1 ch. 14: money, interest rates, and exchange rates
TRANSCRIPT
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Ch. 14: Money, Interest Rates, and Exchange Rates
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The OutlineThe Outline
We learned that exchange rates depend We learned that exchange rates depend on interest rates on the deposits of on interest rates on the deposits of currencies and the expected future currencies and the expected future exchange rate.exchange rate.
What affects interest rates and What affects interest rates and expectations is our next concern.expectations is our next concern.
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MoneyMoneyNominal interest rate in a country is closely Nominal interest rate in a country is closely
related to the supply and demand of money.related to the supply and demand of money.Future price level in a country is closely Future price level in a country is closely
related to the supply and demand of money.related to the supply and demand of money.Future prices of products affect the Future prices of products affect the
expected exchange rate.expected exchange rate.Since supply and demand of money is so Since supply and demand of money is so
influential in determining exchange rates, influential in determining exchange rates, we start with it.we start with it.
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What Is Money?What Is Money?
Money is anything that is accepted in a Money is anything that is accepted in a society in return for goods and services society in return for goods and services and settlements of debts.and settlements of debts.
Money fulfills three functions.Money fulfills three functions.Money is a unit of account.Money is a unit of account.Money is a medium of exchange.Money is a medium of exchange.Money is a store of value.Money is a store of value.
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What Is Money?What Is Money?
Currency and checking deposits fulfill all Currency and checking deposits fulfill all three functions.three functions.
Saving deposits are not a medium of Saving deposits are not a medium of exchange, although the ease with which exchange, although the ease with which they can be transferred to checking they can be transferred to checking deposits make them closer to money.deposits make them closer to money.
For simplicity, we will define money as For simplicity, we will define money as currency plus demand deposits.currency plus demand deposits.
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Money SupplyMoney Supply
The amount of money supplied to the The amount of money supplied to the economy, therefore, depends on the economy, therefore, depends on the available currency outside of the banks available currency outside of the banks and the holdings of checking deposits.and the holdings of checking deposits.
The Federal Reserve, the Central Bank The Federal Reserve, the Central Bank of US, controls the money supply by of US, controls the money supply by manipulating the reserves available for manipulating the reserves available for banks.banks.
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Money DemandMoney DemandCurrency and demand deposits are Currency and demand deposits are
assets for holders.assets for holders.The theory of asset demand says three The theory of asset demand says three
factors determine the demand for an factors determine the demand for an asset.asset.Expected return of an asset compared to Expected return of an asset compared to
returns from other assets.returns from other assets.Riskiness of an asset’s returns.Riskiness of an asset’s returns.Liquidity of an asset.Liquidity of an asset.
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Expected ReturnExpected Return Currency has no return. In the absence of Currency has no return. In the absence of
inflation, $1 bill is worth the same a year from inflation, $1 bill is worth the same a year from now as today.now as today.
Checking deposits may or may not pay interest. Checking deposits may or may not pay interest. Typically, the interest paid is lower than saving Typically, the interest paid is lower than saving deposits or bonds. The difference in interest paid deposits or bonds. The difference in interest paid between checking deposits and bonds is the between checking deposits and bonds is the opportunity cost of holding money.opportunity cost of holding money.
When interest rates rise, the opportunity cost of When interest rates rise, the opportunity cost of holding money rises and people hold less money.holding money rises and people hold less money. The demand for money falls.The demand for money falls.
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RiskinessRiskinessThe riskiness of money is the The riskiness of money is the
unexpected loss of its value due to unexpected loss of its value due to inflation.inflation.
Bonds and saving accounts lose their Bonds and saving accounts lose their value with inflation, too.value with inflation, too.
Inflation, therefore, will not change a Inflation, therefore, will not change a person’s portfolio between money and person’s portfolio between money and bonds.bonds.
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LiquidityLiquidity In order to carry out purchases, people In order to carry out purchases, people
need to hold an inventory of money.need to hold an inventory of money.The higher the value of transactions a The higher the value of transactions a
person expects to conduct per period, person expects to conduct per period, the higher is the demand for money.the higher is the demand for money.
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Additional Variables for the Additional Variables for the Demand for MoneyDemand for Money
Income of the individualIncome of the individualThe higher the income, the higher is the The higher the income, the higher is the
demand for money.demand for money.Price levelPrice level
Likewise, the higher is the price level, the Likewise, the higher is the price level, the higher is the demand for money.higher is the demand for money.
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The Demand for MoneyThe Demand for Money
The demand for money will fall as The demand for money will fall as interest rates rise.interest rates rise.
The demand for money will rise as real The demand for money will rise as real income rises.income rises.
The demand for money will be The demand for money will be proportional to the price level, rising by proportional to the price level, rising by the same percentage.the same percentage.
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The Demand for MoneyThe Demand for Money
Md = P L(R,Y)Md/P = L(R,Y)Real money demand depends on interest rateand real income.
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The Demand for MoneyThe Demand for Money
R
M/P
Increase in Y shifts demandright.
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The Demand for MoneyThe Demand for Money
R
M/PIf R and Y are kept constant, any % increase in P has to be matched by an equal % increase by M.
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The Demand for MoneyThe Demand for Money
R
M/PIf R is allowed to change but Y is kept constant, any increase in P will increase interest rates as well.
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Equilibrium Interest RateEquilibrium Interest Rate
M/P
RReal Money Supply
Real MoneyDemand
R0
R1
What happens at R1?
There is excess supply. People want to hold less money. They try to exchange their money for interest bearing assets, like bonds.Every one trying to buy bonds, raises the price of bonds and lowers the interest rate until equilibrium is reached.
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Equilibrium Interest RateEquilibrium Interest Rate
If there is excess real money supply, If there is excess real money supply, interest rates fall.interest rates fall.
If there is excess real money demand, If there is excess real money demand, interest rates rise.interest rates rise.
If income (output=Y) increases, interest If income (output=Y) increases, interest rates rise.rates rise.
If real money supply increases, interest If real money supply increases, interest rates fall.rates fall.
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Changes in the Money SupplyChanges in the Money Supply
An increase in the money supply lowers the interest rate for a given price level.
A decrease in the money supply raises the interest rate for a given price level.
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Changes in National IncomeChanges in National Income
An increase in national income increases equilibrium interest rates for a given price level.
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Linking the Money Market to the Linking the Money Market to the Foreign Exchange MarketForeign Exchange Market
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Interaction of Monetary Sector Interaction of Monetary Sector and FX Marketand FX Market
R R
RM/P
$/€
Return in $
Expected $ return on euro deposits
E0
R0
E1
R1
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ApplicationApplication
In each following case assume that In each following case assume that nothing else changes: nothing else changes: ceteris paribus.ceteris paribus.
What happens to USD exchange rate if What happens to USD exchange rate if the Fed raises the interest rate?the Fed raises the interest rate?
What happens to USD exchange rate if What happens to USD exchange rate if US economy grows?US economy grows?
In both cases USD appreciates.
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ApplicationApplication What happens to the exchange rate between $ What happens to the exchange rate between $
and €, if the ECB lowers the interest rate?and €, if the ECB lowers the interest rate?
If you said USD appreciates and € depreciates, you were right.
How do you show this in the related markets of money and FX?
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Interaction of Monetary Sector Interaction of Monetary Sector and FX Marketand FX Market
R R
RM/P
$/€
Return in $
Expected $ return on euro deposits
E0
R0
E1
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Changes in the Foreign Money SupplyChanges in the Foreign Money Supply
How would a change in the euro money supply How would a change in the euro money supply affect the US money market and foreign affect the US money market and foreign exchange market?exchange market?
An increase in the EU money supply causes a An increase in the EU money supply causes a depreciation of the euro (appreciation of depreciation of the euro (appreciation of the dollar).the dollar).
A decrease in the EU money supply causes an A decrease in the EU money supply causes an appreciation of the euro (a depreciation of the appreciation of the euro (a depreciation of the dollar).dollar).
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Short Run to Long RunShort Run to Long Run In the short run, both output (Y) and In the short run, both output (Y) and
price level (P) will remain constant.price level (P) will remain constant. In the medium run, output will change In the medium run, output will change
but price level will not.but price level will not.Long run is when the price level is Long run is when the price level is
allowed for full adjustment.allowed for full adjustment.
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Long RunLong Run The long run position of an economy is when The long run position of an economy is when
full employment is reached.full employment is reached. Full employment in an economy occurs Full employment in an economy occurs
when all markets clear and resources are when all markets clear and resources are allocated efficiently.allocated efficiently.
To have clearance in all markets means To have clearance in all markets means prices and wages have adjusted fully.prices and wages have adjusted fully.
An economy with perfect flexibility in prices An economy with perfect flexibility in prices and wages always operates in full and wages always operates in full employment.employment.
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Short RunShort Run
In the short run equilibrium in the In the short run equilibrium in the monetary sector happens with the monetary sector happens with the adjustment of interest rates.adjustment of interest rates.
MMS S = M= M D D MM D D = P L(Y,R)= P L(Y,R)P and Y are constant in the short run.P and Y are constant in the short run.MMSS increase will have to be matched by increase will have to be matched by
R decrease.R decrease.
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Short RunShort RunR
M/P
R1
(M/P)’(M/P)
R2
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Medium RunMedium RunLower interest rates spur more Lower interest rates spur more
investment activities by firms.investment activities by firms.As firms expand operations, income (Y) As firms expand operations, income (Y)
increases.increases.Higher Y pushes the demand for money Higher Y pushes the demand for money
outward.outward. Interest rates rise.Interest rates rise.
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Medium RunMedium RunR
M/P
R1
(M/P)’(M/P)
R2
R3
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Long RunLong Run
In the long run, prices adjust to the higher In the long run, prices adjust to the higher level of money supply.level of money supply.
Long run is also characterized by actual Long run is also characterized by actual inflation being equal to expected inflation.inflation being equal to expected inflation.
In the long run, interest rates will be equal In the long run, interest rates will be equal to real interest rates plus actual inflation.to real interest rates plus actual inflation.
As price level rises, real demand for As price level rises, real demand for money will drop.money will drop.
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Long RunLong RunR
M/P
R1, R3
(M/P)’(M/P)
R2
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Long RunLong Run
Real interest rates are determined by Real interest rates are determined by the interaction of investments (demand the interaction of investments (demand for loanable funds) and savings (supply for loanable funds) and savings (supply of loanable funds).of loanable funds).
Nominal interest rates are equal to real Nominal interest rates are equal to real interest rates in the absence of inflation.interest rates in the absence of inflation.
Income (Y) in the long run is determined Income (Y) in the long run is determined by available capital, labor, and by available capital, labor, and technology, all fully employed.technology, all fully employed.
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Long RunLong RunChanges in money supply will have no Changes in money supply will have no
effect on real variables in the long run.effect on real variables in the long run. I=S will determine R.I=S will determine R.K, L, A will determine Y.K, L, A will determine Y.Rate of increase of M will be exactly Rate of increase of M will be exactly
matched by the rate of increase in P.matched by the rate of increase in P.
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Long Run and Short RunLong Run and Short Run
In the long run, there is a direct relationship In the long run, there is a direct relationship between the inflation rate and changes in the between the inflation rate and changes in the money supply.money supply.
MMss = P x L = P x L((R,YR,Y))
P = MP = Mss/L/L((R,YR,Y))
P/P = P/P = MMss/M/Mss - - L/LL/L
The inflation rate equals growth rate in money supply The inflation rate equals growth rate in money supply minus the growth rate for money demand.minus the growth rate for money demand.
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Money and Prices in the Long Run Money and Prices in the Long Run 1.1. Excess demandExcess demand: an increase in the money supply : an increase in the money supply
implies that people have more funds available to pay implies that people have more funds available to pay for goods and services. for goods and services.
To meet strong demand, producers hire more workers, To meet strong demand, producers hire more workers, creating a strong demand for labor, or make existing creating a strong demand for labor, or make existing employees work harder. employees work harder.
Wages rise to attract more workers or to compensate workers Wages rise to attract more workers or to compensate workers for overtime.for overtime.
Prices of output will eventually rise to compensate for higher Prices of output will eventually rise to compensate for higher costs. costs.
Alternatively, for a fixed amount of output and inputs, Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their producers can charge higher prices and still sell all of their output due to the strong demand.output due to the strong demand.
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Money and Prices in the Long RunMoney and Prices in the Long Run
2.2. Inflationary expectationsInflationary expectations: : If workers expect future prices to rise due to an If workers expect future prices to rise due to an
expected money supply increase, they will want expected money supply increase, they will want to be compensated. to be compensated.
And if producers expect the same, they are more And if producers expect the same, they are more willing to raise wages. willing to raise wages.
Producers will be able to match higher costs if Producers will be able to match higher costs if they expect to raise prices.they expect to raise prices.
Result: expectations about inflation caused by an Result: expectations about inflation caused by an expected money supply increase leads to actual expected money supply increase leads to actual inflation.inflation.
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Exchange Rate in the Long RunExchange Rate in the Long RunWhen the amount of money doubles When the amount of money doubles
under full employment, we expect the under full employment, we expect the price level to double, too.price level to double, too.
The price of foreign currency, therefore, The price of foreign currency, therefore, should double, too.should double, too.
If the price of euros were $1 per euro, it If the price of euros were $1 per euro, it will become $2 per euro.will become $2 per euro.
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Money, Prices and the Money, Prices and the Exchange Rates and Expectations Exchange Rates and Expectations When we consider price changes in the long When we consider price changes in the long
run, inflationary expectations will have an effect run, inflationary expectations will have an effect in the foreign exchange market. in the foreign exchange market.
Suppose that expectations about inflation Suppose that expectations about inflation change as people change their minds, but actual change as people change their minds, but actual adjustment of prices occurs afterwards.adjustment of prices occurs afterwards.
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Inflationary Expectations in the Inflationary Expectations in the Long RunLong Run
R R
RM/P
$/€
Return in $
Expected $ return on euro depositsE0
R0
E1
If M and P grow at the same rate, M/P will remain constant.However, inflation in the future should boost the expected appreciation of euro. USDdepreciates.
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Seeming ParadoxSeeming Paradox In the short run, money supply increase In the short run, money supply increase
lowers the interest rate and depreciates the lowers the interest rate and depreciates the currency.currency.
An increase in the growth rate of money An increase in the growth rate of money increases inflationary expectations and hence increases inflationary expectations and hence raises the nominal interest rate (Fisher effect).raises the nominal interest rate (Fisher effect).This raises the expected appreciation of foreign This raises the expected appreciation of foreign
currency and depreciates the spot value of currency and depreciates the spot value of domestic currency.domestic currency.
An increase of money supply leads to An increase of money supply leads to exchange rate overshooting.exchange rate overshooting.
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Short Run Effect of Money Short Run Effect of Money Supply Increase in USSupply Increase in US
R R
RM/P $/€
Return in $
Expected $ return on euro deposits
E0
R0
Increase of M in US changes expectationsabout future exchange rates. Euro is expectedto appreciate.
E1
R1
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Long Run Effect of Money Long Run Effect of Money Supply Increase in USSupply Increase in US
R R
RM/P $/€
Return in $
Expected $ return on euro deposits
E0
R0
Price increases shift M/P to the left. Higher R in US appreciates USD.
E1
R1
E2
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Change in expectedreturn on euro deposits
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.
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Original (long run) returnon dollar deposits
As prices increases,the real money supply decreases and the domestic interest rate returns to its long run rate.
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Money, Prices and the Money, Prices and the Exchange Rates in the Long RunExchange Rates in the Long Run
A permanent increase in a country’s money supply A permanent increase in a country’s money supply causes a proportional long run depreciation of its causes a proportional long run depreciation of its currency.currency. However, the dynamics of the model predict a large depreciation However, the dynamics of the model predict a large depreciation
first and a smaller first and a smaller subsequent appreciationsubsequent appreciation..
A permanent decrease in a country’s money supply A permanent decrease in a country’s money supply causes a proportional long run appreciation of its causes a proportional long run appreciation of its currency.currency. However, the dynamics of the model predict a large appreciation However, the dynamics of the model predict a large appreciation
first and a smaller first and a smaller subsequent depreciationsubsequent depreciation..
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OvershootingOvershooting A permanent increase in M firstA permanent increase in M first
lowered Rlowered R$$
raised Eraised E00 to E to E11
In time,In time,price level rose.price level rose.RR$$ rose. rose.
EE11 dropped to E dropped to E22
Exchange rate overshooting refers to the Exchange rate overshooting refers to the movement of E away from its long run value.movement of E away from its long run value.
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Exchange Rate OvershootingExchange Rate Overshooting
The exchange rate is said to The exchange rate is said to overshootovershoot when its when its immediate response to a change is greater than its immediate response to a change is greater than its long run response.long run response. We assume that changes in the money supply have We assume that changes in the money supply have
immediate effects on interest rates and exchange rates.immediate effects on interest rates and exchange rates.
We assume that people change their expectations about We assume that people change their expectations about inflation immediately after a change in the money supply.inflation immediately after a change in the money supply.
Overshooting helps explain why exchange rates are Overshooting helps explain why exchange rates are so so volatilevolatile..
Overshooting occurs in the model because prices do Overshooting occurs in the model because prices do not adjust quickly, but expectations about prices do.not adjust quickly, but expectations about prices do.
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Exchange Rate VolatilityExchange Rate Volatility
Changes in price levels are less volatile, suggestingthat price levelschange slowly.
Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.