice level.

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

Figure 14-5: Effect on the Interest Rate of a Rise in Real Income

Increase inreal income

Real money supply

Interestrate, R

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Q2

1'

L(R,Y1)L(R,Y2)

Increase inreal income

MS

P( = Q1)

R2 2

R1 1

Real moneyholdings

The Money Supply and theExchange Rate in the Short Run

Short run analysis• The price level and the real output are given.

Long run analysis• The price level is perfectly flexible and always

adjusted immediately to preserve full employment.

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Short run analysis• The price level and the real output are given.

Long run analysis• The price level is perfectly flexible and always

adjusted immediately to preserve full employment.

Linking Money, the Interest Rate, and the ExchangeRate• The U.S. money market determines the dollar interest

rate, which in turn affects the exchange rate thatmaintains the interest parity.

– Figure 14-6 links the U.S. money market (bottom) andthe foreign exchange market (top).

The Money Supply and theExchange Rate in the Short Run

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Linking Money, the Interest Rate, and the ExchangeRate• The U.S. money market determines the dollar interest

rate, which in turn affects the exchange rate thatmaintains the interest parity.

– Figure 14-6 links the U.S. money market (bottom) andthe foreign exchange market (top).

The Equilibrium Interest Rate: TheInteraction of Money Supply and DemandFigure 14-6: Simultaneous Equilibrium in the U.S. Money Market

and the Foreign-Exchange Market

Return ondollar deposits

Expectedreturn oneuro deposits

Dollar/euroexchange Rate, E$/€

Foreignexchangemarket E1

$/€1'

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Expectedreturn oneuro deposits

L(R$, YUS)

U.S. real money holdings

Rates ofreturn(in dollarterms)

0

(increasing)

Foreignexchangemarket

Moneymarket

E1$/€

1'

R1$

1U.S. realmoneysupply

MSUS

PUS

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

Figure 14-7: Money-Market/Exchange Rate Linkages

EuropeEuropean System

of Central Banks

United StatesFederal Reserve System

(United Statesmoney supply)

MSUS MS

E(Europeanmoney supply)

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Europeanmoney market

United Statesmoney market

R$(Dollar interest rate)

R€(Euro interest rate)

Foreignexchange

market

E$/€(Dollar/Euro exchange rate)

U.S. Money Supply and the Dollar/Euro ExchangeRate• What happens when the Federal Reserve changes the

U.S. money supply?– An increase (decrease) in a country’s money supply

causes its currency to depreciate (appreciate) in theforeign exchange market.

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

Slide 14-25Copyright © 2003 Pearson Education, Inc.

U.S. Money Supply and the Dollar/Euro ExchangeRate• What happens when the Federal Reserve changes the

U.S. money supply?– An increase (decrease) in a country’s money supply

causes its currency to depreciate (appreciate) in theforeign exchange market.

Expectedreturn oneuro deposits

The Equilibrium Interest Rate: TheInteraction of Money Supply and DemandFigure 14-8: Effect on the Dollar/Euro Exchange Rate and Dollar

Interest Rate of an Increase in the U.S. Money Supply

E2$/€ 2'

Dollar/euroexchange Rate, E$/€

Return ondollar deposits

E1$/€

1'

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Increase in U.S.real money supply

Expectedreturn oneuro deposits

U.S. real money holdings

Rates ofreturn(in dollarterms)

0L(R$, YUS)

E1$/€

1'

R1$

1

M1US

PUS

R2$

2M2

USPUS

Europe’s Money Supply and the Dollar/EuroExchange Rate• An increase in Europe’s money supply causes a

depreciation of the euro (i.e., appreciation of thedollar).

• A reduction in Europe’s money supply causes anappreciation of the euro (i.e., a depreciation of thedollar).

• The change in the European money supply does notdisturb the U.S. money market equilibrium.

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

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Europe’s Money Supply and the Dollar/EuroExchange Rate• An increase in Europe’s money supply causes a

depreciation of the euro (i.e., appreciation of thedollar).

• A reduction in Europe’s money supply causes anappreciation of the euro (i.e., a depreciation of thedollar).

• The change in the European money supply does notdisturb the U.S. money market equilibrium.

Figure 14-9: Effect of an Increase in the European Money Supplyon the Dollar/Euro Exchange Rate

Increase in Europeanmoney supply

Dollar/euroexchange Rate, E$/€

E1$/€

1'Dollar return

The Equilibrium Interest Rate: TheInteraction of Money Supply and Demand

E2$/€

2'

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Increase in Europeanmoney supply

U.S. real money holdings

Rates ofreturn(in dollarterms)

0

Expectedeuro return

L(R$, YUS)

U.S. realmoneysupply

MSUS

PUS

R1$

1

E2$/€

2'

Money, the Price Level, and theExchange Rate in the Long Run

Long-run equilibrium• Prices are perfectly flexible and always adjusted

immediately to preserve full employment.

Money and Money Prices• The money market equilibrium (Equation 14-4) can be

rearranged to give the long-run equilibrium price level:

P = Ms/L(R,Y) (14-5)

• An increase in a country’s money supply causes aproportional increase in its price level.

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Long-run equilibrium• Prices are perfectly flexible and always adjusted

immediately to preserve full employment.

Money and Money Prices• The money market equilibrium (Equation 14-4) can be

rearranged to give the long-run equilibrium price level:

P = Ms/L(R,Y) (14-5)

• An increase in a country’s money supply causes aproportional increase in its price level.

The Long-Run Effects of Money Supply Changes• A change in the supply of money has no effect on the

long-run values of the interest rate or real output.

• A permanent increase in the money supply causes aproportional increase in the price level’s long-runvalue.

– This prediction is based on the money marketequilibrium condition: Ms/P = L or P = Ms/L.

– This condition implies that P/P = Ms/Ms - L/L.– The inflation rate equals the monetary growth rate less the

growth rate for money demand.

Money, the Price Level, and theExchange Rate in the Long Run

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The Long-Run Effects of Money Supply Changes• A change in the supply of money has no effect on the

long-run values of the interest rate or real output.

• A permanent increase in the money supply causes aproportional increase in the price level’s long-runvalue.

– This prediction is based on the money marketequilibrium condition: Ms/P = L or P = Ms/L.

– This condition implies that P/P = Ms/Ms - L/L.– The inflation rate equals the monetary growth rate less the

growth rate for money demand.

Empirical Evidence on Money Supplies and PriceLevels• In a cross-section of countries, long-term changes in

money supplies and price levels show a clear positivecorrelation.

Money, the Price Level, and theExchange Rate in the Long Run

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Empirical Evidence on Money Supplies and PriceLevels• In a cross-section of countries, long-term changes in

money supplies and price levels show a clear positivecorrelation.

Figure 14-10: Monetary Growth and Price-Level Change in the SevenMain Industrial Countries, 1973-1997

Money, the Price Level, and theExchange Rate in the Long Run

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Money and the Exchange Rate in the Long Run• A permanent increase (decrease) in a country’s money

supply causes a proportional long-run depreciation(appreciation) of its currency against foreigncurrencies.

Money, the Price Level, and theExchange Rate in the Long Run

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Money and the Exchange Rate in the Long Run• A permanent increase (decrease) in a country’s money

supply causes a proportional long-run depreciation(appreciation) of its currency against foreigncurrencies.

Inflation andExchange Rate Dynamics

Inflation• A situation where an economy’s price level rises. Deflation

• A situation where an economy’s price level falls. Short-Run Price Rigidity versus Long-Run Price

Flexibility• The short-run “stickiness” of price levels is illustrated

in Figure 14-11.

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Inflation• A situation where an economy’s price level rises. Deflation

• A situation where an economy’s price level falls. Short-Run Price Rigidity versus Long-Run Price

Flexibility• The short-run “stickiness” of price levels is illustrated

in Figure 14-11.

Figure 14-11: Month-to-Month Variability of the Dollar/DM ExchangeRate and of the U.S./German Price-Level Ratio, 1974-2001

Inflation andExchange Rate Dynamics

Slide 14-35Copyright © 2003 Pearson Education, Inc.

• A change in the money supply creates demand andcost pressures that lead to future increases in the pricelevel from three main sources:

– Excess demand for output and labor

– Inflationary expectations

– Raw materials prices

Inflation andExchange Rate Dynamics

Slide 14-36Copyright © 2003 Pearson Education, Inc.

• A change in the money supply creates demand andcost pressures that lead to future increases in the pricelevel from three main sources:

– Excess demand for output and labor

– Inflationary expectations

– Raw materials prices

Permanent Money Supply Changes and the ExchangeRate• 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.

Inflation andExchange Rate Dynamics

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Permanent Money Supply Changes and the ExchangeRate• 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.

Figure 14-12: Effects of an Increase in the U.S.Money Supply

Dollar return Dollar return

Dollar/euro exchangeRate, E$/€

Dollar/euro exchangeRate, E$/€

E2$/€

2'

E3$/€

4'

Inflation andExchange Rate Dynamics

3'

2'E2$/€

Expectedeuro return Expected

euro return

Slide 14-38Copyright © 2003 Pearson Education, Inc.

M1US

P1US

M2US

P1US

U.S. real money supplyM2

USP2

USM2

USP1

US

Rates of return(in dollarterms)

U.S. realmoney holdings

0

(a) Short-run effects

0

(b) Adjustment to long-run equilibriumU.S. real

money holdings

E3$/€

4'

R1$

4

R2$

2

R1$

1

3'Expectedeuro return Expected

euro return

L(R$, YUS)R2$

2

L(R$, YUS)

E1$/€ 1'

Figure 14-13: Time Paths of U.S. Economic Variables After a PermanentIncrease in the U.S. Money Supply

Inflation andExchange Rate Dynamics

(a) U.S. money supply, MUS (b) Dollar interest rate, R$

M1US

R1$M2

US

R2$

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P2US E3

$/€

E1$/€

t0

Time(c) U.S. price level, PUS

Time

Time

M1US

t0t0

P1US

t0

R2$

E2$/€

(d) Dollar/euro exchange rate, E$/€

Time

Exchange Rate Overshooting• The exchange rate is said to overshoot when its

immediate response to a disturbance is greater than itslong-run response.

• It helps explain why exchange rates move so sharplyform day to day.

• It is a direct result of sluggish short-run price leveladjustment and the interest parity condition.

Inflation andExchange Rate Dynamics

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Exchange Rate Overshooting• The exchange rate is said to overshoot when its

immediate response to a disturbance is greater than itslong-run response.

• It helps explain why exchange rates move so sharplyform day to day.

• It is a direct result of sluggish short-run price leveladjustment and the interest parity condition.

Summary

Money is held because of its liquidity.

Aggregate real money demand depends negatively onthe opportunity cost of holding money and positivelyon the volume of transactions in the economy.

The money market is in equilibrium when the realmoney supply equals aggregate real money demand.

By lowering the domestic interest rate, an increase inthe money supply causes the domestic currency todepreciate in the foreign exchange market.

Slide 14-41Copyright © 2003 Pearson Education, Inc.

Money is held because of its liquidity.

Aggregate real money demand depends negatively onthe opportunity cost of holding money and positivelyon the volume of transactions in the economy.

The money market is in equilibrium when the realmoney supply equals aggregate real money demand.

By lowering the domestic interest rate, an increase inthe money supply causes the domestic currency todepreciate in the foreign exchange market.

Permanent changes in the money supply push thelong-run equilibrium price level proportionally in thesame 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 theexchange rate to overshoot its long-run level in theshort run.

Summary

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Permanent changes in the money supply push thelong-run equilibrium price level proportionally in thesame 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 theexchange rate to overshoot its long-run level in theshort run.