1. Understanding the Macroeconomy Chapter 2
Money
Econ 7920/Chatterjee
4/16/2017

2. Why is Money Important? Serves as Helps measure “opportunity cost”
Medium of exchange
Store of value
Unit of account
Helps measure “opportunity cost”
Types of Money: “Fiat” and “Commodity”
Econ 7920/Chatterjee
4/16/2017

3. What is the “Price” of Money?
Interest Rate:
Opportunity cost of holding money
“Price” of money relative to time
Exchange Rate:
Price of one currency relative to another
“Price” of money relative to other foreign currencies
Aggregate Price Level:
Average “value” of all goods and services produced
“Price” of money relative to goods and services
Econ 7920/Chatterjee
4/16/2017

4. Money and the Economy Changes in the quantity of money affect
Interest Rates: affect incentives to save and invest
Exchange Rates: affect exports, imports, and international financial transactions
Price Level: creates inflation/deflation; affects spending decisions
How does money affect these variables?
Econ 7920/Chatterjee
4/16/2017

5. Money and the Economy Think in terms of demand and supply
Demand for Money: households, firms, financial institutions, government, and foreigners
Supply of Money: Central Bank
Examples: Federal Reserve, European Central Bank, etc.
When money supply changes, what happens to its three prices?
Econ 7920/Chatterjee
4/16/2017

6. Money supply measures, April 2006
symbol
assets included
amount ($ billions)
$739
Currency C
$1391
C + demand deposits, travelers’ checks, other checkable deposits M1
For more info, see
$6799
M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts M2

7. Money and the Interest Rate
Would you like to receive $100 today or a year from now?
The interest rate is the “opportunity cost” of holding money today
When money supply increases, short-term interest rates fall (why?)
Econ 7920/Chatterjee
4/16/2017

8. Monetary Policy and Interest Rates
How does the Federal Reserve alter the quantity of money in the economy?
Three tools of Monetary Policy:
Discount Rate: The rate at which commercial banks can borrow from the Fed
Reserve Requirement: The fraction of each deposit a bank must maintain as reserves (not to be lent)
Federal Funds Rate: The interest rate commercial banks charge each other for overnight loans (guaranteed by deposits at the Fed)  benchmark nominal interest rate in the economy
Econ 7920/Chatterjee
4/16/2017

9. Monetary Policy
The Fed usually targets the Federal Funds Rate through its Open Market Operations
Open Market Purchase: The Fed buys government bonds and other financial assets  injects cash into the economy (money supply increases)
Open Market Sale: The Fed sells government bonds and other financial assets  withdraws cash from the economy (money supply falls)
Econ 7920/Chatterjee
4/16/2017

10. Money and Exchange Rates
How many units of a foreign currency can one unit of the Home currency buy?
The US-Euro exchange rate: 0.7 Euros/$ (09/05/2008)
Example: What does it mean when
the exchange rate falls to 0.6 Euros/$
the exchange rate rises to 0.8 Euros/$
Understanding “depreciation” and “appreciation” of an exchange rate
Econ 7920/Chatterjee
4/16/2017

11. A Sample of US Exchange Rates
Country
July 14, 2006
Sept 5, 2008
Euro
0.79 Euro/$
0.70 Euro/$
Japan
116.3 Yen/$
Yen/$
Mexico
11.0 Pesos/$
10.46 Pesos/$
Russia
27.0 Rubles/$
25.48 Rubles/$
South Africa
7.2 Rand/$
7.99 Rand/$
U.K.
0.54 Pounds/$
0.57 Pounds/$
Source:

12. Money and Exchange Rates
Exchange Rate Depreciation: a unit of the home currency can buy fewer units of a foreign currency
Exchange Rate Appreciation: a unit of the home currency can buy more units of a foreign currency
If the US dollar has depreciated against the Euro, then the Euro has appreciated against the dollar
Econ 7920/Chatterjee
4/16/2017

13. Money and Exchange Rates
Consequences of a currency depreciation:
Domestic (Home) goods are cheaper to the rest of the world  exports increase
Foreign goods are expensive at Home  imports decrease
Anything that increases the demand for a country’s currency (money) will appreciate its exchange rate
When money supply increases, short-term exchange rates tend to depreciate (why?)
Econ 7920/Chatterjee
4/16/2017

14. Money and the Price Level
An increase in money supply  higher spending on goods and services  increase in aggregate demand
If supply of goods and services cannot meet up with demand  excess demand is created  higher prices to clear markets  inflation
In general, an increase in money supply creates inflation
Countries that have high growth rates of money supply also tend to have higher rates of inflation
Econ 7920/Chatterjee
4/16/2017

15. U.S. inflation and money growth, 1960-20060% 3% 6% 9%
12%
15%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Over the long run, the inflation and money growth rates move together, as the quantity theory predicts.
M2 growth rate
In the long run, inflation and money growth are positively related.
(In the short run, however, inflation and money growth appear highly negatively correlated! One possible reason is that the causality is reversed in the short run: when inflation rises – or is expected to rise – the Fed cuts back on money growth. If the economy slumps and inflation falls, the Fed increases money growth.)
sources:
CPI - BLS
Money supply - Board of Governors of the Federal Reserve
obtained from
inflation rate

16. International data on inflation and money growth, 1996-2004
“Inflation is always and everywhere a monetary phenomenon.” -Milton Friedman ( ) Nobel Prize in Economic Sciences, 1976
Turkey
Ecuador
Indonesia
Belarus
Argentina
U.S.
Switzerland
Singapore
Each variable is measured as an annual average over the period
Source: International Financial Statistics.
International data on inflation and money growth,

17. Putting it All Together…
Increase in Money Supply
The ultimate (long-run) effect on the economy is determined by the interaction of these three factors
Reduces interest rates
Depreciates exchange rate
Creates inflation
Econ 7920/Chatterjee
4/16/2017

18. Inflation and Nominal Interest Rates in the U.S., 1955-2006
percent per year 15
nominal interest rate 10 5
Inflation and the nominal interest rate are very highly correlated. However, they are not perfectly correlated. Over time, the saving and investment curves move around, causing the real interest rate to move, which, in turn, causes the nominal interest rate to change for a given value of inflation.
About the data:
The inflation rate is the percentage change in the (not seasonally adjusted) CPI from 12 months earlier.
The nominal interest rate is the (not seasonally adjusted) 3-month Treasury bill rate in the secondary market.
Data obtained from
inflation rate -5
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005

19. Inflation and Nominal Interest Rates across Countries, 1996-2004
Romania
Zimbabwe
Brazil
Bulgaria
Israel
Germany
U.S.
The nominal interest rate is the rate on short-term government debt. Inflation and interest rates are measured as annual averages over the period
Switzerland

20. “Real” versus “Nominal”
“Nominal” variables: measured in monetary units
Examples: “dollar” value of GDP, wages and salaries, market interest rates and exchange rates
“Real” variables: measured in physical units
Examples: above variables adjusted for prices and/or inflation  Physical output produced (real GDP), wages adjusted for the price level (real wage), etc.
Econ 7920/Chatterjee
4/16/2017

21. Real and Nominal GDP
A country produces 100 units of output in 2006, at a price level of $5 per unit of output.
Nominal GDP = 100 x 5 = $500
Real GDP = 100 units of output
In 2007, the country produced 100 units of output, but prices doubled to $10 per unit.
Nominal GDP = 100 x 10 = $1000
Nominal GDP doubled, but real GDP remained unchanged: is the country richer or better off?
Econ 7920/Chatterjee
4/16/2017

22. Real and Nominal GDP  GDP deflator (Price Level)
A country’s well-being is determined by changes in its real GDP and not nominal GDP
Economic Growth: percentage change in real GDP over time
Real GDP = Nominal GDP/Price level
 GDP deflator (Price Level)
= Nominal GDP/Real GDP
Econ 7920/Chatterjee
4/16/2017

23. Real and Nominal Interest Rates
“Real” interest rate = Nominal interest rate – Rate of inflation
The real interest rate is determined by the demand for investment and the supply of savings
Nominal interest rate = real interest rate + rate of inflation
Positive relationship between nominal interest rates and inflation
Econ 7920/Chatterjee
4/16/2017

24. Monetary Policy and the Term-Structure of Interest Rates
Nominal Interest Rates tend to rise with inflation as creditors care about their command over future output (i.e., they care about the “real” interest rate)
An increase in money supply may reduce short- term interest rates, but by increasing inflationary expectations, can lead to an increase in the long- term interest rate.
Econ 7920/Chatterjee
4/16/2017

25. Nominal and Real Exchange Rates
Real exchange rates track changes in the value of goods across countries after adjusting for inflation
Example:
Suppose US-Mexico exchange rate is 1 Peso/$ today
A shirt in the US costs $1, and in Mexico it costs Pesos
So, shirts are cheaper in Mexico relative to the US
Americans will choose to buy Mexican shirts
Econ 7920/Chatterjee
4/16/2017

26. Now, suppose the US-Mexico exchange rate falls by 25%
The new exchange rate is: 0.75 Pesos/$
The US currency has depreciated against the Peso
If prices remain constant, then the $1 shirt in the US will cost Pesos to Mexicans
The 0.80 Pesos Mexican shirt would now cost $1.07 to Americans (=0.8/0.75)
American shirts cheaper to Mexicans, and Mexican shirts more expensive for Americans
US exports to Mexico rise, but imports fall  US trade balance improves
Lesson: an exchange rate depreciation improves the trade balance
Econ 7920/Chatterjee
4/16/2017

27. Let’s complicate things…
Next year, US inflation rose from 0 to 30%, while in Mexico, prices remained stable.
So, the $1 shirt in the US now costs $1.30
The $1.30 shirt in the US will cost 0.98 Pesos to Mexicans (=1.30 x 0.75)
To Americans, the cost of a Mexican shirt is still $1.07 (=0.80/0.75)
Mexican shirts now cheaper than American shirts
American exports decrease and imports increase  US trade balance worsens
Lesson: it’s just not enough to compare changes in “nominal” exchange rates when comparing goods prices  one must keep track of inflation rates across countries too
Econ 7920/Chatterjee
4/16/2017

28. The Real Exchange Rate % in real exchange rate =
% in nominal exchange rate –
(inflation rate in foreign – inflation rate at home)
In our example: though the US nominal exchange rate depreciated, its real exchange rate (relative to the Peso) appreciated
Inflation differential across countries (if large enough) can offset the effects of a nominal depreciation of the exchange rate
Econ 7920/Chatterjee
4/16/2017

29. Moral of the Story…
If a country is experiencing a rapid growth in money supply, then
Nominal exchange rates can depreciate
But inflation can cause a real exchange rate appreciation
Eventually, exports can fall and imports rise  worsening of the trade balance
Econ 7920/Chatterjee
4/16/2017

30. CASE STUDY: The Mexican peso crisis
Mexico’s central bank had maintained a fixed exchange rate with the U.S. dollar at about 29 cents per peso.

31. CASE STUDY: The Mexican peso crisis
In the week before Christmas 1994, the central bank abandoned the fixed exchange rate, allowing the peso’s value to “float.” In just one week, the peso lost nearly 40% of its value, and fell further during the following months.

32. The Peso crisis didn’t just hurt Mexico
U.S. goods suddenly more expensive to Mexicans
U.S. firms lost revenue
Hundreds of bankruptcies along U.S.-Mexican border
Mexican assets worth less in dollars
Reduced wealth of millions of U.S. citizens as there was substantial US investment in Mexican assets (through mutual funds, pension funds, 401 k’s, etc…)

33. Understanding the crisis
In the early 1990s, Mexico was an attractive place for foreign investment:
Mexican interest rates were high  promise of higher returns on investment
Mexican Central Bank maintained and had committed to a fixed exchange rate against the dollar
This made returns from foreign investment very stable
There were large capital inflows into Mexico in the early
1990’s, including a substantial portion from the US

34. What did Investors Miss?
The high interest rate in Mexico reflected inherent risk:
During 1994, political developments made Mexico a risky place to invest (peasant uprising in the Chiapas and assassination of leading presidential candidate)
Capital outflows started as early as December 1993, but the information was concealed by the Central Bank
Mexican inflation rate was much higher than the US rate
The Federal Reserve raised U.S. interest rates several times during to prevent U.S. inflation
Though the Mexican nominal exchange rate was fixed, there was substantial real exchange rate appreciation of the Peso
Maintaining the peg became increasingly difficult for the Mexican Central Bank
Econ 7920/Chatterjee
4/16/2017

35. Understanding the crisis
These events put downward pressure on the peso
Mexico’s central bank had repeatedly promised foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate
Doing this requires that Mexico’s central bank have adequate reserves of dollars Did it?

36. Dollar reserves of Mexico’s central bank
December 1993 ……………… $28 billion August 17, 1994 ……………… $17 billion December 1, 1994 …………… $ 9 billion December 15, 1994 ………… $ 7 billion
Defending the peso in the face of large capital outflows was draining the reserves of Mexico’s central bank.
(August 17, 1994 was the date of the presidential election.)
Why did Mexico’s central bank not warn anybody that it was running out of foreign exchange reserves?
The answer: If people had known that the reserves were dwindling, then they would also have known that the central bank would soon have to devalue or abandon the fixed exchange rate altogether. They would have expected the peso to fall, which would have caused a further increase in Mexico’s risk premium, which would have put even more downward pressure on Mexico’s exchange rate and made it even harder for the central bank to “defend the peso.”
Source (not only for the data on this slide, but some of the other information in this case study): Washington Post National Weekly Edition, pp8‑9, Feb 20‑ , various issues of The Economist in Jan & Feb '95.
During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

37.  the disaster 
Dec. 20, 1994: Mexico devalues the peso by 13% (fixes the Peso at 25 cents instead of 29 cents per $)
Investors are SHOCKED! – they had no idea Mexico was running out of reserves.
Investors start dumping Mexican assets, pulling their capital out of Mexico.
Dec. 22, 1994: central bank’s reserves nearly gone. It abandons the fixed rate and lets the Peso float.
Within a week, the Peso falls another 30%.

38. The rescue package
1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt.
This helped restore confidence in Mexico, and reduced the risk premium on their interest rate.
After a hard recession in 1995, Mexico began a strong recovery from the crisis (also helped by NAFTA)
Moral of the Story: Had investors paid attention to the Peso’s real exchange rate, they could have saved millions of dollars