Upload
others
View
6
Download
0
Embed Size (px)
Citation preview
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
Slide 14-2Copyright © 2003 Pearson Education, Inc.
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
Slide 14-5Copyright © 2003 Pearson Education, Inc.
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
Slide 14-6Copyright © 2003 Pearson Education, Inc.
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
Slide 14-7Copyright © 2003 Pearson Education, Inc.
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
Slide 14-8Copyright © 2003 Pearson Education, Inc.
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
Slide 14-9Copyright © 2003 Pearson Education, Inc.
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
Slide 14-10Copyright © 2003 Pearson Education, Inc.
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.
Slide 14-11Copyright © 2003 Pearson Education, Inc.
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
Slide 14-12Copyright © 2003 Pearson Education, Inc.
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
Slide 14-13Copyright © 2003 Pearson Education, Inc.
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
Slide 14-14Copyright © 2003 Pearson Education, Inc.
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
Slide 14-15Copyright © 2003 Pearson Education, Inc.
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
Slide 14-16Copyright © 2003 Pearson Education, Inc.
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
Slide 14-17Copyright © 2003 Pearson Education, Inc.
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
Slide 14-18Copyright © 2003 Pearson Education, Inc.
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
Slide 14-19Copyright © 2003 Pearson Education, Inc.
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
Slide 14-20Copyright © 2003 Pearson Education, Inc.
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.
Slide 14-21Copyright © 2003 Pearson Education, Inc.
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
Slide 14-22Copyright © 2003 Pearson Education, Inc.
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
$/€1'
Slide 14-23Copyright © 2003 Pearson Education, Inc.
Expectedreturn oneuro deposits
L(R$, 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)
Slide 14-24Copyright © 2003 Pearson Education, Inc.
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$/€
1'
Slide 14-26Copyright © 2003 Pearson Education, Inc.
Increase in U.S.real money supply
Expectedreturn oneuro deposits
U.S. real money holdings
Rates ofreturn(in dollarterms)
0L(R$, 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
Slide 14-27Copyright © 2003 Pearson Education, Inc.
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$/€
2'
Slide 14-28Copyright © 2003 Pearson Education, Inc.
Increase in Europeanmoney supply
U.S. real money holdings
Rates ofreturn(in dollarterms)
0
Expectedeuro return
L(R$, 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.
Slide 14-29Copyright © 2003 Pearson Education, Inc.
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
Slide 14-30Copyright © 2003 Pearson Education, Inc.
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
Slide 14-31Copyright © 2003 Pearson Education, Inc.
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
Slide 14-32Copyright © 2003 Pearson Education, Inc.
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
Slide 14-33Copyright © 2003 Pearson Education, Inc.
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.
Slide 14-34Copyright © 2003 Pearson Education, Inc.
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
Slide 14-37Copyright © 2003 Pearson Education, Inc.
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$M2
US
R2$
Slide 14-39Copyright © 2003 Pearson Education, Inc.
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
Slide 14-40Copyright © 2003 Pearson Education, Inc.
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
Slide 14-42Copyright © 2003 Pearson Education, Inc.
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.