Topic 6A Money, Interest Rates, and Exchange Rates

1
Topic 6AMoney, Interest Rates, and Exchange
Rates

• Textbook Chapter 14

2
Learning objectives

• Learn how the money market determines the
  interest rate
• Examine how the money market determines the
  overall level of prices, including the domestic
  currency price of foreign currency, and the
  expected exchange rate.
• Introduce the mechanism for exchange rate
  overshooting

3
Aggregate money demand

• Three factors affect aggregate money demand (Md)
• Md falls as the interest rate rises
• Md rises as the price level rises to maintain the
  same level of liquidity
• Md rises as real national GNP rises.

4
Aggregate money demand

• Formally, we have
• Md P?L(R,Y)
• Aggregate real money demand is
• Md /P L(R,Y)
• where P is the price level, R is the nominal
  interest rate, and Y is output.

5
Figure 14-1 Aggregate real money demand and the
interest rate
6
Equilibrium in the money market

• Equilibrium condition for the money market is
• MsMd
• In real terms, we have
• Ms /P L(R,Y)

7
Figure 14-3 Determination of the equilibrium
interest rate
8
Money market shocks

• An increase in the money supply lowers the
  interest rate, while a fall in the money supply
  raises the interest rate, given the price level
  and output.
• An increase in real output raises the interest
  rate, while a fall in real output lowers the
  interest rate, given the price level and money
  supply.

9
Figure 14-4 Effect of an increase in the money
supply on the interest rate
10
Figure 14-5 Effect on the interest rate of a
rise in real income
11
Short-run equilibrium in the money market and
foreign exchange market

• The U.S. money market determines the dollar
  interest rate, which in turn affects the exchange
  rate that maintains the interest parity.
• Similarly, the European money market determines
  the euro interest rate, which in turn also
  affects the exchange rate that maintains the
  interest parity.

12
Figure 14-6 Simultaneous equilibrium in the U.S.
money market and the foreign-exchange market
13
Figure 14-7 Money-market/exchange rate linkages
14
Short-run effects on the E/ and R of an
increase in the U.S. money supply

• Given PUS and YUS, an increase in the money
  supply reduces the dollar interest rate and
  causes the dollar to depreciate against euro.
• Similarly, a decrease in the money supply raises
  the dollar interest rate and causes the dollar to
  appreciate against euro.

15
Short-run effects on the E/ of an increase in
the European money supply

• An increase (a decrease) in the European money
  supply reduces (raises)
• the euro interest rate
• the dollar rate of return on euro deposits
• the exchange value of the dollar.

16
Figure 14-9 Effect of an increase in the
European money supply on the dollar/euro exchange
rate
17
Money-market equilibrium in the long run

• All else equal, an increase in a countrys money
  supply causes a proportional increase in its
  price level.
• PMs/L(R,Y)
• The price level is determined by domestic money
  demand and supplies.

18
More on the short-run effect of an increase in
the U.S. money supply

• A permanent increase in the U.S. money supply
• increases the real money supply
• lowers the dollar interest rate
• causes people to expect a future dollar
  depreciation (Ee/?) so that the expected euro
  return curve shifts to the right.
• In the short run, the dollar depreciates more
  than it would if the money supply increase were
  temporary.

19
Adjustment to long-run equilibrium

• The price level rises in proportion to the
  money-supply increase so that
• the real money supplied falls back to the
  original level
• the dollar interest rate goes up and returns to
  its original level
• the dollar appreciates against the euro
• In the long run, the exchange rate is higher (the
  dollar is weaker) than that before the U.S. money
  supply increase.

20
Figure 14-12 Short-run and long-run effects of
an increase in the U.S. money supply (given real
output, Y )
21
Figure 14-13 Time paths of U.S. economic
variables after a permanent increase in the U.S.
money supply
22
Summary

• In the short run, an increase in the money supply
  causes the interest rate to fall and the domestic
  currency to depreciate more than proportionally
  (exchange rate overshooting), and vice versa.
• In the long run, the price level rises in
  proportion to money supply followed by a domestic
  currency appreciation to its long-run level.