Chapter 15 Money, Interest Rates, and Exchange Rates November 2011

15-2 Preview What is money? The supply of money The demand for money Equilibrium in the money market

15-3 What Is Money? Money is any asset that is widely used and accepted as a means of payment. So, a country’s quantity of money (M s ) includes  All currency with the public and  The value of all checking accounts bank deposits in a foreign currency are excluded from this definition. M1 and M2 are two well-known periodically published measures of the quantity of money M1M2

What Is Money? No Return We can classify all assets into:  Money, which earns no return Currency with the public, checking accounts  Assets that earn a return Stocks, bonds, real estate, etc. 15-4

15-5 What Is Money? High Liquidity Money is very liquid:  that is, it can easily and quickly be used to purchase goods and services. Assets that earn a return are less liquid

15-6 Money Supply The quantity of money is also called the money supply Who controls the money supply? Central banks determine the money supply.  In the US, the central bank is 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.

15-7 Money Demand Money demand is the amount of their wealth that people are willing to hold in the form of money  (instead of other assets that are less liquid but earn a return). What influences our willingness to hold money?

15-8 What Influences Individual Demand for Money? 1.Expected returns/interest rate on interest-earning assets. 2.Risk: the risk of holding money principally comes from unexpected inflation, thereby unexpectedly reducing the purchasing power of money.  but many other assets have this risk too, so this risk is not very important in money demand 3.Liquidity: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought in transactions increases.

15-9 What Influences Aggregate Demand for Money? 1.Interest rates: money pays little or no interest. So, the interest rate on non-money assets (such as bonds) is the opportunity cost of holding money (instead of non-money assets).  A higher interest rate means a higher opportunity cost of holding money  lower money demand. 2.Prices: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.  A higher price level means a greater need for liquidity to buy the same amount of goods and services  higher money demand.

14-10 What Influences Aggregate Demand for Money? (cont.) 3.Income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions.  A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity  higher money demand.

15-11 A Model of Aggregate Money Demand The aggregate demand for money can be expressed by: M d = P x L(R,Y)(15-1) where: P is the price level Y is real national income R is the interest rate L(R,Y) is the aggregate real money demand (M d /P)

15-12 Functional Notation L is the real aggregate demand for money (M d /P) L(R,Y) is a concise mathematical way of saying “L depends on R and Y.”  Some people say, “L is a function of R and Y.” This is why L(R,Y) is said to be an instance of functional notation. If Y is constant, L and R are inversely related: when one increases the other decreases If R is constant, L and Y are directly related: when one increases so does the other

15-13 A Model of Aggregate Money Demand From M d = P x L(R,Y) we getM d /P = L(R,Y)(15-2) This is the aggregate real money demand. It is directly related to GNP and inversely related to the interest rate.

A Model of Aggregate Money Demand 15-14

Fig. 15-1: Aggregate Real Money Demand and the Interest Rate For a given level of income, real money demand (M d /P) decreases as the interest rate increases.

Fig. 15-2: Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income When income increases, real money demand increases at every interest rate.

15-17 The Money Market Equilibrium in the money market requires: M s = M d (15-3) Alternatively, equilibrium requires the supply of real money be equal to the demand for real money (by dividing both sides by the price level): M s /P = L(R,Y) (15-4)

Fig. 15-3: Determination of the Equilibrium Interest Rate 15-18

Two markets: foreign exchange and money So far, we have seen the equilibrium conditions for the two asset markets  The foreign exchange market, and  The money market 15-19

What’s next? Next, we will look at the equilibrium equation for the goods market Read chapter 17, up to the section “How Output is Determined in the Short Run” In that chapter, the two equations in the previous slide are used to derive a link, between the exchange rate (E) and output (Y), called the AA curve