Download Chapter 14

Chapter 14
Money, Interest Rates, and
Exchange Rates
Preview
• What is money?
• Control of the supply of money
• The demand for money
• A model of real money balances +interest rates
• A model of real money balances +interest rates
+exchange rates
• Long run effects of changes in money on prices,
interest rates and exchange rates
2
What Is Money?
• Money is an asset that is widely used and accepted as a
means of payment.
– Our definition of Money: Currency + checking accounts (bank
deposits in the FX market excluded from this definition).
• Characteristics of money (M)
– very liquid: it can be easily and quickly used to pay for goods and
services.
– pays little or no rate of return.
• Group assets into money (liquid assets) and all other assets
(illiquid or less liquid assets).
– All other assets are less liquid but pay a higher return
3
Money Supply
• Money Supply (MS)= the quantity of money that
circulates in an economy.
• Central banks determine the money supply.
– In the US: the Federal Reserve System.
– The Federal Reserve directly regulates the amount of
currency in circulation.
– It indirectly controls the amount of checking deposits
issued by private banks.
4
Money Demand
•
Money demand = the amount of assets that people are
willing to hold as money (instead of illiquid assets).
•
What influences individuals’ willingness to hold money?
–
Expected returns/interest rate on money relative to the
expected returns on other assets.
–
Risk: from unexpected inflation, which unexpectedly reduces
the purchasing power of money. But many other assets have
this risk too, so this risk is not very important in money demand.
–
Liquidity: A need for greater liquidity occurs when either the
price of transactions (P) increases or the quantity of goods
bought in transactions increases.
5
What Influences Aggregate
Money Demand (MD)?
1. Interest rates: ↑R then ↓MD
Why? money pays little or no interest, so R is the opportunity
cost of holding money instead of other assets, like bonds, which
have a higher expected return/interest rate, R.
2. Prices: ↑ P then ↑ MD
Why? higher price level means a greater need for liquidity to
buy the same amount of goods and services  higher money
demand.
3. Income: ↑ Y then ↑ MD
Why? greater income implies more goods and services can be
bought, so that more money is needed to conduct transactions.
6
A Model of Aggregate Money Demand
The aggregate demand for money can be expressed by:
Md = P x 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
Or:
Md/P = L(R,Y)
Aggregate real money demand is a function of Y and R.
Real MD {is negatively related to R.
{shifts with a change in P or Y
7
A Model of Aggregate Money Demand
For a given level of
income, real money
demand decreases
as the interest rate
increases.
8
A Model of Aggregate MD (cont.)
When income
increases, real money
demand increases at
every interest rate.
9
Equilibrium in the Money Market
• The condition for equilibrium in the money
market is:Ms = Md
Using the supply of real money and the
demand for real money (by dividing both
sides by the price level):
Ms/P = L(R,Y)
• This equilibrium condition will yield an
equilibrium interest rate, R.
10
Equilibrium in the Money market
11
The Money Market (cont.)
• XS of money → XD for interest bearing assets (bonds).
– People with an excess supply of money are willing to acquire
bonds by selling their supply of money at a lower R.
– Potential money holders are more willing to hold additional
quantities of M as R (the opportunity cost of holding M) falls.
• XD for money → XS of interest bearing assets.
– People who desire money but do not have access to it are willing
to sell assets with a higher R in return for the money balances
that they desire.
– Those with money balances are more willing to give them up in
return for interest bearing assets as the R on these assets rises
and as the opportunity cost of holding money (the interest rate)
rises.
12
Equilibrium in the Money market
• R2: XS of M (liquidity).
Purchases of bonds, price of
bonds Pb↑, R↓, opportunity
cost of M lower, hence L, M
demand, starts to ↑ (move
down along the L curve), and
XS of M ↓ until we reach R1
• R3: XD for M (shortage of
liquidity). Sell bonds, price of
bonds Pb ↓, R ↑, opportunity
cost of holding M rises, L starts
to ↓ (move up along the curve),
XD for M ↓.
13
Changes in the Money Supply
A decrease in the
money supply raises
the interest rate for a
given price level.
An increase in
the money supply
lowers the interest
rate for a given
price level.
14
Changes in National Income
An increase in
national income
increases equilibrium
interest rates for a
given price level.
15
Linking the Money Market to the FX Market
16
Linking the Money Market to the FX Market
Aggregate real
money supply
Aggregate real
money demand,
L(R,Y)
Real money
holdings
Real money
holdings
MS
P
Aggregate real
money supply
R1
MS
P
Aggregate real
money demand,
L(R,Y)
Interest
rate, R
R1
Interest
rate, R
17
Effect on the Dollar/Euro ER and the $R of a Rise in the U.S. MS
E$/€
Return on $
deposits
E 2$/€
E 1$/€
0
M 1US
PUS
M 2US
PUS
U.S. real
money holdings
2'
1'
R2$ R1$
Expected
return on
euro deposits
Rates of return
(in $ terms)
L(R$, YUS)
U.S. real MS
Increase in U.S.real MS
1
2
18
Changes in the Foreign MS
• An increase in the EU MS ↓ interest rates in the
EU → ↓ the expected return on euro deposits
→ depreciation of €: E↓ ($ appreciates)
• A decrease in the EU MS ↑ interest rates in the
EU → ↑ the expected return on euro deposits
→ appreciation of €: E↑ ($ depreciates).
• The change in the EU MS does not change the
US money market equilibrium.
19
Effect of an Increase in European MS on th$/Euro Exchange Rate
E$/€
$ return
1'
E1$/€
Increase in European MS
2'
E2$/€
Expected
euro return
0
R1$
M SUS
PUS
U.S. real money holdings
↑EU MS reduces expected return on EU
deposits→$ appreciates, eq’m in FX market
shifts from 1’ to 2’, eq’m in MM doesn’t change.
Rates of return
(in dollar terms)
L(R$, YUS)
U.S. real MS
1
20
Long Run (LR) and Short Run (SR)
• In the short run, the price level is fixed at some
level.
– the analysis heretofore has been a short run analysis.
• In the long run, price of output (P), price of factors
of production (ex. wages) and interest rates have
adjusted to eliminate XD or XS and bring Y to its
full employment level YFE.
– R is also fixed and independent of MS (depends on the
supply and demand of saving in the economy and the
inflation rate).
**In the LR, the level of the MS does not influence the
amount of real output nor the interest rate**
21
Long Run (LR) and Short Run (SR)
In the LR prices adjust proportionally to changes
in the MS
P = Ms/L(R*,YFE)
Since R* and YFE do not change as Ms changes, then
neither does L(.). Hence, P must respond one-forone to permanent changes in Ms in the LR. In other
words, the inflation rate (the rate of increase of prices)
should equal the growth rate of money in the LR
P/P = M s/M s .
This is called long-run “neutrality of money
22
How does a rise in money supply lead to an
increase in the price level?
By creating pressure on prices through 3 main
channels:
– it creates demand for output and labor;
– it creates demand for commodities and other raw
materials;
– it raises inflationary expectations, which affect current
prices (If workers expect future prices to ↑ due to an expected
MS ↑, they will want higher wages to be compensated. To match
higher costs, producers will raise prices.
Empirically, long-term changes in money supplies
and price levels show a positive correlation:
23
24
– If a permanent ↑ in a country’s MS causes a
proportional LR ↑ in P, it is intuitive that it should
cause a LR depreciation of the currency:
• High inflation countries tend to exhibit depreciating
(‘weaker’) currencies.
• The depreciation is necessary to keep prices
measured in a common currency in line across
countries (this is the theory of Purchasing Power
Parity discussed in the next chapter).
– Therefore, when studying the E.R. effects of a
change in MS, we must consider the adjustment in
the expected future exchange rate Ee (which we
have, so far, taken as given): a permanent ↑ in
MS→Ee ↑ in the SR.
25
Conditions of Adjustment in SR,
SR towards LR, and LR equilibrium
• Immediate SR:
– P and Ee fixed, E and R do all the adjustment to bring
markets to equilibrium.
• Adjustment towards new LR:
– P is allowed to adjust.
– Ee is allowed to adjust if policy is permanent.
• New LR
– Expected spot rate is equal to actual spot rate: Ee=E
– Thus R=R*
26
SR and LR Effects of a Permanent Increase in U.S. MS
(b) Adjustment to LR equilibrium
(a) SR effects
E$/€
E$/€
R$
E2$/€
R$
2'
E2$/€
3'
E1$/€
0
M1US
P1US
M2US
P1US
M/P
2'
1'
Expected
euro return
R2$ R1$ L(R , Y )
$
US
1
Expected
euro return
4'
E3$/€
M/P
2
•The $ is expected to
depreciate, increasing the
return on deposits in €s.
0
M1US
P1US
M2US
P1US
M/P
ROR(in $ terms)
R2$
R1$
L(R$, YUS)
4
M/P
2
As P↑, Ms/P ↓ and R
returns to its LR level.
27
M, Prices and the E.Rs the LR (cont.)
• A permanent ↑ in a country’s MS→a proportional LR depreciation of
its currency.
– But the dynamics of the model predict a large depreciation first and a
smaller subsequent appreciation.
• A permanent ↓ in a country’s MS→a proportional LR appreciation of
its currency.
– But the dynamics of the model predict a large appreciation first and a
smaller subsequent depreciation.
• E is said to overshoot when its immediate response to a change >
its LR response.
– We assume that changes in the MS have immediate effects on R and E.
– We assume that people change their expectations about inflation
immediately after a change in the MS.
• Overshooting helps explain why ERs are so volatile.
• Overshooting occurs in the model because prices do not adjust
quickly, but expectations about prices do.
28
29
Exchange Rate Volatility
Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.
Exchange rates are
influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.
30
Summary
1. Real money demand depends negatively on
the opportunity cost of holding money (R)
and positively on the volume of transactions
in the economy (Y).
2. The money market is in equilibrium when
the real money supply =real money demand.
3. In the SR, an increase in MS causes a fall in
the domestic interest rate (in the money
market) and a depreciation of the domestic
currency (in the FX market) .
31
Summary (cont’d)
• In the long LR, permanent increases in MS
cause:
– a proportional increase in the P level;
– no change in real income, Y;
– no change in interest rate, R.
• In the SR, an increase in the MS can cause the
E to overshoot its LR level because expectations
about inflation adjust quickly, but P adjusts only
in LR.
– Overshooting occurs when the immediate response of
E due to a change is > its LR response to the change.
– Overshooting helps explain why ERs are so volatile
32
33