Money, Interest Rates, and Exchange Rates - PowerPoint PPT Presentation

About This Presentation
Title:

Money, Interest Rates, and Exchange Rates

Description:

Chapter 14 Money, Interest Rates, and Exchange Rates – PowerPoint PPT presentation

Number of Views:189
Avg rating:3.0/5.0
Slides: 28
Provided by: markt228
Category:

less

Transcript and Presenter's Notes

Title: Money, Interest Rates, and Exchange Rates


1
Chapter 14
  • Money, Interest Rates, and Exchange Rates

2
Preview
  • What changes interest rates, which will in turn
    affect E ?
  • i
  • Interest rate as the price of money is
    determined by supply of and demand for money
  • Impact of Money Supply on interest rate is
    different for Short-run(-) and Long run()

3
1. What Is Money?
  • Money is an asset that is widely used and
    accepted as a means of payment.
  • Different groups of assets may be classified as
    money.
  • Currency and checking accounts form a useful
    definition of money, but bank deposits in the
    foreign exchange market are excluded from this
    definition.

4
2. Two Different Amounts of Money Supply(Demand)
  • What we see as Money Supply(Demand) is the
    Nominal Money Supply(Demand). This is dollar
    value as we see.
  • What matters is Real Money Supply(Demand), which
    is the Quantity of Money Supply.
  • Quantity of Real Money is Nominal Amount of Money
    divided by the General Price Level
  • ms Ms/P

5
Who controls Money?
  • People just accept whatever Nominal Money Supply
    supplied to them
  • MD MS
  • 2) People determine real quantity of their demand
    for money by controlling the price level

6
What Influences Real Demand for Money?
  • 1. Interest rates money pays little or no
    interest, so the interest rate is the opportunity
    cost of holding money instead of other assets,
    like bonds, which have a higher expected
    return/interest rate.
  • A higher interest rate means a higher opportunity
    cost of holding money ? lower money demand
  • 2. Income greater income implies more goods and
    services can be bought, so that more money is
    needed to conduct transactions.
  • A higher real national income (GNP) means more
    goods and services are being produced and bought
    in transactions, increasing the need for
    liquidity ? higher money demand.

7
Math for Real Money Demand
  • can be expressed by
  • L(R,Y)
  • where
  • P is the price level
  • Y is real national income
  • R is a measure of interest rates
  • L(R,Y) is the aggregate real money demand

8
Equilibrium in Money Market
  • In equilibrium, Real Money Supply is equal to
    Real Money Demand
  • Ms/P L(R,Y)
  • This equilibrium condition will yield an
    equilibrium price of fund, i.e., interest rate.

9
Note Dynamic Mechanism
  • Step 1
  • People decides on their desired Real Money
    Demand through L(R,Y). At this time, Ms/P
    L(R,Y)
  • Step 2
  • If the Central Bank injects Nominal Money Supply
    into the economy, first People just accepts it
    all Ms Md
  • However, inside, Ms/P

10
Two Kinds of Interest Rates
  • Fisher Equation
  • Nominal Interest Rate Real Interest Rate
    Expected Inflation Rate
  • Real Interest Rate determines Investment, and
    National Income.
  • In the short run, Real Interest Rate can be
    affected by Money Supply (and Money Demand).
  • In the Long-run, Real Interest Rate is determined
    by Real Factors, and is equal to MP of Capital.

11
What will happen to Interest Rates and Exchange
Rates when the Central Bank increases Nominal
Money Supply?
  • In the Short-run, Price Level does not change
    the Real Interest rate goes down investment may
    rise Business may get better National Income
    may rise
  • As real interest falls, there will be capital
    outflow E will go up.
  • In the Long-run, people will speed up
    expenditures P up Real Interest Rate, I and Y
    all go back the initial level
  • With repeated Increases in Money Supply,
    Inflation may develop Nominal Interest Rate goes
    up E will go up.

12
Impact of Monetary Policy in the Short-run
  • Expansionary Monetary Policy
  • Real Money Supply gt Real Money Demand
  • In Disequilibrium, the price should change.
  • When there is an excess real supply of money,
    the price of money or the interest rate falls.
  • As interest rate falls, investment rises and
    real national income rises.
  • Stringent Monetary Policy
  • When there is a short supply of money, the
    price of money or the interest rate rises.

13
Linking the Money Market to the Foreign Exchange
Market in the Short-run
14
What happens to the domestic interest rate and
the FOREX rate (E) when the central bank
increases the Money Supply?
It is not really necessary to think of this lower
part of this graph Just consider the upper part.
15
So, now we know that the impact of the Money
Supply on E in the Short-run
  • Easy Monetary Policy (an increase in a countrys
    money supply) causes its interest rate to fall
    and FOREX rate or E to rise Its currency
    depreciate.
  • Strict Monetary Policy( a decrease in a countrys
    money supply) causes its interest rate to go up
    and FOREX rate to go down its currency to
    appreciate.

16
Changes in Real Money Supply in the Foreign
Country in the short-run
  • An increase in the EU money supply causes a
    depreciation of the euro (appreciation of the
    dollar).
  • A decrease in the EU money supply causes an
    appreciation of the euro (a depreciation of the
    dollar).

17
What will happen to the foreign interest rate and
E in the short-run if the foreign government
increases its Money Supply?
You do not have to look at the lower part of the
graph.
18
What will happen to E in the short run if a
foreign country changes its (Foreign) Money
Supply?
  • The increase in the EU money supply reduces
    interest rates in the EU, reducing the expected
    return on euro deposits.
  • This reduction in the expected return on euro
    deposits leads to a depreciation of the euro.
  • The change in the EU money supply does not change
    the US money market equilibrium.

19
Note
  • The interest rates here in this graph are all
    Real Interest Rate or Real Returns.

20
In the Long-Run, we cannot use the above model
  • The above does NOT work in the long-run.
  • We need a New Model for FOREX Rate, which deals
    with Nominal Variables
  • Purchasing Power Parity Theory to come in Chapter
    15.
  • (The remainder of Chapter 14 is a prelude for
    Chapter 15.)

21
Long Run Impact of Money Supply
Prelude to Chapter 16
  • In the long run, more Money Supply simply means a
    Higher Price Level and a Higher Interest Rate.

22
In Long Run, Money does not matter for Real
Interest Rate and Real National Income
  • In the Long-run, only K. L, T affect Real Output
    - Supply Side Economics.
  • In the long run, the money supply does not
    influence the amount of real output or real
    interest rate.
  • There is a dichotomy between the nominal sector
    (Money), and the real sector (Real Output, Real
    National Income, or Real Interest Rate).

23
Long Run Impact of Money Supply is on the Price
Level
  • In the long run, there is a direct relationship
    between the money supply and the price level.
  • P and M are moving in the same direction and at
    the same speed.
  • 1) Repeated Increases in Money Supply lead to
    Inflation 2) inflation rate roughly equals
    growth rate in money supply.
  • ?P ?Ms

24
And on Inflationary expectations
  • If workers expect money supply to increase, they
    will expect future prices to rise.
  • They will demand higher wages.
  • Producers will be able to match higher costs if
    they expect to raise prices.
  • No one is better off, unchanging in real terms.
  • Result an expected money supply increase leads
    to an expected inflation, which in turn causes an
    actual inflation.

25
So what is the long-run impact of an increased
Money Supply?
  • The main impact is on Price Level, and Inflation
    Rate.
  • We need a new Model which links Price Level and
    Inflation to FOREX Rate.
  • When the Price Level goes up, the (Domestic)
    Currency Value falls, and the Price of FOREX
    should go up.
  • In the simplest way, FOREX Rate is a relative
    value of two currenies or the Domestic Currency
    Price of One Unit of Foreign Currency.
  • In fact, this model is called Purchasing Power
    Parity Theory.
  • conceptually Easier to understand.

26
Impact of Money Supply on FOREX Rate in the
Long-run
  • In the long-run, an increase in Money Supply
    leads to Price Level Rise, or Inflation
  • The value of the domestic currency falls
  • The relative value of the foreign currency rises
    - FOREX rate or E goes up.
  • Vice versa

27
Empirical Evidence P and M move together.
Write a Comment
User Comments (0)
About PowerShow.com