1. (Dollar interest rate) (Dollar/Euro exchange rate)
Equilibrium Interest Rates and Exchange Rates
Money-Market/Exchange Rate Linkages
United States
Federal Reserve System
Europe
European System
of Central Banks
(United States
money supply)
MSUS
MSE
(European
money supply)
United States
money market
European
money market
Foreign
exchange
market R$
(Dollar interest rate) R€
(Euro interest rate)
E$/€
(Dollar/Euro exchange rate)

2. Money, Interest, and the Exchange Rate
Medium of Exchange
Unit of Account
Express prices, keep records,…write contracts!
Store of Value … Low risk
Other, riskier assets are less liquid but pay higher return.
Money Supply (Ms)
Ms = Currency + Checkable Deposits
Controlled by central bank

3. Aggregate Money Demand
Md = P x L(R,Y)
where:
P = price level
Y = real national income
R = interest rate
The demand for money can be expressed as the demand for real balances:
Md/P = L(R,Y)

4. Aggregate Money Demand
Aggregate Real Money Demand and the Interest Rate
Interest
rate, R
Aggregate real
money demand
Md/P = L(R,Y)

5. Effect on Aggregate Real Money Demand of Rise in Real Income
Interest
rate, R
Aggregate real
money demand
L(R,Y2)
L(R,Y1)
Increase in
real income

6. Equilibrium in the Money Market: Md = Ms or Ms/P = L(R,Y)
Interest
rate, R
Real money
holdings
Real money supply
Aggregate real
money demand,
L(R,Y) R2 Q2 2 1 R1 R3 Q3 3 MS P
( = Q1)

7. Money Supply and Exchange Rate
Short run analysis: The price level and real output are given  sticky prices Assume real output (Y) starts at full-employment Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment.
Short – run
Long – run

8. Linking Money, the Interest Rate, and the Exchange Rate
United States
Federal Reserve System
Europe
European System
of Central Banks
(United States
money supply)
MSUS
MSE
(European
money supply)
United States
money market
European
money market
Foreign
exchange
market R$
(Dollar interest rate) R€
(Euro interest rate)
E$/€
(Dollar/Euro exchange rate)

9. Money Market and Exchange Market Interaction: Our Elaborated Model
Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market
U.S. real money holdings
Rates of return
(in dollar terms)
Dollar/euro
exchange Rate, E$/€
(increasing)
Return on
dollar deposits
Foreign
exchange
market
E1$/€ 1'
Expected
return on
euro deposits
Money
market
R1$ 1
L(R$, YUS)
U.S. real
money
supply
MSUS
PUS

10. Money, Price Level, & Exchange Rate: the Long Run
Long-run equilibrium: Prices are perfectly flexible  adjust to preserve full employment.
Money and Money Prices
From the money market equilibrium condition, Ms/P = L(R,Y)
P = Ms/L(R,Y)
The Classical Dichotomy: Ms  proportional P
A change in Ms has no effect on the long-run values of R (the relative price of money) or Y (full employment output).
In order for E to remain stable, R must return to R* in the long-run.
This long-run equilibrium condition implies that
P/P = Ms/Ms - L/L.
The inflation rate equals the growth rate of Ms minus the growth rate of the demand for money (real balances).
In long-run, E adjusts to P, keeping relative prices (foreign and domestic) constant  purchasing power parity.
If E in long-run, Ee right away. (We’ve read the textbook).

11. Permanent Money Supply Changes and the Exchange Rate
Short-run and Long-run Effects of an Increase in the U.S.Money Supply
Dollar/euro exchange
Rate, E$/€
Rates of return
(in dollar terms)
U.S. real
money holdings
(a) Short-run effects
(b) Adjustment to long-
run equilibrium
Dollar/euro exchange
Rate, E$/€
U.S. real
money holdings
Dollar return
Dollar return 2'
E2$/€
Expected
euro return
Expected
euro return
E2$/€ 2' 3' 4'
E3$/€
E1$/€ 1'
R2$ 2
R1$ 1
R2$ 2
R1$ 4
M1US
P1US
L(R$, YUS)
M2US
P2US
L(R$, YUS)
U.S. real money supply
M2US
P1US
M2US
P1US

12. Permanent Money Supply Changes and the Exchange Rate
Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply
(a) U.S. money supply, MUS
Time
(b) Dollar interest rate, R$
Time
M2US
R1$ t0 t0
M1US
R2$
(c) U.S. price level, PUS
Time
(d) Dollar/euro exchange rate, E$/€
Time
E2$/€ t0
P2US
E3$/€
P1US
E1$/€ t0

13. Effect of an Increase in the European Money Supply on Dollar/Euro Exchange Rate: Short-run response
Expected return on euro holdings
declines both because R* falls and
Ee declines (euro is expected to
depreciate).
U.S. real money holdings
Rates of return
(in dollar terms)
Dollar/euro
exchange Rate, E$/€
Dollar return
Expected
euro return 1'
E1$/€
Increase in European
money supply 2'
E2$/€
R1$ 1
L(R$, YUS)
U.S. real
money
supply
MSUS
PUS