Money, Interest Rates, and Exchange Rates

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Chapter 14

• Money, Interest Rates, and Exchange Rates

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Preview

• What changes interest rates, which will in turn
  affect E ?
• i
• Interest rate as the price of money is
  determined by supply of and demand for money
• Impact of Money Supply on interest rate is
  different for Short-run(-) and Long run()

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1. What Is Money?

• Money is an asset that is widely used and
  accepted as a means of payment.
• Different groups of assets may be classified as
  money.
• Currency and checking accounts form a useful
  definition of money, but bank deposits in the
  foreign exchange market are excluded from this
  definition.

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2. Two Different Amounts of Money Supply(Demand)

• What we see as Money Supply(Demand) is the
  Nominal Money Supply(Demand). This is dollar
  value as we see.
• What matters is Real Money Supply(Demand), which
  is the Quantity of Money Supply.
• Quantity of Real Money is Nominal Amount of Money
  divided by the General Price Level
• ms Ms/P

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Who controls Money?

• People just accept whatever Nominal Money Supply
  supplied to them
• MD MS
• 2) People determine real quantity of their demand
  for money by controlling the price level

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What Influences Real Demand for Money?

• 1. Interest rates money pays little or no
  interest, so the interest rate is the opportunity
  cost of holding money instead of other assets,
  like bonds, which have a higher expected
  return/interest rate.
• A higher interest rate means a higher opportunity
  cost of holding money ? lower money demand
• 2. Income greater income implies more goods and
  services can be bought, so that more money is
  needed to conduct transactions.
• A higher real national income (GNP) means more
  goods and services are being produced and bought
  in transactions, increasing the need for
  liquidity ? higher money demand.

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Math for Real Money Demand

• can be expressed by
• L(R,Y)
• where
• P is the price level
• Y is real national income
• R is a measure of interest rates
• L(R,Y) is the aggregate real money demand

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Equilibrium in Money Market

• In equilibrium, Real Money Supply is equal to
  Real Money Demand
• Ms/P L(R,Y)
• This equilibrium condition will yield an
  equilibrium price of fund, i.e., interest rate.

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Note Dynamic Mechanism

• Step 1
• People decides on their desired Real Money
  Demand through L(R,Y). At this time, Ms/P
  L(R,Y)
• Step 2
• If the Central Bank injects Nominal Money Supply
  into the economy, first People just accepts it
  all Ms Md
• However, inside, Ms/P

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Two Kinds of Interest Rates

• Fisher Equation
• Nominal Interest Rate Real Interest Rate
  Expected Inflation Rate
• Real Interest Rate determines Investment, and
  National Income.
• In the short run, Real Interest Rate can be
  affected by Money Supply (and Money Demand).
• In the Long-run, Real Interest Rate is determined
  by Real Factors, and is equal to MP of Capital.

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What will happen to Interest Rates and Exchange
Rates when the Central Bank increases Nominal
Money Supply?

• In the Short-run, Price Level does not change
  the Real Interest rate goes down investment may
  rise Business may get better National Income
  may rise
• As real interest falls, there will be capital
  outflow E will go up.
• In the Long-run, people will speed up
  expenditures P up Real Interest Rate, I and Y
  all go back the initial level
• With repeated Increases in Money Supply,
  Inflation may develop Nominal Interest Rate goes
  up E will go up.

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Impact of Monetary Policy in the Short-run

• Expansionary Monetary Policy
• Real Money Supply gt Real Money Demand
• In Disequilibrium, the price should change.
• When there is an excess real supply of money,
  the price of money or the interest rate falls.
• As interest rate falls, investment rises and
  real national income rises.
• Stringent Monetary Policy
• When there is a short supply of money, the
  price of money or the interest rate rises.

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Linking the Money Market to the Foreign Exchange
Market in the Short-run
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What happens to the domestic interest rate and
the FOREX rate (E) when the central bank
increases the Money Supply?
It is not really necessary to think of this lower
part of this graph Just consider the upper part.
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So, now we know that the impact of the Money
Supply on E in the Short-run

• Easy Monetary Policy (an increase in a countrys
  money supply) causes its interest rate to fall
  and FOREX rate or E to rise Its currency
  depreciate.
• Strict Monetary Policy( a decrease in a countrys
  money supply) causes its interest rate to go up
  and FOREX rate to go down its currency to
  appreciate.

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Changes in Real Money Supply in the Foreign
Country in the short-run

• An increase in the EU money supply causes a
  depreciation of the euro (appreciation of the
  dollar).
• A decrease in the EU money supply causes an
  appreciation of the euro (a depreciation of the
  dollar).

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What will happen to the foreign interest rate and
E in the short-run if the foreign government
increases its Money Supply?
You do not have to look at the lower part of the
graph.
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What will happen to E in the short run if a
foreign country changes its (Foreign) Money
Supply?

• The increase in the EU money supply reduces
  interest rates in the EU, reducing the expected
  return on euro deposits.
• This reduction in the expected return on euro
  deposits leads to a depreciation of the euro.
• The change in the EU money supply does not change
  the US money market equilibrium.

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Note

• The interest rates here in this graph are all
  Real Interest Rate or Real Returns.

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In the Long-Run, we cannot use the above model

• The above does NOT work in the long-run.
• We need a New Model for FOREX Rate, which deals
  with Nominal Variables
• Purchasing Power Parity Theory to come in Chapter
  15.
• (The remainder of Chapter 14 is a prelude for
  Chapter 15.)

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Long Run Impact of Money Supply
Prelude to Chapter 16

• In the long run, more Money Supply simply means a
  Higher Price Level and a Higher Interest Rate.

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In Long Run, Money does not matter for Real
Interest Rate and Real National Income

• In the Long-run, only K. L, T affect Real Output
  - Supply Side Economics.
• In the long run, the money supply does not
  influence the amount of real output or real
  interest rate.
• There is a dichotomy between the nominal sector
  (Money), and the real sector (Real Output, Real
  National Income, or Real Interest Rate).

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Long Run Impact of Money Supply is on the Price
Level

• In the long run, there is a direct relationship
  between the money supply and the price level.
• P and M are moving in the same direction and at
  the same speed.
• 1) Repeated Increases in Money Supply lead to
  Inflation 2) inflation rate roughly equals
  growth rate in money supply.
• ?P ?Ms

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And on Inflationary expectations

• If workers expect money supply to increase, they
  will expect future prices to rise.
• They will demand higher wages.
• Producers will be able to match higher costs if
  they expect to raise prices.
• No one is better off, unchanging in real terms.
• Result an expected money supply increase leads
  to an expected inflation, which in turn causes an
  actual inflation.

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So what is the long-run impact of an increased
Money Supply?

• The main impact is on Price Level, and Inflation
  Rate.
• We need a new Model which links Price Level and
  Inflation to FOREX Rate.
• When the Price Level goes up, the (Domestic)
  Currency Value falls, and the Price of FOREX
  should go up.
• In the simplest way, FOREX Rate is a relative
  value of two currenies or the Domestic Currency
  Price of One Unit of Foreign Currency.
• In fact, this model is called Purchasing Power
  Parity Theory.
• conceptually Easier to understand.

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Impact of Money Supply on FOREX Rate in the
Long-run

• In the long-run, an increase in Money Supply
  leads to Price Level Rise, or Inflation
• The value of the domestic currency falls
• The relative value of the foreign currency rises
  - FOREX rate or E goes up.
• Vice versa

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Empirical Evidence P and M move together.