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Chapter 14
Supplementary Notes
What is Money?
• Medium of Exchange
– A generally accepted means of payment
• A Unit of Account
– A widely recognized measure of value
• A Store of Value
– A transfer of purchasing power from the
present into the future
Money Supply
• Money includes assets widely used and
accepted as a means of payment.
• Money is very liquid, but pays little or no
return.
– All other assets are less liquid but pay higher
return.
• Money Supply (Ms)
Ms = Currency + Checkable Deposits
Money Supply
• How the Money Supply Is Determined
– An economy’s money supply is controlled by
its central bank.
– The central bank:
• Directly regulates the amount of currency in
existence
• Indirectly controls the amount of checking deposits
issued by private banks
The Demand for Money
by Individuals
• Demand for money is about why individuals
choose money instead of other assets.
• Other assets include stocks, bonds, real estate,
etc. These nonmonetary assets are collectively
called “bonds.”
• Three factors influence money demand:
– Expected return
– Risk
– Liquidity
Money vs. Bonds
Money
• Pay no interest. 
Expected return is
zero.
• Liquidity is higher.
Bonds
• Pay interest. 
Expected return is
higher.
• Liquidity is lower.
Expected Return
• Money is held for liquidity purposes.
• The interest rate measures the opportunity
cost of holding money rather than interestbearing bonds.
– A rise in the interest rate raises the cost of
holding money and causes money demand to
fall.
Riskiness
• Holding money is risky.
– Unexpected increase in the price level
reduces the value of money.
• Changes in riskiness equally affect both
money and bonds.
• Thus, risk is not an important factor in
money demand.
Liquidity
• Money is held for liquidity.
• The value of holding liquidity increases with
transactions. The magnitude of transactions is
positively related to income.
• When income rises, transaction volume
increases and the demand for money rises.
• If the price level increases, nominal transaction
volume increases and the demand for nominal
money balance increases.
Aggregate Money Demand
• The total demand for money by all
households and firms in the economy.
• It is determined by three main factors:
– Interest rate
• Is negatively related to money demand.
– Real national income
• Is positively related to money demand.
– Price level
• Is positively related to money demand.
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
Alternatively:
Md/P = L(R,Y)
Aggregate real money demand is a function of national income and
interest rates.
Aggregate Money Demand
For a given level of
income, real money
demand decreases
as the interest rate
increases.
Increase in Money Demand
When income
increases, real money
demand increases at
every interest rate.
The Money Market
• The condition for equilibrium in the
money market is:
Ms = Md or Ms/P = Md/P
 Ms/P = L(R,Y)
• This equilibrium condition will yield an
equilibrium interest rate.
Money Market Equilibrium
Changes in the Money Supply
An increase in the
money supply lowers
the interest rate for a
given price level.
Changes in National Income
An increase in
national income
increases equilibrium
interest rates for a
given price level.
Linking the Money Market to the
Foreign Exchange Market
Linking the
Money Market
to the Foreign
Exchange
Market
Changes in the
Domestic Money
Supply
Changes in the
Foreign Money
Supply
Money, Prices and the
Exchange Rates in the Long Run
• Money is neutral in the long run.
– It has no effects on real variables. (Neutral)
– A permanent increase in a country’s money
supply causes a proportional increase in the
price level.
– The domestic currency depreciates
proportionately.
Short Run and Long Run
In the short run (with
fixed P), an increase
in money supply
• Leaves P unaffected
• Lowers R
In the long run (with
flexible P), an increase
in money supply
• Raises P
proportionately
• Has no effect on R
Goods Prices
in the Short Run and Long Run
• Observation: Prices are sticky. They move
slowly.
• Theory (abstraction): We assume that prices are
fixed in the short run but flexible in the long run.
• In the long run, nominal variables (M, P, and E)
change proportionately.
• Individuals have rational expectations. They
expect E and P to move according to the longrun rule. In other words, as M increases, Ee and
Pe move in the same proportion as the increase
in M now in the short run!
Money, Prices and the
Exchange Rates in the Short Run
• In the short run, when money supply increases,
– The price level (P) is fixed and the interest rate (R) declines to clear the
money market.
– The expected future exchange rate rises (Ee ). (A)
• How would the exchange rate move?
– Because, the domestic interest is now lower than the foreign interest
rate, according to the interest parity condition, R-R* = (Ee-E)/E, the
expected rate of depreciation must be negative.
– I.e., the domestic currency must be expected to appreciate! (B)
– (A) and (B) are simultaneously true only if the exchange rate (E) rises
more in the short run than it would in the long run (as indicated by Ee).
– The exchange rate (E) overshoots its long-run level (Ee).
– After the overshooting, the exchange rate declines (appreciates) to its
long-run level.
Change in expected
return on euro deposits
Money, Prices, the
Exchange Rates,
and Expectations
The expected return on
euro deposits rises because
of inflationary expectations:
•The dollar is expected to
be less valuable when
buying goods and services
and less valuable when
buying euros.
•The dollar is expected to
depreciate, increasing the
return on deposits in euros.
Money, Prices
and the
Exchange
Rates in the
Long Run
As prices increases,
the real money
supply decreases
and the domestic
interest rate returns
to its long run rate.
Original
return
on dollar
deposits
Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its
long run response.
– We assume that changes in the money supply have
immediate effects on interest rates and exchange rates.
– We assume that people change their expectations about
inflation immediately after a change in the money supply.
• Overshooting helps explain why exchange rates are
so volatile.
• Overshooting occurs in the model because prices do
not adjust quickly, but expectations about prices do.
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.