Ch. 15: Money, Interest Rates,
and Exchange Rates
Udayan Roy
ECO41 International Economics
What is Money?
• Money is any asset that is widely used and accepted
as a means of payment.
• So, a country’s quantity of money (Ms) includes
– All currency with the public and
– All checkable deposits
• bank deposits in a foreign currency are excluded from this
definition.
– M1 and M2 are two well-known periodically
published measures of the quantity of money
Properties of Money: No Return
• We can classify all assets into:
– Money, which earns no return
• Currency with the public plus checking accounts
– Assets that earn a return
• Stocks, bonds, real estate, etc.
Properties of Money: Liquid
• Money is very liquid:
– that is, it can easily and quickly be used to purchase goods
and services.
• Assets that earn a return are less liquid than money
• So, when deciding how much of their wealth to keep
in the form of money, people face a trade off
between the convenience of liquid assets and the
higher return from less-liquid assets
Money Supply
• The quantity of money is also called the money
supply
• Who controls the money supply?
• Central banks determine the money supply.
– In the US, the central bank is the Federal Reserve.
– The Federal Reserve directly regulates the amount of
currency in circulation.
– It indirectly controls the amount of checkable deposits
issued by private banks.
Money Demand
• Money demand is the amount of their wealth that
people are willing to hold in the form of money …
– (… instead of other assets that are less liquid but earn a
higher return).
Money Demand: Individual
1. Interest rate (on interest-earning assets): this is the cost (or,
downside) of holding money.
2. Risk: the risk of holding money principally comes from
unexpected inflation, thereby unexpectedly reducing the
purchasing power of money.
–
but many other assets have this risk too, so this risk is not very
important in money demand
3. Liquidity: A need for greater liquidity occurs when either the
price of transactions increases or the quantity of goods
bought in transactions increases.
Money Demand: Aggregate
• Interest rate
• Average level of prices
• Income
Money Demand: Aggregate
• Money pays little or no interest.
• So, the interest rate on interest-earning assets
(such as bonds) is the opportunity cost of
holding money (instead of non-money assets).
• A higher interest rate means a higher
opportunity cost of holding money  lower
money demand
• Therefore, aggregate money demand (Md) is
inversely related to the interest rate (R)
Money Demand: Aggregate
• The overall level of prices of goods and
services bought in transactions will influence
the willingness to hold money to conduct
those transactions.
• A higher overall price level means a greater
need for liquidity to buy the same amount of
goods and services  higher money demand
• Therefore, aggregate money demand (Md) is
directly related to the overall level of prices (P)
Money Demand: Aggregate
• Higher income implies more goods and
services are being produced and bought
• So, more money would be 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
• Therefore, aggregate money demand (Md) is
directly related to GNP (Y)
Money Demand: Aggregate
• 𝑀𝑑 = 𝑃 × 𝐿 𝑅, 𝑌
– here blue indicates a direct effect and red
indicates an inverse effect
Money Demand: Aggregate
• Let’s be specific about the L in money demand
• Let 𝐿 𝑅, 𝑌 =
𝐿0 ∙𝑌
𝑅
– here L0 represents all factors—other than P, R,
and Y—that affect people’s willingness to hold
their wealth in the form of money.
𝑑
• Then, 𝑀 =
𝑃∙𝐿0 ∙𝑌
𝑅
Equilibrium
• For an economy to be in equilibrium, money
supply must equal money demand
• A central bank may determine the money
supply
• But it cannot force people to hold exactly that
much of their wealth in the form of money
• Therefore, 𝑀𝑑 = 𝑀 𝑠 is necessary for
equilibrium
Equilibrium
• Therefore, 𝑴𝒔 = 𝑴𝒅 = 𝑷 ∙ 𝑳 𝑹, 𝒀 is
essential for equilibrium
• With our simplified form of L, the equilibrium
𝑷∙𝑳𝟎 ∙𝒀
𝒔
condition becomes 𝑴 =
𝑹
• This equation has
– two parameters—Ms and L0—with values that are
assumed known, and
– three variables—P, Y, and R—of unknown value
This topic is actually in Chapter 17. But let’s do it now anyway.
THE AA CURVE
Two Markets: Foreign Exchange and
Money
• So far, we have seen the equilibrium
conditions for the two asset markets
– The foreign exchange market (Ch. 14), and
– The money market (this chapter)
𝒆
𝑬
𝑹 = 𝑹∗ +
−𝟏
𝑬
𝑷 ∙ 𝑳𝟎 ∙ 𝒀
𝑴 =
𝑹
𝒔
Equilibrium in Asset Markets
• We have simplified the money market
𝑃∙𝐿0 ∙𝑌
𝑠
equilibrium equation to 𝑀 =
𝑅
• Equivalently, 𝑌 =
𝑀𝑠
𝐿0 ∙𝑃
∙𝑅
• The interest parity equation then yields 𝑌 =
𝑀𝑠
𝐿0 ∙𝑃
∙ 𝑅∗ +
𝐸𝑒
𝐸
−1
• This equation—the AA equation—must be
true if there is equilibrium in the foreign
exchange and money markets
Equilibrium in Asset Markets
• AA equation: 𝑌 =
𝑀𝑠
𝐿0 ∙𝑃
∗
∙ 𝑅 +
𝐸𝑒
𝐸
−1
• If all parameters and all variables except Y and
E are constant, then we get an inverse link
between Y and E.
• Why? If E increases, the right-hand-side of the
equation decreases. Therefore, Y must
decrease. This gives us the AA Curve
of Chapter 17.
Fig. 17-7: The AA Curve
𝑒
𝑀𝑠
𝐸
𝑌=
∙ 𝑅∗ +
−1
𝐿0 ∙ 𝑃
𝐸
Shifting the AA Curve
• 𝑌=
𝑀𝑠
𝐿0 ∙𝑃
∙
𝑅∗
+
𝐸𝑒
𝐸
−1
– Suppose the economy is initially
at Point 2
– Suppose there is a decrease in Ms
or R* or Ee, or an increase in L0 or
P
– If E stays unchanged at E2, then Y
must decrease
– The economy must go from Point
2 to, perhaps, Point 3
– In other words, a decrease in Ms
or R* or Ee, or an increase in L0 or
P shifts the AA curve left
3
AA2
Shifting the AA Curve
•
The AA curve shifts right if:
–
–
–
–
–
Ms increases
𝑒
𝑀𝑠
𝐸
∗+
𝑌
=
∙
𝑅
−1
P decreases
𝐿0 ∙ 𝑃
𝐸
Ee increases
R* increases
L decreases for some unknown reason (L0↓)
E
E0
E1
Y0
Y1
Y