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United States Federal Reserve System. Europe European System of Central Banks. (United States money supply). (European money supply). M S US. M S E. United States money market. European money market. Foreign exchange market. Equilibrium Interest Rates and Exchange Rates. - PowerPoint PPT Presentation
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Equilibrium Interest Rates and Exchange Rates
Money-Market/Exchange Rate Linkages
European money market
United Statesmoney market
EuropeEuropean System
of Central Banks
United StatesFederal Reserve System
(United Statesmoney supply)
MSUS MS
E(European money supply)
R$
(Dollar interest rate)
R€
(Euro interest rate)
Foreignexchange
market
E$/€
(Dollar/Euro exchange rate)
Money, Interest, and the Exchange Rate
MONEYMedium of Exchange
Unit of Account– Express prices, keep records,…write contracts!
Store of Value … Low risk• Other, riskier assets are less liquid but pay
higher return.
Money Supply (Ms)
Ms = Currency + Checkable DepositsControlled by central bank
Aggregate Money Demand
Md = P x L(R,Y)where:
P = price level
Y = real national income
R = interest rate
• The demand for money can be expressed as the demand for real balances:
Md/P = L(R,Y)
Aggregate Real Money Demand and the Interest Rate
Md/P = L(R,Y)
Interest rate, R
Aggregate realmoney demand
Aggregate Money Demand
Effect on Aggregate Real Money Demand of Rise in Real Income
L(R,Y2)
Increase inreal income
L(R,Y1)
Interest rate, R
Aggregate realmoney demand
Equilibrium in the Money Market: Md = Ms or Ms/P = L(R,Y)
Aggregate realmoney demand,L(R,Y)
Interest rate, R
Real moneyholdings
Real money supply
MS
P( = Q1)
R2
Q2
2
R1 1
R3
Q3
3
Money Supply and Exchange Rate
Short run analysis: The price level and real output are given sticky prices
Assume real output (Y) starts at full-employment
Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment.
Short – run Long – run
Linking Money, the Interest Rate, and the Exchange Rate
European money market
United Statesmoney market
EuropeEuropean System
of Central Banks
United StatesFederal Reserve System
(United Statesmoney supply)
MSUS MS
E(European money supply)
R$
(Dollar interest rate)
R€
(Euro interest rate)
Foreignexchange
market
E$/€
(Dollar/Euro exchange rate)
Money Market and Exchange Market Interaction:Our Elaborated Model
Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market
Return on dollar deposits
Expectedreturn oneuro deposits
L(R$, YUS)
U.S. real money holdings
Rates of return(in dollar terms)
Dollar/euro exchange Rate, E$/€
0
(increasing)
Foreignexchangemarket
Moneymarket
E1$/€
1'
R1$
1
U.S. realmoneysupply
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).
Short-run and Long-run Effects of an Increase in the U.S.Money Supply
Dollar return Dollar return
M1US
P1US
M2US
P1US
U.S. real money supply
M2US
P2US
M2US
P1US
Dollar/euro exchangeRate, E$/€
Rates of return(in dollar terms)
U.S. real money holdings
0
(a) Short-run effects
0
(b) Adjustment to long- run equilibrium
Dollar/euro exchangeRate, E$/€
U.S. real money holdings
E2$/€
2'
E3$/€
4'
R1$
4
R2$
2
R1$
1
Permanent Money Supply Changes and the Exchange Rate
3'
2'E2$/€
Expectedeuro return Expected
euro return
L(R$, YUS)R2
$
2
L(R$, YUS)
E1$/€
1'
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
P2US E3
$/€
E1$/€
t0
(a) U.S. money supply, MUS
Time
(c) U.S. price level, PUS
Time
(b) Dollar interest rate, R$
Time
M1US
t0t0
R1$
M2US
P1US
t0
R2$
E2$/€
(d) Dollar/euro exchange rate, E$/€
Time
Effect of an Increase in the European Money Supply on Dollar/Euro Exchange Rate: Short-run response
Increase in Europeanmoney supply
U.S. real money holdings
Rates of return(in dollar terms)
Dollar/euro exchange Rate, E$/€
0
Expectedeuro return
L(R$, YUS)
U.S. realmoneysupply
MSUS
PUS
R1$
1
E1$/€
1'Dollar return
E2$/€
2'
Expected return on euro holdingsdeclines both because R* falls andEe declines (euro is expected to depreciate).
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