INTERNATIONAL FINANCE INTERNATIONAL FINANCE

CHAPTER 14 Money, Interest Rates, and Exchange Rates

Money Defined: a Brief Review Money as a Medium of Exchange Money as a Medium of Exchange Money as a Unit of Account Money as a Unit of Account Money as a Store of Value Money as a Store of Value What Is Money? What Is Money?

How the Money Supply Is Determined An economy’s money supply is controlled by its central bank.

The Demand For Money by Individuals Expected Return Expected Return Risk Risk Liquidity Liquidity The expected return the asset offers compared with the returns offered by other assets The riskiness of the asset’s expected return The asset’s liquidity

Aggregate Money Demand (I) The interest rate (R ) The interest rate (R ) M d = f (R) - A rise in the interest rate cause each individual in the economy to reduce her demand for money. All else equal, aggregate money demand therefore falls when the interest rate rises.

Aggregate Money Demand (II) The price level ( P ) The price level ( P ) M d = f (P) + P is the price of a broad reference basket of goods and services in terms of currency. If the price level rises, people would like to demand for more money in order to maintain the same level liquidity as before. Therefore M d and P are positively correlated.

Aggregate Money Demand (III) Real national income (Y ) Real national income (Y ) M d = f (Y) + When real national (GNP) rises, more goods and services are being sold in the economy. This increase in the real value of transactions raises the demand for money, given the price level.

Aggregate Money Demand (IV) How is L(R, Y) determined by the three main factors, R, P and Y? How is L(R, Y) determined by the three main factors, R, P and Y? M d = f( R, P, Y ) or M d = P x L(R, Y) (14-1) The equivalent form of (14-1) is: M d /P = L(R, Y) (14-2) where L(R, Y) is aggregate money demand. real

The Equilibrium Interest Rate: The Interaction of Money Supply And Demand Equilibrium in the Money Market Equilibrium in the Money Market Interest Rates and the Money Supply Interest Rates and the Money Supply Output and the Interest Rate Output and the Interest Rate

Equilibrium in the Money Market If M s is the money supply, the condition for equilibrium in the money market is: M s = M d (14-3) ∵ M d = P x L(R, Y) ; M d /P = L(R, Y) ∴ The money market equilibrium condition can also be express as M s /P = L(R, Y) (14-4)

Equilibrium in the Money Market Given P, Y and M s /P, money market equilibrium is at point 1. Therefore the equilibrium interest rate is R 1 M s /P = L(R, Y)

Interest Rates & the Money Supply Given P and Y, an increase in the money supply reduces interest rate, and vice versus.

Output and the Interest Rate Given M s /P(=Q 1 ), a rise in Y raises R, while a fall in Y lowers R.

The Money Supply And the Exchange Rate In the Shout Run Linking Money, the Interest Rate, and the Exchange Rate Linking Money, the Interest Rate, and the Exchange Rate U.S. Money Supply and the Dollar/Euro Exchange Rate U.S. Money Supply and the Dollar/Euro Exchange Rate Europe’s Money Supply and the Dollar/Euro Exchange Rate Europe’s Money Supply and the Dollar/Euro Exchange Rate

Linking Money, the Interest Rate, and the Exchange Rate Foreign exchange market Money market

Money-Market/ Exchange Rate Linkages Federal Reserve System (the Fed) European System of Central Banks (ESCB) USD money marketEUR money market FX market M s us MsEMsE R$R$ R€R€ E $/€

U.S. Money Supply and the Dollar/Euro Exchange Rate Given P us and Y us, when the money supply rises from M 1 us to M 2 us, the dollar interest rate decline( as money-market equilibrium is reestablished at point 2) and the dollar depreciates against the euro( as foreign exchange market equilibrium is reestablished at point 2’)

Europe’s Money Supply and the Dollar/Euro Exchange Rate By lowering the dollar return on euro deposits( shown as a leftward shift in the expected euro return curve), an increase in Europe’s money supply causes the dollar to appreciate against the euro. Equilibrium in the foreign exchange market shifts from point 1’ to point 2’, but equilibrium in the U.S. money market remains at point 1.

Money, the Price Level, and the Exchange Rate in the Long Run Money and Money Price Money and Money Price The Long-Run Effects of Money Supply Changes The Long-Run Effects of Money Supply Changes Money and the Exchange Rate in the Long Run Money and the Exchange Rate in the Long Run

Money and Money Price If the price level and output are fixed in the short run, the condition ( ) of money market equilibrium, Ms/Ms/P =L(R,Y)(14-4) (14-5) + All else equal, an increase in a country’s money supply causes a proportional increase in its price level.

The Long-Run Effects of Money Supply Changes P= M s /L(R,Y) Permanent increase (14-5) A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.

Money and the Exchange Rate in the Long Run A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies. Similarly, a permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency against foreign currencies.

Inflation and Exchange Rate Dynamics Short-Run Price Rigidity versus Long-Run Price Flexibility Short-Run Price Rigidity versus Long-Run Price Flexibility Permanent Money Supply Changes and the Exchange Rate Permanent Money Supply Changes and the Exchange Rate Exchange Rate Overshooting Exchange Rate Overshooting

Short-Run Price Rigidity versus Long-Run Price Flexibility (I) Since output prices depend heavily on production costs, the behavior of the overall price level is influenced by the sluggishness of wage movements. In extremely inflationary conditions, such as those seen in the 1980s in some Latin American countries, long- term contracts specifying domestic money payments may go out of use.

Short-Run Price Rigidity versus Long-Run Price Flexibility (II) Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. These pressures come from three main sources: Excess demand for output and labor. Inflationary expectations. Raw materials prices.

Permanent Money Supply Changes and the Exchange Rate (I) (a) Short-run adjustment of the asset markets. (b) How the R $, P us, and E $/€ move over time as the economy approaches its long-run equilibrium M/P = L(R $,Y) R $ =R € +(E e /E- 1) E /P = L( M R$R$,Y) R$R$ =R € +( EeEe /-1) In the Short Run In the Long Run R $ =R € +(E e /E- 1) M/P = L(R $,Y) M/= L(,Y)P R$R$ E R$R$ =R € +( Ee/Ee/ -1) Rudi Dornbusch 鲁迪 · 多恩布什 Hi! This part is about the theory of exchange rate over shooting put forward by me.

Permanent Money Supply Changes and the Exchange Rate (II) At t 0, M s increases When M s increases at t 0, R falls down. When M s increases and R falls down at t 0, P remains unchanged. As R falls down at t 0, E jumps up. As the time goes by, M s remains unchanged at a higher level. As the time goes by, P keeps rising until M 2 /P 2 =M 1 /P 1 As P keeps rising R rises until its original level is reached. As R rises, E keeps falling until its long-run level is reached. Exchange rate overshooting is an important phenomenon because it helps explain why exchange rates move so sharply from day to day. Only if the dollar/euro exchange rate overshoots E initially will market participants expect a subsequent appreciation of the dollar against the euro. 超调

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