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Money Econ 7920/Chatterjee 5/15/2017 1 Serves as ◦ Medium of exchange ◦ Store of value ◦ Unit of account Helps measure “opportunity cost” Types of Money: “Fiat” and “Commodity” Econ 7920/Chatterjee 5/15/2017 2 Interest Rate: ◦ Opportunity cost of holding money ◦ “Price” of money relative to time Exchange Rate: ◦ Price of one currency relative to another ◦ “Price” of money relative to other foreign currencies Aggregate Price Level: ◦ Average “value” of all goods and services produced ◦ “Price” of money relative to goods and services Econ 7920/Chatterjee 5/15/2017 3 Changes in the quantity of money affect ◦ Interest Rates: affect incentives to save and invest ◦ Exchange Rates: affect exports, international financial transactions imports, and ◦ Price Level: creates inflation/deflation; affects spending decisions How does money affect these variables? Econ 7920/Chatterjee 5/15/2017 4 Think in terms of demand and supply Demand for Money: households, firms, financial institutions, government, and foreigners Supply of Money: Central Bank ◦ Examples: Federal Reserve, European Central Bank, etc. When money supply changes, what happens to its three prices? Econ 7920/Chatterjee 5/15/2017 5 symbol assets included C amount ($ billions) Currency $739 M1 C + demand deposits, travelers’ checks, other checkable deposits $1391 M2 M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts $6799 Would you like to receive $100 today or a year from now? The interest rate is the “opportunity cost” of holding money today When money supply increases, short-term interest rates fall (why?) Econ 7920/Chatterjee 5/15/2017 7 How does the Federal Reserve alter the quantity of money in the economy? Three tools of Monetary Policy: ◦ Discount Rate: The rate at which commercial banks can borrow from the Fed ◦ Reserve Requirement: The fraction of each deposit a bank must maintain as reserves (not to be lent) ◦ Federal Funds Rate: The interest rate commercial banks charge each other for overnight loans (guaranteed by deposits at the Fed) benchmark nominal interest rate in the economy Econ 7920/Chatterjee 5/15/2017 8 The Fed usually targets the Federal Funds Rate through its Open Market Operations Open Market Purchase: The Fed buys government bonds and other financial assets injects cash into the economy (money supply increases) Open Market Sale: The Fed sells government bonds and other financial assets withdraws cash from the economy (money supply falls) Econ 7920/Chatterjee 5/15/2017 9 How many units of a foreign currency can one unit of the Home currency buy? The US-Euro exchange rate: 0.7 Euros/$ (09/05/2008) Example: What does it mean when ◦ the exchange rate falls to 0.6 Euros/$ ◦ the exchange rate rises to 0.8 Euros/$ Understanding “depreciation” and “appreciation” of an exchange rate Econ 7920/Chatterjee 5/15/2017 10 Country July 14, 2006 Sept 5, 2008 Euro 0.79 Euro/$ 0.70 Euro/$ Japan 116.3 Yen/$ 107.75 Yen/$ Mexico 11.0 Pesos/$ 10.46 Pesos/$ Russia 27.0 Rubles/$ 25.48 Rubles/$ South Africa 7.2 Rand/$ 7.99 Rand/$ U.K. 0.54 Pounds/$ 0.57 Pounds/$ Exchange Rate Depreciation: a unit of the home currency can buy fewer units of a foreign currency Exchange Rate Appreciation: a unit of the home currency can buy more units of a foreign currency If the US dollar has depreciated against the Euro, then the Euro has appreciated against the dollar Econ 7920/Chatterjee 5/15/2017 12 Consequences of a currency depreciation: ◦ Domestic (Home) goods are cheaper to the rest of the world exports increase ◦ Foreign goods are expensive at Home imports decrease Anything that increases the demand for a country’s currency (money) will appreciate its exchange rate When money supply increases, short-term exchange rates tend to depreciate (why?) Econ 7920/Chatterjee 5/15/2017 13 An increase in money supply higher spending on goods and services increase in aggregate demand If supply of goods and services cannot meet up with demand excess demand is created higher prices to clear markets inflation In general, an increase in money supply creates inflation Countries that have high growth rates of money supply also tend to have higher rates of inflation Econ 7920/Chatterjee 5/15/2017 14 15% 12% Over the long run, the inflation and money growth rates move together, M2 growth as the quantity theory rate predicts. 9% 6% 3% 0% 1960 1965 inflation rate 1970 1975 1980 1985 1990 1995 2000 2005 100 Inflation rate Turkey Ecuador Indonesia (percent, logarithmic scale) Belarus 10 1 Argentina U.S. Singapore Switzerland 0.1 1 International data on inflation and money growth, 1996-2004 10 100 Money Supply Growth (percent, logarithmic scale) Increase in Money Supply Reduces interest rates Depreciates exchange rate Creates inflation The ultimate (long-run) effect on the economy is determined by the interaction of these three factors Econ 7920/Chatterjee 5/15/2017 17 percent per year 15 nominal interest rate 10 5 0 inflation rate -5 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Nominal 100 Interest Rate Romania (percent, logarithmic scale) Zimbabwe Brazil 10 Bulgaria Israel U.S. Germany Switzerland 1 0.1 1 10 100 1000 Inflation Rate (percent, logarithmic scale) “Nominal” variables: measured in monetary units ◦ Examples: “dollar” value of GDP, wages and salaries, market interest rates and exchange rates “Real” variables: measured in physical units ◦ Examples: above variables adjusted for prices and/or inflation Physical output produced (real GDP), wages adjusted for the price level (real wage), etc. Econ 7920/Chatterjee 5/15/2017 20 A country produces 100 units of output in 2006, at a price level of $5 per unit of output. ◦ Nominal GDP = 100 x 5 = $500 ◦ Real GDP = 100 units of output In 2007, the country produced 100 units of output, but prices doubled to $10 per unit. ◦ Nominal GDP = 100 x 10 = $1000 ◦ Real GDP = 100 units of output Nominal GDP doubled, but real GDP remained unchanged: is the country richer or better off? Econ 7920/Chatterjee 5/15/2017 21 A country’s well-being is determined by changes in its real GDP and not nominal GDP Economic Growth: percentage change in real GDP over time Real GDP = Nominal GDP/Price level GDP deflator (Price Level) = Nominal GDP/Real GDP Econ 7920/Chatterjee 5/15/2017 22 “Real” interest rate = Nominal interest rate – Rate of inflation The real interest rate is determined by the demand for investment and the supply of savings Nominal interest rate = real interest rate + rate of inflation Positive relationship between nominal interest rates and inflation Econ 7920/Chatterjee 5/15/2017 23 Nominal Interest Rates tend to rise with inflation as creditors care about their command over future output (i.e., they care about the “real” interest rate) An increase in money supply may reduce shortterm interest rates, but by increasing inflationary expectations, can lead to an increase in the longterm interest rate. Econ 7920/Chatterjee 5/15/2017 24 Real exchange rates track changes in the value of goods across countries after adjusting for inflation Example: ◦ Suppose US-Mexico exchange rate is 1 Peso/$ today ◦ A shirt in the US costs $1, and in Mexico it costs 0.80 Pesos ◦ So, shirts are cheaper in Mexico relative to the US ◦ Americans will choose to buy Mexican shirts Econ 7920/Chatterjee 5/15/2017 25 Now, suppose the US-Mexico exchange rate falls by 25% ◦ The new exchange rate is: 0.75 Pesos/$ ◦ The US currency has depreciated against the Peso ◦ If prices remain constant, then the $1 shirt in the US will cost 0.75 Pesos to Mexicans ◦ The 0.80 Pesos Mexican shirt would now cost $1.07 to Americans (=0.8/0.75) ◦ American shirts cheaper to Mexicans, and Mexican shirts more expensive for Americans ◦ US exports to Mexico rise, but imports fall US trade balance improves Lesson: an exchange rate depreciation improves the trade balance Econ 7920/Chatterjee 5/15/2017 26 Let’s complicate things… Next year, US inflation rose from 0 to 30%, while in Mexico, prices remained stable. ◦ So, the $1 shirt in the US now costs $1.30 ◦ The $1.30 shirt in the US will cost 0.98 Pesos to Mexicans (=1.30 x 0.75) ◦ To Americans, the cost of a Mexican shirt is still $1.07 (=0.80/0.75) ◦ Mexican shirts now cheaper than American shirts ◦ American exports decrease and imports increase US trade balance worsens Lesson: it’s just not enough to compare changes in “nominal” exchange rates when comparing goods prices one must keep track of inflation rates across countries too Econ 7920/Chatterjee 5/15/2017 27 % in real exchange rate = % in nominal exchange rate – (inflation rate in foreign – inflation rate at home) In our example: though the US nominal exchange rate depreciated, its real exchange rate (relative to the Peso) appreciated Inflation differential across countries (if large enough) can offset the effects of a nominal depreciation of the exchange rate Econ 7920/Chatterjee 5/15/2017 28 If a country is experiencing a rapid growth in money supply, then ◦ Nominal exchange rates can depreciate ◦ But inflation can cause a real exchange rate appreciation ◦ Eventually, exports can fall and imports rise worsening of the trade balance Econ 7920/Chatterjee 5/15/2017 29 U.S. Cents per Mexican Peso 35 30 25 20 15 10 7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95 U.S. Cents per Mexican Peso 35 30 25 20 15 10 7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95 U.S. goods suddenly more expensive to Mexicans ◦ U.S. firms lost revenue ◦ Hundreds of bankruptcies along U.S.-Mexican border Mexican assets worth less in dollars ◦ Reduced wealth of millions of U.S. citizens as there was substantial US investment in Mexican assets (through mutual funds, pension funds, 401 k’s, etc…) In the early 1990s, Mexico was an attractive place for foreign investment: ◦ Mexican interest rates were high promise of higher returns on investment ◦ Mexican Central Bank maintained and had committed to a fixed exchange rate against the dollar ◦ This made returns from foreign investment very stable ◦ There were large capital inflows into Mexico in the early 1990’s, including a substantial portion from the US The high interest rate in Mexico reflected inherent risk: ◦ During 1994, political developments made Mexico a risky place to invest (peasant uprising in the Chiapas and assassination of leading presidential candidate) ◦ Capital outflows started as early as December 1993, but the information was concealed by the Central Bank Mexican inflation rate was much higher than the US rate ◦ The Federal Reserve raised U.S. interest rates several times during 1994 to prevent U.S. inflation Though the Mexican nominal exchange rate was fixed, there was substantial real exchange rate appreciation of the Peso Maintaining the peg became increasingly difficult for the Mexican Central Bank Econ 7920/Chatterjee 5/15/2017 34 These events put downward pressure on the peso Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate Doing this requires that Mexico’s central bank have adequate reserves of dollars Did it? December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15, 1994 ………… $ 7 billion During 1994, Mexico’s central bank hid the fact that its reserves were being depleted. Dec. 20, 1994: Mexico devalues the peso by 13% (fixes the Pesoat 25 cents instead of 29 cents per $) Investors are SHOCKED! – they had no idea Mexico was running out of reserves. Investors start dumping Mexican assets, pulling their capital out of Mexico. Dec. 22, 1994: central bank’s reserves nearly gone. It abandons the fixed rate and lets the Peso float. Within a week, the Peso falls another 30%. 1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt. This helped restore confidence in Mexico, and reduced the risk premium on their interest rate. After a hard recession in 1995, Mexico began a strong recovery from the crisis (also helped by NAFTA) Moral of the Story: Had investors paid attention to the Peso’s real exchange rate, they could have saved millions of dollars