Chapter 2

Money, Interest Rate and Exchange Rate

1-1
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• What is money?
• Control of the supply of money
• The willingness to hold monetary assets
• A model of real monetary assets and
interest rates
• A model of real monetary assets, interest rates, and
exchange rates
• Long-run effects of changes in money on prices,
interest rates, and exchange rates
 What Is Money?
• Money is an asset that is widely used as a means of payment.
– Different groups of assets may be classified as money.
• Money can be defined narrowly or broadly.
• Currency in circulation, checking deposits, and debit card
accounts form a narrow definition of money.
• Deposits of currency are excluded from this narrow
definition, although they may act as a substitute for money in
a broader definition.
 What Is Money?
• Money is a liquid asset: it can be easily used to pay for goods and
services or to repay debt without substantial transaction costs.
– But monetary or liquid assets earn little or no interest.
• Illiquid assets require substantial transaction costs in terms of time,
effort, or fees to convert them to funds for payment.
– But they generally earn a higher interest rate or rate of return
than monetary assets.
 Money Supply
• The central bank controls the quantity of money that circulates in an
economy, the money supply.
• The central bank directly regulates the amount of currency in
circulation.
• It indirectly influences the amount of checking deposits, debit card
accounts, and other monetary assets.
 Money Demand
• Money demand represents the amount of monetary assets that
people are willing to hold (instead of illiquid assets).

– What influences willingness to hold monetary assets?

– We consider individual demand of money and aggregate demand

of money (the total demand for money of all households and
firms in the economy).
 What Influences Demand of Money for Individuals and
Institutions?
1. Interest rates/expected rates of return on monetary assets
relative to the expected rates of returns on non-monetary assets.
2. Risk: the risk of holding monetary assets principally comes from
unexpected inflation, which reduces the purchasing power of
money.
– But many other assets have this risk too, so this risk is not very
important in defining the demand of monetary assets versus
nonmonetary assets.
3. Liquidity: A need for greater liquidity occurs when the price of
transactions increases or the quantity of goods bought in
transactions increases.
 What Influences Aggregate Demand of Money?
1. Interest rates/expected rates of return: monetary assets pay little
or no interest, so the interest rate on non-monetary assets like
bonds, loans, and deposits is the opportunity cost of holding
monetary assets.
– A higher interest rate means a higher opportunity cost of
holding monetary assets  lower demand of money.
2. Price level (the price of broad reference basket of goods and
services in terms of currency).
If the price level rises, individuals, households, firms must
spend money to purchase their usual weekly baskets of goods and
services. To hold the same level of liquidity, they need to hold more
money.
 What Influences Aggregate Demand of Money?

3. Income:

– A higher real national income (GNP) means more goods and

services are being produced and bought in transactions,
increasing the need for liquidity  higher demand of money.
 A Model of Aggregate Money Demand

The aggregate demand of money can be expressed as:

Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets
Alternatively:
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of national
income and interest rates.
Fig. 15-1: Aggregate Real Money
Demand and the Interest Rate
Fig. 15-2: Effect on the Aggregate Real Money Demand Schedule of
a Rise in Real Income

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 A Model of the Money Market
• Equilibrium in the Money Market:

Ms = Md

• Alternatively, when the quantity of real monetary assets supplied

matches the quantity of real monetary assets demanded, the model
achieves an equilibrium:

Ms/P = L(R,Y)
Fig. 15-3: Determination of the Equilibrium Interest Rate
Fig. 15-4: Effect of an Increase in the Money Supply on
the Interest Rate
Fig. 15-5: Effect on the Interest
Rate of a Rise in Real Income
Model of Foreign Exchange Market
 Model of Foreign Exchange Market

• The effects of changing interest rates:

– an increase in the interest rate paid on deposits denominated in a
particular currency will increase the rate of return on those
deposits.
– This leads to an appreciation of the currency.
– Higher interest rates on dollar-denominated assets cause the
dollar to appreciate.
– Higher interest rates on euro-denominated assets cause the dollar
to depreciate.
Effect of a Rise in the Dollar Interest Rate
Effect of a Rise in the Euro Interest Rate
 Fig. 15-6: Simultaneous
Equilibrium in the U.S.
Money Market and the
Foreign Exchange Market
Fig. 15-7: Money Market/Exchange Rate Linkages
 Fig. 15-8: Effect on the
Dollar/Euro Exchange Rate
and Dollar Interest Rate of an
Increase in the U.S. Money
Supply
 Changes in the Domestic Money Supply

• An increase in a country’s money supply causes interest rates to fall,

rates of return on domestic currency deposits to fall, and the
domestic currency to depreciate.

• A decrease in a country’s money supply causes interest rates to rise,

rates of return on domestic currency deposits to rise, and the
domestic currency to appreciate.
 Changes in the Foreign Money Supply

• How would a change in the supply of euros affect the U.S. money
market and foreign exchange markets?

• An increase in the supply of euros causes a depreciation of the euro

(an appreciation of the dollar).

• A decrease in the supply of euros causes an appreciation of the euro

(a depreciation of the dollar).
 Fig. 15-9: Effect of an Increase in
the European Money Supply on the
Dollar/Euro Exchange Rate
 Changes in the Foreign Money Supply (cont.)

• The increase in the supply of euros reduces interest rates in the EU,
reducing the expected rate of return on euro deposits.

• This reduction in the expected rate of return on euro deposits causes

the euro to depreciate.

• We predict no change in the U.S. money market due to the change in

the supply of euros.
 Long Run and Short Run

• In the short run, prices do not have sufficient time to adjust to market
conditions.
– The analysis heretofore has been a short-run analysis.
• In the long run, prices of factors of production and of output have
sufficient time to adjust to market conditions.
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers
and other factors of production—by the economy’s productive
capacity—not by the quantity of money supplied.
– (Real) interest rates depend on the supply of saved funds and the
demand of saved funds.
 Long Run and Short Run (cont.)

• In the long run, the quantity of money supplied is predicted not to

influence the amount of output, (real) interest rates, and the
aggregate demand of real monetary assets L(R,Y).

• However, the quantity of money supplied is predicted to make the

level of average prices adjust proportionally in the long run.

– The equilibrium condition Ms/P = L(R,Y) shows that P is

predicted to adjust proportionally when Ms adjusts, because
L(R,Y) does not change.
 Long Run and Short Run (cont.)

• In the long run, there is a direct relationship between the inflation

rate and changes in the money supply.

Ms = P x L(R,Y)

P = Ms/L(R,Y)

P/P = Ms/Ms – L/L

– The inflation rate is predicted to equal the growth rate in money

supply minus the growth rate in money demand.
Fig. 15-10: Average Money
Growth
and Inflation in Western
Hemisphere Developing
Countries, by Year, 1987–
2007
 Money and Prices in the Long Run
• How does a change in the money supply cause prices
of output and inputs to change?
1. Excess demand of goods and services: a higher quantity of money
supplied implies that people have more funds available to pay for
goods and services.
– To meet high demand, producers hire more workers, creating a strong
demand of labor services, or make existing employees work harder.
– Wages rise to attract more workers or to compensate workers for
overtime.
– Prices of output will eventually rise to compensate for higher costs.
 Money and Prices in the Long Run (cont.)
– Alternatively, for a fixed amount of output and inputs, producers can
charge higher prices and still sell all of their output due to the high
demand.
2. Inflationary expectations:
– If workers expect future prices to rise due to an expected money supply
increase, they will want to be compensated.
– And if producers expect the same, they are more willing to raise wages.
– Producers will be able to match higher costs if they expect to raise
prices.
– Result: expectations about inflation caused by an expected increase in
the money supply causes actual inflation.
Fig. 15-11: Month-to-Month Variability of the Dollar/Yen Exchange
Rate and of the U.S./Japan Price Level Ratio, 1980–2013
 Money, Prices, Exchange Rates, and Expectations

• When we consider price changes in the long run,

inflationary expectations will have an effect in foreign
exchange markets.

• Suppose that expectations about inflation change as

people change their minds, but actual adjustment of
prices occurs afterwards.
Fig. 15-12: Short-Run and Long-Run Effects of an Increase in the
U.S. Money Supply (Given Real Output, Y)
 Money, Prices, and Exchange Rates in the Long Run

• A permanent increase in a country’s money supply

causes a proportional long-run depreciation of its
currency.
– However, the dynamics of the model predict a large depreciation
first and a smaller subsequent appreciation.

• A permanent decrease in a country’s money supply

causes a proportional long-run appreciation of its
currency.
– However, the dynamics of the model predict a large appreciation
first and a smaller subsequent depreciation.
 Fig. 15-13: Time Paths of U.S. Economic Variables
after a Permanent Increase in the U.S. Money Supply
 Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long-
run response.
• Overshooting is predicted to occur when monetary policy
has an immediate effect on interest rates, but not on
prices and (expected) inflation.
• Overshooting helps explain why exchange rates are so
volatile.
1.
Summary
Money demand for individuals and institutions is primarily
determined by interest rates and the need for liquidity, the latter of
which is influenced by prices and income.
2. Aggregate money demand is primarily determined by interest rates,
the level of average prices, and national income.
• Aggregate demand of real monetary assets depends negatively on the
interest rate and positively on real national income.
 Summary (cont.)
3. When the money market is in equilibrium, there are no surpluses
or shortages of monetary assets: the quantity of real monetary
assets supplied matches the quantity of real monetary assets
demanded.
4. Short-run scenario: changes in the money supply affect domestic
interest rates, as well as the exchange rate. An increase in the
domestic money supply
1. lowers domestic interest rates,
2. thus lowering the rate of return on deposits of domestic currency,
3. thus causing the domestic currency to depreciate.
 Summary (cont.)
5. Long-run scenario: changes in the quantity of money supplied are
matched by a proportional change in prices, and do not affect real
income and real interest rates. An increase in the money supply
1. causes expectations about inflation to adjust,
2. thus causing the domestic currency to depreciate further,
3. and causes prices to adjust proportionally in the long run,
4. thus causing interest rates to return to their long-run values,
5. and causes a proportional long-run depreciation in the domestic
currency.
 Summary (cont.)
6. Interest rates adjust immediately to changes in monetary policy,
but prices and (expected) inflation may adjust only in the long run,
which results in overshooting of the exchange rate.
• Overshooting occurs when the immediate response of the exchange
rate due to a change is greater than its long-run response.
• Overshooting helps explain why exchange rates are so volatile.