Chapter 15 - Money, Interest Rates, and Exchange Rates

Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market

Both asset markets are in equilibrium at the interest rate R1 and exchange rate E1. At these values, money supply equals money demand (point 1) and the interest parity condition holds (point 1')

what is the effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate?

By lowering the dollar return on euro deposits, an increase in Europe's money supply causes the dollar to appreciate against the euro. Equilibrium in the foreign exchange market shifts from point 1' to point 2' but equilibrium in the U.S. money market remains at point 1. An increase in a country's money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate

How does a change in the money supply cause prices of output and inputs to change?

Excess demand of goods and services: a higher quantity of money supplied implies that people have more funds available to pay for goods and services. vAlternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the high demand.

aggregate money demand

For a given real income level Y, real money demand rises as the interest rate falls.

What is the effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply

Given PUS and YUS when the money supply rises from M1 to M2 the dollar interest rate declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates against the euro (as foreign exchange market equilibrium is reestablished at point 2')

What is the direct relationship between the inflation rate and changes in the money supply?

The inflation rate is predicted to equal the growth rate in money supply minus the growth rate in money demand. Ms = P*L(R,Y) P = Ms / L(R, Y) AP/P = (AMs^2 / M^2) - (AL / L) A -> change, delta

Money as a Medium of Exchange

a generally accepted means of payment - most important function of money - Eliminates double coincidence of wants problem associated with a barter economy.

Money as a Store of Value

can be used to transfer purchasing power from the present into the future. - essential for any medium of exchange - most liquid of all assets

What does the exchange rate between currencies look like?

the interest that can be earned on deposits of those currencies and the expected future exchange rate.

Money as a Unit of Account

widely recognized measure of value - Prices of goods, services, and assets are typically expressed in terms of money. - simplifies economic calculations by making it easy to compare the prices of different commodities

Does currency depreciate or appreciate in the foreign exchange market when a country's money supply increases?

"an increase in a country's money supply causes its currency to depreciate in the foreign exchange market, while a reduction in the money supply causes its currency to appreciate." Short run: Assumptions - The price level is fixed, - Output is held constant

Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y

(a) Short-run adjustment of the asset markets. (b) How the interest rate, price level, and exchange rate move over time as the economy approaches its long-run equilibrium.

The interest rate.

- A rise in the interest rate causes each individual in the economy to reduce her demand for money. - All else equal, aggregate money demand therefore falls when the interest rate rises.

Real national income

- As real national income (GNP) rises, more goods and services are sold in the economy. - This increase in the real value of transactions raises the demand for money, given the price level.

Determining Equilibrium interest rates

- At interest rate R2, the money market is in disequilibrium. The demand for money exceeds the supply of money. - Economic agents will use the excess money supply to buy interest buying assets. Increase in demand for assets lead to an increase in the price of assets and a fall in the interest rate.

The expected return of an asset compared to return on alternative assets

- Currency pays no interest. The opportunity cost of holding money (currency) is the interest rate on alternative assets - The higher the interest rate, the more you sacrifice by holding wealth in the form of money. - "all else equal, a rise in the interest rate causes the demand for money to fall.

How do Inflationary expectations effect the economy?

- If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. - And if producers expect the same, they are more willing to raise wages. - Producers will be able to match higher costs if they expect to raise prices. - Result: expectations about inflation caused by an expected increase in the money supply causes actual inflation.

The price level

- In increase in the price level leads to an increase in the demand for money. - More money will be needed to purchase the same amount of goods if the price level rises

The riskiness of the asset's expected return

- Risk is not an important factor in money demand. Unexpected rise in the price level leads to a fall in the value of money. - Alternative assets such as government bonds (fixed face value) will also be affected the same way as money when there is unexpected rise in the price level.

Exchange Rate Overshooting

- The exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response. - Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation. - Overshooting helps explain why exchange rates are so volatile.

The asset's liquidity:

- The main benefit of holding money is liquidity. - Households and firms hold money because it is the easiest way of financing their everyday purchases. - An individual's need for liquidity rises when the average daily value of his transactions rises. - a rise in the average value of transactions carried out by a household or firm causes its demand for money to rise.

what happens when there is an excess demand of goods and services?

- To meet high demand, producers hire more workers, creating a strong demand of labor services, or make existing employees work harder. - Wages rise to attract more workers or to compensate workers for overtime. - Prices of output will eventually rise to compensate for higher costs.

How do price factors of production and output adjust to market conditions?

- Wages adjust to the demand and supply of labor - Real output and income are determined by the amount of workers and other factors of production—by the economy's productive capacity—not by the quantity of money supplied. - (Real) interest rates depend on the supply of saved funds and the demand of saved funds.

Long-run vs Short-run

- short run, prices do not have sufficient time to adjust to market conditions. - In the long run, prices of factors of production and of output have sufficient time to adjust to market conditions

What is Money?

1. Money as a Medium of Exchange 2. Money as a Unit of Account 3. Money as a Store of Value

Demand for money is determined by...

1. The expected return of an asset compared to return on alternative assets 2. The riskiness of the asset's expected return 3. The asset's liquidity

Three main factors determine aggregate money demand:

1. The interest rate 2.The price level 3.Real national income

How does a permanent decrease of a country's money supply effect the long-run?

A permanent decrease in a country's money supply causes a proportional long-run appreciation of its currency. - However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

How does a permanent increase of a country's money supply effect the long-run?

A permanent increase in a country's money supply causes a proportional long-run depreciation of its currency. - However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.

Time Paths of U.S. Economic Variables after a Permanent Increase in the U.S. Money Supply

After the money supply increases at t0 in panel (a), the interest rate [in panel (b)], price level [in panel (c)], and exchange rate [in panel (d)] move as shown toward their long-run levels. As indicated in panel (d) by the initial jump from E1 to E2 , the exchange rate overshoots in the short run before settling down to its long-run level, E3.

How is Money Supply Determined?

An economy's money supply is controlled by its central bank. The central bank directly regulates the amount of currency in existence.

What happens to interest rates and rates of return domestically when money supply increase?

An increase in a country's money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.

what is the effect of an increase in money supply on the interest rate?

An increase in money supply lowers the interest rate. A fall in the money supply leads to a fall in the interest rate. - At a higher quantity of money demanded, lower interest rates make it easier for people to borrow money and consume.

Effect of a rise in real income on aggregate real money demand.

An increase in real income from Y1 to Y2 raises the demand for real money balances at every level of the interest rate and causes the whole demand schedule to shift upward

desired money holding ( real purchasing power)

Md/P

Money Supply

Monetary aggregate 1 (M1): the total amount of currency and checking deposits held by households and firms.

Money Market/Exchange Rate Linkages

Monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The ECB can affect the exchange rate by changing the European money supply and interest rate.

Equilibrium in the money market

Ms = Md Ms/P = Md/P Ms/P = L(R, Y)

The central bank does not have perfect control over the money supply. Why?

It only has an indirect control over the amount of checking deposits issued by private banks. - The behavior of private banks and the general public affect the money supply. - An economy's money supply is influenced by the central bank, private banks and the general public.

real money demand

L(R, Y)

The aggregate demand for money, Md, can be expressed as

Md = PL(R,Y) L(R,Y) rises when R rises, and falls when Y falls Md/P = L(R, Y)