MONEY, INTEREST RATES,

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CHAPTER 14 MONEY, INTEREST RATES, AND EXCHANGE
RATES
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Monetary factors affect the exchange rate by
changing (i) interest rates and (ii) expected
future prices. THE EQUILIBRIUM INTEREST RATE
THE INTERACTION OF MONEY SUPPLY AND DEMAND The
interest rate is determined by the interaction of
money supply and money demand. Money supply
refers to the monetary aggregate that the
Federal Reserve calls M1 (currency and checking
deposits). The money supply is assumed to be
under the control of the Fed (the central bank).
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Money Demand is determined by three factors (i)
the interest rate (R), (ii) the price level (P),
and (iii) real national income (Y) This can be
expressed as follows The Equilibrium Interest
Rate The equilibrium interest rate is determined
when money supply is equal to money
demand. Figure An increase in money supply
(holding everything else constant) reduces the
interest rate. Figure An increase in real output
(holding everything else constant) increases the
interest rate. Figure
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THE MONEY SUPPLY AND EXCHANGE RATE IN THE SHORT
RUN A change in the U.S. Money Supply The price
level is assumed to be fixed in the short run.
An increase in the U.S. money supply lowers U.S.
interest rates. A decrease in the rate of return
on U.S. assets relative to that of German assets
increases the /DM exchange rate (i.e.,
depreciates the U.S. dollar and appreciates the
DM. Figure A change in the German Money
Supply An increase in the German money supply
lowers German interest rates and hence the rate
of return on German assets. The result is a
decrease in the /DM exchange rate (i.e., an
appreciation of the U.S. dollar and
depreciation of the DM. Figure
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MONEY, THE PRICE LEVEL, AND THE EXCHANGE RATE
IN THE LONG RUN In the long run all prices are
flexible and the economy is at full employment.
Using the money market equilibrium
condition,the long run equilibrium price level
can be expressed as follows Everything else
remaining constant, a permanent increase in
the money supply causes a proportional increase
in the price level. Example
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Money and Exchange Rates in the Long Run A
permanent increase (decrease) in a countrys
money supply causes a proportional long-run
depreciation (appreciation) of its currency
against foreign currencies. Example

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INFLATION AND EXCHANGE RATE DYNAMICS Short-Run
Price Rigidity versus Long-Run Price
Flexibility Figure 14-11 shows that the exchange
rate is more variable than relative price
levels. Figure 14-11 This observation can be
explained by the exchange rate over- shooting
hypothesis. Many prices in the economy are
written into long-term contracts and cannot be
changed immediately when changes in the money
supply occur. A permanent increase in M,
holding P constant, increases the real money
supply (M/P) and lowers the nominal interest
rate (R). This shifts the dollar return schedule
left. A
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permanent increase in M also creates the
expectation that in the long run all prices
including the exchange rate would rise. A rise
in the expected exchange rate shifts the ERR(DM)
schedule right. Therefore, in the short run
equilibrium is established at point 2. In the
long run the price level adjusts and rises
proportionately with the money supply.
Therefore, M/P and R return to their initial
levels in the long run and the equilibrium
exchange rate is determined at point 3. In
other words, the exchange rate first overshoots
and then returns to its long run level.
Therefore, the fluctuations in E are much
stronger than those of P. Figure