MONEY, INTEREST RATES, AND EXCHANGE RATES

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MONEY, INTEREST RATES, AND EXCHANGE RATES
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Defining Money

• Our favorite definition Money is the services
  provided by liquidity
• Other definitions
• Medium of exchange
• Store of value
• Unit of account

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M1

• This monetary aggregate sounds like a rifle model
  to many when they first hear it
• M1 is a narrow definition of money consisting
  of
• cash and coin in circulation
• checking deposits held by households and firms

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M1currently 1.33tr (approx.)
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M1currently 1.33tr (approx.)

Current GDP11.3tr (approx)
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M1currently 1.33tr (approx.)
So the current money supply is approximately
(1.33/11.3)12 of GDP.

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Role of Central Banks

• Central Banking the process whereby central
  authorities control a nations money supply, has
  as long and interesting a history as, for
  example, international military history.
• Central (and other) banks dont exert direct
  control over the size of the money stock.

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Role of Central Banks

• Still, a nations money supply is controlled by a
  well-functioning central bank, so for now well
  assume the process works just as if the Central
  Bank did have direct control.
• Consider this a temporary simplifying assumption.

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The Demand for Money

• By this we mean demand for the services of
  liquidity.
• Demand for any asset depends on
• the return it offers
• the degree of risk attached to this return
• the degree of the assets liquidity.

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Now Consider Money With Respect to

• Return money is a non-interest bearing asset
• Risk holding money is virtually risk-free
  (unless, for example, the inflation rate is
  volatile)
• Liquidity money is the most liquid of all assets

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Because of These Characteristics

• The opportunity cost of holding money is interest
  that could have been earned on the least risky,
  most liquid alternative asset
• A good candidate for this alternative is US
  Treasuries
• Conclusion willingness to hold money will vary
  with the interest rate on alternative assets
  Treasuries for example

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Speculative Demand

• The relationship between the interest rate and
  the demand for money is called speculative
  demand for money.
• Speculative demand has to do with money as a part
  of households portfolios (the structure of the
  wealth they hold)

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Speculative Demand
A specimen speculative demand curve for money
might be written as SPLo-?R, Where the parameter
? measures the rate of change of speculative
demand for money with respect to changes in the
interest rate R.
Speculative Demand
Slope equals minus ?
Interest Rate
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Speculative Demand
In reality, a straight-line speculative demand
curve is highly unlikely. Still, assuming this
shape makes the algebra much easier, so well
assume this form as a simplifying assumption.
Speculative Demand
Slope equals minus ?
Interest Rate
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Transactions Demand
Demand for money for transactions purposes, on
the other hand, is an upward-sloping function of
income
Transactions Demand
Slope is approximately .12
Income
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Aggregate Money Demand
Your textbook writes the total demand for money
using this equation
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Aggregate Money Demand
Read the equation as follows demand for money
equals price level times demand for nominal
liquidity itself a function of the interest
rate and nominal income.
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Aggregate Money Demand
We can re-write demand for nominal liquidity by
using our specified transactions and speculative
demand functions
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Aggregate Money Demand
Aggregate money demand can now be specified as
where
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Aggregate Money Demand
Graphing this function requires we hold all but
two variables constant
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Aggregate Money Demand
Here we assume the price level and the level of
income are fixed
Md
But since it is traditional to view this diagram
with the axes reversed
R
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Aggregate Money Demand
Here we draw the figure as it appears in your
textbook
R
Now consider the comparative statics of this
demand curve
Md
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Aggregate Money Demand
An increase in the level of income
R
Will raise the demand for money at any interest
rate the curve shifts to the right
Md
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Aggregate Money Demand
An increase in the price level
R
Will also raise the demand for money at any
interest rate the curve shifts to the right
Md
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Aggregate Money Demand
An increase in the price level
R
can be imagined as lowering the real value of any
nominal money stockit is as if more is needed
to do the same job
Md
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Aggregate Money Demand
Similarly, a decrease in the price level
R
can be imagined as raising the real value of any
nominal money stockit is as if less is needed
to do the same job.
Md
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Aggregate Money Supply
The supply of money is determined by the banking
system as a whole in terms of the a constant,
determined jointly by monetary policies pursued
by the central bank in coordination (we hope!)
with the federal government
R
Ms
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Equilibrium Interest Rate
Interaction of the money supply and demand curves
jointly determine the equilibrium interest rate,
denoted here as R
R
R
Ms
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How a Change in Income Affects the Interest Rate
An increase in income shifts the money demand
curve to the right households now need more cash
balances to finance day-to-day transactions this
new scarcity of cash puts upward pressure on
interest rates. The process continues until the
interest rate has risen to R.
R
R
Ms
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Change in Money Supply the Interest Rate
An increase in the money stock shifts the money
supply curve to the right there is now,
everywhere, more liquidity in the system than is
needed. Interest rates fall, and households
shift more cash into speculative balances because
the opportunity cost of holding idle balances
falls from R to R.
R
R
Ms
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E
R2
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Linking Money Foreign Exchange Markets
An increase in the real money supply will lower
the interest rate, lower the rate of return on
domestic currency deposits, cause a shift from
domestic currency deposits to foreign currency
deposits, and lower the external value of the US
dollar.
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E
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Linking Money Foreign Exchange Markets
An increase in the European real money supply
will lower the dollar return on Euro deposits,
causing a leftward shift in the expected euro
return curve this raises the external value of
the US dollar.
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Derivation of the LM Curve

• Later in the term we will look at a relationship
  between the product market and the interest rate
  known as the LM Curve
• The LM Curve is easily derived from the specified
  money demand curve, when we assume equilibrium in
  the money market

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Derivation of the LM Curve
Where Ms is understood as the real value of the
money supply, this condition states quantity of
money supplied equals transactions plus
speculative demand
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Derivation of the LM Curve
If we solve this expression for R, we get R as a
function of Y specifically, the solution is
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Derivation of the LM Curve
The LM curve shows R as an upward sloping
function of Y it shifts to the right with an
increase in the real money supply, left with a
decrease
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Money Supply and Price Level
Alternately we can solve this for P to show Price
level as a function of Y
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Money Supply and Price Level
Your textbook makes this easy by using the
non-specified version of the equation
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Money Supply and Price Level
Your textbook makes this easy by using the
non-specified version of the equation Which we
show aboveThis is easily solved for P
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Money Supply and Price Level
The solution is simply this expression.
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Money Supply and Price Level
An interesting conclusion follows from this
expression. Assuming income is growing at its
long run equilibrium level, and the interest rate
is consistent with this rate of growth
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Money Supply and Price Level
-- any increase in the nominal money stock will
induce an increase in the average aggregate price
level
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Money Supply and Price Level in the Long Run
It is more accurate to say any increase in the
nominal money stock will induce an increase in
the average aggregate price level in the long
run. Definition the long run can be thought of
as a period of time long enough for all wages and
prices to adjust to their market clearing levels.

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Money Supply and Price Level in the Long Run
If prices were perfectly flexible they would
always adjust immediately to any disturbance or
shock (e.g. rapid crude oil price movements,
changes in expectations, technological advances,
political events, strikes, etc.). The length of
time it takes for real-world prices to adjust to
the level they would have attained had they been
perfectly flexible is the difference between the
short and long runs.
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Money Supply and Price Level
Certainly nobody would argue the whole story is
told by these data drawn from the Yale
macroeconomic simulation model
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Money Supply and Price Level
Still, they show a mild positive association
between percentage changes in the money stock
(lagged 6 quarters) and percent changes in the
GDP deflator
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Money Supply and Price Level
These data from Latin America, 1987-2000, (log
scales on both axes) argue more persuasively for
the relationship
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Money Supply and Price Level
Cross section world data, 1973-1997, seem to
argue for the money supply-price level
relationship
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Money Supply and Price Level
But take out the Italy observation
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Money Supply and Price Level
But take out the Italy observation
And whats left?
Without Italy the positive association seems to
disappear
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Money Supply Exchange Rate in the Long Run
However if the long run relationship between
money growth and inflation (price growth)
holds, then we can say a permanent increase in a
countrys money supply causes a proportional long
run depreciation of its currency against foreign
currencies. A permanent decrease in a countrys
money supply causes a proportional long run
appreciation of its currency against foreign
currencies.
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Money supply and future changes in the price
level
With an increase in the money supply, these
demand and cost pressures will lead to eventual
increases in the price level

• Excess demand for output and labor overtime, new
  ordering and hiring raises costs
• Inflationary expectations higher wage demands
  met by planned price increases
• Raw material price adjustments inelastic demand
  and supply causing, for example, price spikes

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But expectations change causing a shift in the
expected euro return curve additional exchange
rate adjustment
And the exchange rate adjusts in an opposite
direction
Causes exchange rate adjustment
Causing interest rates to increase
Lowers nominal interest rate
Increase in money supply
As prices adjust the real value of the money
stock shrinks
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