14-1 Money, Interest Rates, and Exchange Rates Chapter 14

14-2 Preview What changes interest rates, which will in turn affect E ? i $ Interest rate as the price of money is determined by supply of and demand for money Impact of Money Supply on interest rate is different for Short-run(-) and Long run(+)

What Is Money? Money is an asset that is widely used and accepted as a means of payment.  Different groups of assets may be classified as money.  Currency and checking accounts form a useful definition of money, but bank deposits in the foreign exchange market are excluded from this definition.

Two Different Amounts of Money Supply(Demand) What we see as Money Supply(Demand) is the Nominal Money Supply(Demand). This is dollar value as we see. What matters is Real Money Supply(Demand), which is the Quantity of Money Supply. Quantity of Real Money is Nominal Amount of Money divided by the General Price Level: ms = Ms/P

14-5 Who controls Money? 1)People just accept whatever Nominal Money Supply supplied to them MD = MS 2) People determine real quantity of their demand for money by controlling the price level

14-6 What Influences Real Demand for Money? 1. Interest rates: money pays little or no interest, so the interest rate is the opportunity cost of holding money instead of other assets, like bonds, which have a higher expected return/interest rate.  A higher interest rate means a higher opportunity cost of holding money  lower money demand 2. 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.

14-7 Math for Real Money Demand can be expressed by 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

14-8 Equilibrium in Money Market In equilibrium, Real Money Supply is equal to Real Money Demand M s /P = L(R,Y) This equilibrium condition will yield an equilibrium price of fund, i.e., interest rate.

14-9 *Note: Dynamic Mechanism Step 1: People decides on their desired Real Money Demand through L(R,Y). At this time, Ms/P = L(R,Y) Step 2: If the Central Bank injects Nominal Money Supply into the economy, first People just accepts it all: Ms’ =Md’ However, inside, Ms’/P

14-10 Two Kinds of Interest Rates Fisher Equation Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate Real Interest Rate determines Investment, and National Income. In the short run, Real Interest Rate can be affected by Money Supply (and Money Demand). In the Long-run, Real Interest Rate is determined by Real Factors, and is equal to MP of Capital.

14-11 What will happen to Interest Rates and Exchange Rates when the Central Bank increases Nominal Money Supply? In the Short-run, Price Level does not change; the Real Interest rate goes down; investment may rise; Business may get better; National Income may rise; As real interest falls, there will be capital outflow; E will go up. In the Long-run, people will speed up expenditures; P up; Real Interest Rate, I and Y all go back the initial level; With repeated Increases in Money Supply, Inflation may develop; Nominal Interest Rate goes up; E will go up.

14-12 Impact of Monetary Policy in the Short-run Expansionary Monetary Policy: Real Money Supply > Real Money Demand In Disequilibrium, the price should change. When there is an excess real supply of money, the price of money or the interest rate falls. As interest rate falls, investment rises and real national income rises. Stringent Monetary Policy: When there is a short supply of money, the price of money or the interest rate rises.

14-13 Linking the Money Market to the Foreign Exchange Market in the Short-run

What happens to the domestic interest rate and the FOREX rate (E) when the central bank increases the Money Supply? It is not really necessary to think of this lower part of this graph: Just consider the upper part.

14-15 So, now we know that the impact of the Money Supply on E in the Short-run: Easy Monetary Policy (an increase in a country’s money supply) causes its interest rate to fall and FOREX rate or E to rise: Its currency depreciate. Strict Monetary Policy( a decrease in a country’s money supply) causes its interest rate to go up and FOREX rate to go down: its currency to appreciate.

14-16 Changes in Real Money Supply in the Foreign Country in the short-run An increase in the EU money supply causes a depreciation of the euro (appreciation of the dollar). A decrease in the EU money supply causes an appreciation of the euro (a depreciation of the dollar).

14-17 What will happen to the foreign interest rate and E in the short-run if the foreign government increases its Money Supply? You do not have to look at the lower part of the graph.

14-18 *What will happen to E in the short run if a foreign country changes its (Foreign) Money Supply? The increase in the EU money supply reduces interest rates in the EU, reducing the expected return on euro deposits. This reduction in the expected return on euro deposits leads to a depreciation of the euro. The change in the EU money supply does not change the US money market equilibrium.

14-19 Note The interest rates here in this graph are all Real Interest Rate or Real Returns.

14-20 In the Long-Run, we cannot use the above model The above does NOT work in the long-run. We need a New Model for FOREX Rate, which deals with Nominal Variables: Purchasing Power Parity Theory to come in Chapter 15. (The remainder of Chapter 14 is a prelude for Chapter 15.)

14-21 Long Run Impact of Money Supply In the long run, more Money Supply simply means a Higher Price Level and a Higher Interest Rate. Prelude to Chapter 16

14-22 In Long Run, Money does not matter for Real Interest Rate and Real National Income In the Long-run, only K. L, T affect Real Output - “Supply Side Economics”. In the long run, the money supply does not influence the amount of real output or real interest rate. There is a dichotomy between the nominal sector (Money), and the real sector (Real Output, Real National Income, or Real Interest Rate).

14-23 Long Run Impact of Money Supply is on the Price Level: In the long run, there is a direct relationship between the money supply and the price level. P and M are moving in the same direction and at the same speed. 1) Repeated Increases in Money Supply lead to Inflation; 2) inflation rate roughly equals growth rate in money supply.  P=  M s

14-24 And on Inflationary expectations:  If workers expect money supply to increase, they will expect future prices to rise.  They will demand higher wages.  Producers will be able to match higher costs if they expect to raise prices.  No one is better off, unchanging in real terms.  Result: an expected money supply increase leads to an expected inflation, which in turn causes an actual inflation.

14-25 So what is the long-run impact of an increased Money Supply? The main impact is on Price Level, and Inflation Rate. We need a new Model which links Price Level and Inflation to FOREX Rate. When the Price Level goes up, the (Domestic) Currency Value falls, and the Price of FOREX should go up. In the simplest way, FOREX Rate is a relative value of two currenies: or the Domestic Currency Price of One Unit of Foreign Currency. In fact, this model is called Purchasing Power Parity Theory. conceptually “Easier” to understand.

14-26 Impact of Money Supply on FOREX Rate in the Long-run In the long-run, an increase in Money Supply leads to Price Level Rise, or Inflation The value of the domestic currency falls The relative value of the foreign currency rises - FOREX rate or E goes up. Vice versa

14-27 Empirical Evidence: P and M move together.