Download Study Guide 14

Welcome to Econ 414
International Economics
Study Guide
Week Fourteen
1
Asst 7: # 9, Page 316
Key
a. Supply of pound goes down because, due to decrease in their
income, British can’t afford to buy as many US goods as before.
S2
$/pound
S1
D
pounds
Pound appreciates
2
Part b
• US residents have more income. They will
demand more British goods. Demand
increases
$/pound
S
Pound
appreciates.
D2
D1
pounds
3
Part c
• Due to inflation in the US, both Americans & British would want to
buy more British goods. Therefore, Supply decreases and demand
increases.
$/pound
S2
S1
Pound will
appreciate
D2
D1
pounds
4
Part d
• American’s purchasing poser goes down.
So, they will demand fewer British goods.
Demand for pound goes down
$/pound
S
Pound will
depreciate.
D1
D2
pounds
5
CHAPTER 14
Money, Interest
Rates, and the
Exchange Rate
6
What is money?
•
Anything that can be used for final
discharge a debt.
–
–
–
Credit card is not money
Balance in checking account is money
Coins and currency are money
7
What can money be used for?
1) Medium of Exchange
•
What is the main problem with
barter economy?
– It requires double coincidence of
wants.
2) Unit of Account
•
•
Measure and compare values
Makes economic transactions
easier to compare
8
What can money be used for?
3) Store of Value
• Save now spend later
• Smoothes inconsistencies
between money earned and
money spent
• Note: Individuals in high inflation
countries my keep other
currencies or goods as a store of
value.
9
What is the Supply of Money?
• Coins and paper currency act as
primary mediums of exchange –
money.
• Demand deposits held at banks and
depository institutions provide the
same function as currency – money.
10
The Supply of Money
• M1:
• Is total quantity of currency plus
demand deposits (narrow money,
internationally).
• There are broader measures
of money such as M2,
M3,…etc. They include other
(less liquid) assets.
• M1<M2<M3
11
What is Monetary Base
(B)?
• Cash held by the public (C) and the
total quantity of bank reserves (R) on
deposit at central bank
B = C +R
12
What is Reserve Requirement?
• The percentage of deposits (r)
banks are legally required to keep
on deposit with the central bank
13
What is Money Multiplier (MM)?
• The reciprocal of the reserve
requirement
MM = 1/r
• Money supply (M1) is equal to the
monetary base multiplied by the
money multiplier.
• MS = M1 = 1/r * B
14
Example
•
•
•
•
•
•
€80 = Cash in hands of the public
€230 = Bank Reserve
Required reserve = 0.1
What is MS?
MS = 1/0.1 * (310)
MS = 3100
15
Monetary policy
Refers to central bank changing
money supply by changing the
monetary base and/or the money
multiplier.
• MS = M1 = 1/r * B
MS↑ if
B↑ or if
r↓
16
How can the central bank
change B or r?
1. Change the interest rate banks
pay on borrowed money from the
central bank
 Discount Rate (US), Marginal
Lending rate (Europe):
• Lower interest rate  increase in
borrowed reserves  B↑  MS↑
17
How can the central bank
change B or r?
2. Changing reserve requirement (r):
• Lower reserve requirement
means banks could make more
loans.
– If r↓  MM↑ MS↑
• Rarely used b/c effect too powerful
18
How can the central bank
change B or r?
3. Open Market Operations,
refinancing :
• Buying and selling bonds by
central bank
• If the central bank buys bonds,
money is given to bond seller
(public or bank) and more
money is in the economy 
B↑ MS↑
19
Money Supply Curve
Controlled by the central
bank
Interest Rate
(i)
MS2
Money
Supply
(MS)
MS1
Contractionary
Expansionary
monetary
monetary
policy
policy
Money (M1)
20
I received a question
• Can you please explain again with some
examples the open market operations?
thank you
21
Answer
• Bank of Ireland has some government bonds.
• If the central bank wants to increase the supply of
money
– Offer higher than normal prices for bonds
– Bank of Ireland sell their €1000 bond to the central bank
– Central bank makes a €1000 deposit into their Bank of
Ireland Reserve Account at the central bank.
– Bank of Ireland’s reserves goes up Bank of Ireland make
more loans that means the people (borrowers) will have
more money in their checking accounts (borrowed)  M1
goes up MS goes up
22
The central bank supplies money.
Who demands money?
• Firms
• individuals
23
Why do we demand money
(M1)?
1) To buy goods and services.
•
Transactions demand for money
• Varies directly with nominal GDP
2) In case of emergencies that require
purchases above normal spending
levels
 Precautionary demand for money
3) As an asset
24
Three motivations for holding money
combine to create the aggregate
demand for money
•
If interest rates go up, do we
demand more or less money?
–
Less
•
•
interest rate is the opportunity cost of holding
money
If the price level goes up, do we
demand more or less money?
–
More
•
need more money to cover our purchases
25
• If our income goes up, will we demand more
or less money?
– More
• Can afford to buy more goods and services
• Money demand related to interest rate, price
level and real income as:
MD = f(-i, +P, +Y)
i = Interest rate
P = Price level
Y = Real GDP
26
Money Demand Curve
Interest Rate
(i)
Shows the relationship between
interest rate and the quantity of
money demanded holding
everything else constant
Demand for Money
(MD)
Money (M)
27
What shifts the Money Demand
Curve?
D1
Interest Rate
(i)
Increase to
D1 if P↑ or
Y↑
D2
Decrease
to D2 if
P↓ or Y↓
Demand for Money
(MD)
Money (M)
28
The Equilibrium Interest Rate:
The Interaction of Money Supply
and Money Demand
Interest Rate
(i)
Supply for
Money (MS)
i
Demand for
Money (MD)
Money (M)
29
How does an increase in the price
level affect the interest rates?
Interest Rate
(i)
i2
i
MD ↑
i↑
Supply for
Money (MS)
G
E
MD2
Demand for
Money (MD)
Money (M)
30
How does a economic recession
affect the interest rate?
Supply for
Money (MS)
Interest Rate
(i)
MD↓
i↓
i
E
i1
F
MD1
Demand for
Money (MD)
Money (M)
31
How does an open market sale
by the central bank affect the
interest rate?
Interest Rate
(i)
i2
i
MS2
Supply for
Money
(MS)
MS ↓
i↑
This is a
contractionary
monetary
policy
Demand for
Money (MD)
Money (M)
32
Another Question
• I'm trying to understand the example in
page 329 about appreciation and
depreciation but I think there's something
wrong in it. Can you do it in class?
33
My answer
• Let go over it together
34
How does the interest
rate relate to the
exchange rate?
• Interest Arbitrage:
– Relationship between interest rates and
the exchange rate in the short run
35
The Interest Rate And the
Exchange Rate in the Short
Run
•
Example:
– You own a company in U.S. looking to
invest $10,000 cash.
– Assume U.K. has the best rate of 12%.
– You must first buy pounds in the foreign
exchange market, then invest pounds in
U.K. market.
– If spot exchange rate is $2/pound, which
gives you £5000 to invest
36
The Interest Rate And the
Exchange Rate in the
Short Run
•
Example (continued):
– In 3 months the money will be worth
•
5000 (1+0.12/4) = £5,150
1. If the exchange rate is the same, you will
get
•
5,150 * 2 = $10,300
37
The Interest Rate And the
Exchange Rate in the Short Run
2. If pound drops to $1.975/pound
– By how much has pound
depreciated?
[(2-1.975) / 2] * 100 = %1.25 in 3 months
•
the books says 5% (that is the annual
rate) 1.25 * 4 = 5% depreciation
– You end up with £5,150 * 1.975 =
$10,171.25
– So what is your rate of return?
[(10,171.25-10,000)/10,000] * 4 = 7%
38
So your total rate of return is the
• difference between annual interest rate in
U.K. (12%) and depreciation of the pound
(5%) = approx. 7%.
39
Similarly
•
If the pound appreciates by 5%
– Total return is sum of annual interest
rate in U.K. (12%) and appreciation of
the pound (5%) = approx. 17%
40
To eliminate exchange-rate
risk
•
•
Buy foreign currency in spot
exchange market
At same time sell pound in forward
exchange market delivering on
date of investment’s maturity
1.
If forward rate > current spot rate
(pound is selling at a forward premium)
–
2.
more profitable to invest in U.K.
If forward rate < current spot rate
(pound is selling at forward discount)
–
must compare the gain in favorable interest
rate to loss suffered by exchange rate
41
But really the story is more complicated than
that. Here is a rough numerical example to
show the interest rate parity
•
•
•
•
Annual yield (interest rate) on US bond = 10%
Annual yield (interest rate) on Irish bond = 6%
Spot exchange rate  $1 = €1
Forward exchange rate  $1 = €1
42
So Irish will want to invest in the
US
• Spot demand for dollar goes up  dollar
appreciates by 1 %
• Demand for US bonds goes up  price of bonds
goes up  interest rate goes down by 1% point.
• Demand for Irish bonds goes down price of
bond goes down  interest rate goes up by 1%
point.
• Forwards supply of dollar goes up  dollar
depreciates by 1%
• Now
– Dollar sells at 2% forward discount = Interest rate in US
is 2% point higher than in Ireland
43
Interest rate parity
• Funds continue moving between the two
countries until
– forward premium or discount equals the
interest rate differential
44
The Interest Rate And the Exchange
Rate in the Short Run
•
What does tightening of money in
Ireland do to interest rates?
–
•
What does this do in the market for
euro?
–
–
•
MS declines interest rates go up
Demand goes up euro appreciates
Supply goes down euro appreciates
This process continues until
interest parity is achieved.
45
Interest Rates, the Exchange
Rate, and the Balance of
Payments
•
Changes in Interest Rates:
–
Increasing a country’s interest rate:
•
•
–
Decreasing a country’s interest rate:
•
•
–
–
Causes capital inflow
Appreciation of a country’s currency
Causes capital outflow
Depreciates a country’s currency
Movement of capital causes change
exchange rates
Interest rate volatility  exchange rate
volatility
46
Suppose there is no
capital inflow or outflow
$/Euro
D & S are due current
account activities
S1 (imports
of G & S)
2.5
2.0
E
1.5
At E,
quantity
demanded
for euros =
quantity
supplied 
current
account
balance
D1 (exports
of G $ S)
100
200 300 400 500
Euros
47
What happens if there are now
capital flows between countries?
•
Assume U.S. interest rates increase
– Capital moves into US.
– Supply of euro increases
– Does demand for euro decrease?
•
No there was no capital inflow before.
48
Supply shift right
euro depreciates
imports of goods and services go down to less than 200
exports of goods and services go up to more than 400
$/Euro
current
S1
(imports
of G & S)
2.5
2.0
E1
1.5
E2
100
200 300 400 500
account
surplus
= net
capital
outflow
S2 =S1
+ capital
outflow
D1 (exports
of G $ S)
Euros
49
Asst 8
•
•
•
•
Questions 9, 10, and 13, Page 338
It is an individual assignment
Has 20 points
Is due before 10PM on Friday, November
30
• Do not attach the graphs in a separate
document form the texts. Attach only one
document to your email please.
50
I will be flying back to the US
• On Saturday, December 1
• We will have regular classes during the
week of December 3
• Our class meets on MWF at 2 PM in
Thomas 103
• See you on Monday, December 3
51