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Chapter 14

Money, Interest Rates, and Exchange Rates

Prepared by Iordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

by Paul R. Krugman and Maurice Obstfeld

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Chapter Organization

Introduction
Money Defined: A Brief Review
The Demand for Money by Individuals
Aggregate Money Demand
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand

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Chapter Organization

The Money Supply and the Exchange Rate in the Short Run
Money, the Price Level, and the Exchange Rate in the Long Run
Inflation and Exchange Rate Dynamics
Summary

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Introduction

Factors that affect a country’s money supply or demand are among the most powerful determinants of its currency’s exchange rate against foreign currencies.
This chapter combines the foreign-exchange market with the money market to determine the exchange rate in the short run.

It analyzes the long-term effects of monetary changes on output prices and expected future exchange rates.

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Money Defined: A Brief Review

Money as a Medium of Exchange

A generally accepted means of payment

Money as a Unit of Account

A widely recognized measure of value

Money as a Store of Value

A transfer of purchasing power from the present into the future

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Money Defined: A Brief Review

What Is Money?

Assets widely used and accepted as a means of payment.
Money is very liquid, but pays little or no return.

All other assets are less liquid but pay higher return.

Money Supply (M^s)

M^s = Currency + Checkable Deposits

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Money Defined: A Brief Review

How the Money Supply Is Determined

An economy’s money supply is controlled by its central bank.

The central bank:

Directly regulates the amount of currency in existence
Indirectly controls the amount of checking deposits issued by private banks

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The Demand for �Money by Individuals

Three factors influence money demand:

Expected return
Risk
Liquidity

Expected Return

The interest rate measures the opportunity cost of holding money rather than interest-bearing bonds.

A rise in the interest rate raises the cost of holding money and causes money demand to fall.

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The Demand for �Money by Individuals

Risk

Holding money is risky.

An unexpected increase in the prices of goods and services could reduce the value of money in terms of the commodities consumed.

Changes in the risk of holding money need not cause individuals to reduce their demand for money.

Any change in the riskiness of money causes an equal change in the riskiness of bonds.

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The Demand for �Money by Individuals

Liquidity

The main benefit of holding money comes from its liquidity.

Households and firms hold money because it is the easiest way of financing their everyday purchases.

A rise in the average value of transactions carried out by a household or firm causes its demand for money to rise.

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Aggregate Money Demand

Aggregate money demand

The total demand for money by all households and firms in the economy.
It is determined by three main factors:

Interest rate

It reduces the demand for money.

Price level

It raises the demand for money.

Real national income

It raises the demand for money.

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Aggregate Money Demand

The aggregate demand for money can be expressed by:

M^d = P x L(R,Y) (14-1)

where:

P is the price level

Y is real national income

L(R,Y) is the aggregate real money demand

Equation (14-1) can also be written as:

M^d/P = L(R,Y) (14-2)

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Aggregate Money Demand

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Figure 14-1: Aggregate Real Money Demand and the Interest Rate

L(R,Y)

Interest

rate, R

Aggregate real

money demand

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Figure 14-2: Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income

L(R,Y²)

Increase in

real income

L(R,Y¹)

Interest

rate, R

Aggregate real

money demand

Aggregate Money Demand

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Equilibrium in the Money Market

The condition for equilibrium in the money market is:

M^s = M^d(14-3)

The money market equilibrium condition can be expressed in terms of aggregate real money demand as:

M^s/P = L(R,Y) (14-4)

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-3: Determination of the Equilibrium Interest Rate

Aggregate real

money demand,

L(R,Y)

Interest

rate, R

Real money

holdings

Real money supply

M^S

( = Q¹)

R²

Q²

R¹

R³

Q³

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Interest Rates and the Money Supply

An increase (fall) in the money supply lowers (raises) the interest rate, given the price level and output.

The effect of increasing the money supply at a given price level is illustrated in Figure 14-4.

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

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M²

R²

M¹

Real money

supply

Real money

supply increase

The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-4: Effect of an Increase in the Money Supply on the Interest Rate

L(R,Y¹)

R¹

Interest

rate, R

Real money

holdings

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Output and the Interest Rate

An increase (fall) in real output raises (lowers) the interest rate, given the price level and the money supply.

Figure 14-5 shows the effect on the interest rate of a rise in the level of output, given the money supply and the price level.

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

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Q²

The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-5: Effect on the Interest Rate of a Rise in Real Income

L(R,Y¹)

L(R,Y²)

Increase in

real income

Real money supply

M^S

( = Q¹)

R²

R¹

Interest

rate, R

Real money

holdings

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The Money Supply and the Exchange Rate in the Short Run

Short run analysis

The price level and the real output are given.

Long run analysis

The price level is perfectly flexible and always adjusted immediately to preserve full employment.

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The Money Supply and the Exchange Rate in the Short Run

Linking Money, the Interest Rate, and the Exchange Rate

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

Figure 14-6 links the U.S. money market (bottom) and the foreign exchange market (top).

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-6: Simultaneous Equilibrium in the U.S. Money Market

and the Foreign-Exchange Market

Return on

dollar deposits

Expected

return on

euro deposits

L(R_$, Y_US)

U.S. real money holdings

Rates of return

(in dollar terms)

Dollar/euro

exchange Rate, E_$_/_€

(increasing)

Foreign

exchange

market

Money

market

E¹_$/€

R¹_$

U.S. real

money

supply

M^S_US

P_US

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-7: Money-Market/Exchange Rate Linkages

European

money market

United States

money market

Europe

European System

of Central Banks

United States

Federal Reserve System

(United States

money supply)

M^S_US

M^S_E

(European

money supply)

R_$

(Dollar interest rate)

R_€

(Euro interest rate)

Foreign

exchange

market

E_$/€

(Dollar/Euro exchange rate)

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U.S. Money Supply and the Dollar/Euro Exchange Rate

What happens when the Federal Reserve changes the U.S. money supply?

An increase (decrease) in a country’s money supply causes its currency to depreciate (appreciate) in the foreign exchange market.

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

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Increase in U.S.

real money supply

Expected

return on

euro deposits

The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

Figure 14-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply

E²_$/€

U.S. real money holdings

Rates of return

(in dollar terms)

Dollar/euro

exchange Rate, E_$/€

Return on

dollar deposits

L(R_$, Y_US)

E¹_$/€

R¹_$

M¹_US

P_US

R²_$

M²_US

P_US

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Europe’s Money Supply and the Dollar/Euro Exchange Rate

An increase in Europe’s money supply causes a depreciation of the euro (i.e., appreciation of the dollar).
A reduction in Europe’s money supply causes an appreciation of the euro (i.e., a depreciation of the dollar).
The change in the European money supply does not disturb the U.S. money market equilibrium.

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The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

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Figure 14-9: Effect of an Increase in the European Money Supply

on the Dollar/Euro Exchange Rate

Increase in European

money supply

U.S. real money holdings

Rates of return

(in dollar terms)

Dollar/euro

exchange Rate, E_$/€

Expected

euro return

L(R_$, Y_US)

U.S. real

money

supply

M^S_US

P_US

R¹_$

E¹_$/€

Dollar return

The Equilibrium Interest Rate: The �Interaction of Money Supply and Demand

E²_$/€

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Money, the Price Level, and the Exchange Rate in the Long Run

Long-run equilibrium

Prices are perfectly flexible and always adjusted immediately to preserve full employment.

Money and Money Prices

The money market equilibrium (Equation 14-4) can be rearranged to give the long-run equilibrium price level:

P = M^s/L(R,Y) (14-5)

An increase in a country’s money supply causes a proportional increase in its price level.

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The Long-Run Effects of Money Supply Changes

A change in the supply of money has no effect on the long-run values of the interest rate or real output.
A permanent increase in the money supply causes a proportional increase in the price level’s long-run value.

This prediction is based on the money market equilibrium condition: M^s/P = L or P = M^s/L.
This condition implies that ΔP/P = ΔM^s/M^s- ΔL/L.

The inflation rate equals the monetary growth rate less the growth rate for money demand.

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Money, the Price Level, and the Exchange Rate in the Long Run

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Empirical Evidence on Money Supplies and Price Levels

In a cross-section of countries, long-term changes in money supplies and price levels show a clear positive correlation.

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Money, the Price Level, and the Exchange Rate in the Long Run

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Figure 14-10: Monetary Growth and Price-Level Change in the Seven Main Industrial Countries, 1973-1997

Money, the Price Level, and the Exchange Rate in the Long Run

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Money and the Exchange Rate in the Long Run

A permanent increase (decrease) in a country’s money supply causes a proportional long-run depreciation (appreciation) of its currency against foreign currencies.

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Money, the Price Level, and the Exchange Rate in the Long Run

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Inflation and �Exchange Rate Dynamics

Inflation

A situation where an economy’s price level rises.

Deflation

A situation where an economy’s price level falls.

Short-Run Price Rigidity versus Long-Run Price Flexibility

The short-run “stickiness” of price levels is illustrated in Figure 14-11.

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Figure 14-11: Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U.S./German Price-Level Ratio, 1974-2001

Inflation and �Exchange Rate Dynamics

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Inflation and �Exchange Rate Dynamics

A change in the money supply creates demand and cost pressures that lead to future increases in the price level from three main sources:

Excess demand for output and labor
Inflationary expectations
Raw materials prices

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Inflation and �Exchange Rate Dynamics

Permanent Money Supply Changes and the Exchange Rate

How does the dollar/euro exchange rate adjust to a permanent increase in the U.S. money supply?

Figure 14-12 shows both the short-run and long-run effects of the increase in the U.S. money supply.

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Figure 14-12: Effects of an Increase in the U.S.Money Supply

Dollar return

M¹_US

P¹_US

M²_US

P¹_US

U.S. real money supply

M²_US

P²_US

M²_US

P¹_US

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

E²_$/€

E³_$/€

R¹_$

R²_$

R¹_$

Inflation and �Exchange Rate Dynamics

E²_$/€

Expected

euro return

Expected

euro return

L(R_$, Y_US)

R²_$

L(R_$, Y_US)

E¹_$/€

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Figure 14-13: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply

Inflation and

Exchange Rate Dynamics

P²_US

E³_$/€

E¹_$/€

t₀

(a) U.S. money supply, M_US

Time

(b) Dollar interest rate, R_$

Time

M¹_US

t₀

R¹_$

M²_US

P¹_US

t₀

R²_$

E²_$/€

(d) Dollar/euro exchange rate, E_$/€

Time

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Inflation and �Exchange Rate Dynamics

Exchange Rate Overshooting

The exchange rate is said to overshoot when its immediate response to a disturbance is greater than its long-run response.
It helps explain why exchange rates move so sharply form day to day.
It is a direct result of sluggish short-run price level adjustment and the interest parity condition.

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Summary

Money is held because of its liquidity.
Aggregate real money demand depends negatively on the opportunity cost of holding money and positively on the volume of transactions in the economy.
The money market is in equilibrium when the real money supply equals aggregate real money demand.
By lowering the domestic interest rate, an increase in the money supply causes the domestic currency to depreciate in the foreign exchange market.

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Summary

Permanent changes in the money supply push the long-run equilibrium price level proportionally in the same direction.

These changes do not influence the long-run values of output, the interest rate, or any relative prices.

An increase in the money supply can cause the exchange rate to overshoot its long-run level in the short run.

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