The Goods Market, Money, and Foreign Exchange

The Linkages

Macroeconomic Measures• The national income analysis is generally

done in terms of real goods and services.• Most economic aggregate measures are

more conceptual than real:• The real market value of the economy’s output• The overall price index • Labor force and employment measures• The interest rate as the price of capital• Money stock• Demand for money

• Often we use proxy indicators to measure macroeconomic aggregates

The Two Dimensions of Macroeconomics: The

“Real” Economy and the Monetary Economy

• The Real Economy and The Goods Market

• The Monetary Economy and the Money Market

• The linkages between the two markets:

The overall price and wage levels

The Interest rate

The foreign exchange rate (through

its impact on BOP)

The Central Role of the Interest Rate

• It plays a central role in the goods market as the price (a determinant) of capital

• It is the price of money in the money market

• It is an important factor in determining the exchange rate, especially in the short run

The linkGiven the price level and the exchange rate:

Y = C + I + G + (X – IMP)

I = I (i) Md = M (i)

IS

i

Q0

M0

i

DM

Money • The story of money: From the commodity money

to the modern fiat money • Stock of money

• Types of money– Notes and coins– Checkable deposits – Near moneys

• Money as an instrument of liquidity (medium of exchange)

• Other functions of money • Money as a form of asset• Real money versus nominal money• Money and the banking system

• How money is created• The central banking system

How does the Fed create money?

Day One

Assets Liabilities

--------------------------------------------------------

FX 100 Currency 200

Govt. bonds 100

Money stock = 200

Day Two

A commercial bank opens: Com Bank

Com Bank Fed

Assets Liabilities Assets Liabilities

------------------------ ------------------------Reserve 50

Net worth 50

FX 100

Govt. Bonds 100

Com B. Res. Dep. 50

Currency 150

Money stock = 150

Day Three: Com. Bank receives deposits.

Com Bank

Assts Lib

--------------------------------

The Fed

Assts Lib

-------------------------------Reserve 150 Deposits 100

Net worth 50

FX 100

Govt bonds 100

Com B Res Dep 150

Currency 50

*Note the ratio between the com. bank’s reserve and its demand deposit. Total money stock = 150

Day Four: Com. Bnk makes a loan.

Com Bank

Assts Lib

-------------------------------

The Fed

Assts Lib

------------------------------------Reserves 150

Loan papers 100

Deposits 200

Net worth 50

FX 100

Govt bonds 100

Com B Res Dep 150

Currency 50

Money stock: 250

Reserve/Deposit ratio: ¾ or 75%

Day Five: Com. Bnk makes more loans

Com Bank

Assts Lib

-------------------------------

The Fed

Assts Lib

------------------------------------Reserves 150

Loan papers 100Loan papers 100

Deposits 300

Net worth 50

FX 100

Govt bonds 100

Com B Res Dep 150

Currency 50

Money stock: 350

Reserve/Deposit ratio: 1/2 or 50%

Day Six: Com. Bnk makes more loans Com Bank

Assts Lib

-------------------------------

The Fed

Assts Lib

------------------------------------Reserves 150

Loan papers 100Loan papers 100Loan papers 450

Deposits 750

Net worth 50

FX 100

Govt bonds 100

Com B Res Dep 150

Currency 50

Money stock: 800 Reserve/Deposit ratio: 1/5 or 20% *Note that a total reserve of $150 lead to the creation of $750’s worth of checkable Deposits.

800800

Reserve Requirements and Money Multiplier

• The reserve requirement ratio: The required ratio between the deposits held by a commercial bank and the sum of its cash reserve and its reserve deposit with the Fed.

• Money multiplier mm= 1/rrr

M = mm(Bank Reserves) + Currency in cir.

The potential increase in the money stock (checkable deposits) resulting from one dollar increase in the com. banks’ reserves.

How does the Fed change the money

stock?

• Open Market Operation• Buying or selling bonds

• FX Market Intervention• Buying or selling FX

• Other methods

Given the currency in circulation,

Δ M = mm (Δ GB + Δ FXR)

The Money Market

• Real money versus nominal money Real Money = L = M/P

• Demand for real money • Transaction demand • Asset demand

LD = L ( Q, i)

• Money stock (supply) The stock money is (exogenously) determined

by monetary authorities.

Money Market Equilibrium

For any given level of output, Q, the money market is in equilibrium if the interest rate is at a level at which the quantity of real money, L, people want to hold is equal to the stock of real money provided by the monetary authorities (the Fed).

Money Market

L0

rMo/Po

LD =L( Q1 , i)

LD =L( Qo , i)

r2

ro

r1

Shifts in LD : Changes in Q Other exogenous changesShifts in real money stock: Changes in M Changes in P

Money Market Equilibrium and the Output Level: The LM Curve

As the out put level changes the demand for real money will change, given the money stock, resulting in changes in the interest rate:

Q LD (Given M/P) i

A positive relationship between Q and equilibrium i: The LM curve

The LM Curve

Q

i i

0 0

LD =L( Q1 , i)

LD =L( Qo , i)

Qo Q1

LMM/Po

Shifts in the LM Curve

Q

i i

0 0

LD =L( Q1 , i)

LD =L( Qo , i)

Qo Q1

LMoMo/Po

M1/Po

LM1

Factors Causing Shifts in the LM Curve • Changes in the real money stock

– Changes in the nominal money stock

• Monetary and FX policies affecting banks reserves: Buying and selling bonds and/or FX

– Changes in the price level

• The price level could be affected by both internal (domestic) and external (foreign) factors.

IS and LM Curves

Q

i

0

LMo

LM1

IS

IS’

Q’ Q

Balance of Payment EquilibriumRecall:

CAB = X (Q*, R) – Imp (Q, R)CAB = CAB ( Q*, Q, R )

KAB = K inflow – K outflowAlso recall:

At parity i = i* + (ef-e)/e or I*+ (ee-e)/e That means direction of the funds would

depend on i, i*, e, ef , ee

So we write:

KAB = KAB (i, i*, e, ef , ee)

+ - + - -

At equilibrium:

CAB ( Q*, Q, R ) = - KAB (i, i*, e, ef , ee)

+ - - + - + - -

Given i*, e, ef , ee , Q*, R

CAB (Q) = - KAB ( i )

As Q increases CAB worsens, for the BOP to be restored the interest rate must increase.

BOP EquilibriumCAB (Q)

KAB (i)

45o

BOP>o

BOP<0

BOP Equilibrium

Q

i

0

BOP

i*, e, ef , ee , Q*, R - + - - + -

Adjustments under Flexible X Rate

Q

i

0

LMo

IS(eo)

Q’ Q

BOP(eo)

BOP(e1)

IS(e1)

(eo) > (e1)

E

E’

The adjustment process:The case of a BOP surplus:

Appreciation of the home currency, e will fall

R will increase Exports will decrease

Imports will increaseIS curve will shift to the left BOP curve will shift to the left

The case of a BOP Deficit:Depreciation of the home currency, e will increase

R will decrease Exports will increase

Imports will decreaseIS curve will shift to the right BOP curve will shift to the right

Adjustments Under A Fixed X Rate Regime

The case of a BOP surplus:To keep the X rate fixed the Fed would have to buy FX. An increase in the money stock

Shift of the LM curve to the rightThe case of a BOP deficit:

To keep the X rate fixed the Fed would have to sell FX. A reduction in the money stock

Shift of the LM curve to the left

Adjustments under a Fixed X Rate

Q

i

0

LMo

IS(e)

Q Q’

BOP(e)

E

E’

LM1

i

i’