Topic 8
Money, Interest
Rates, and
Exchange Rates
Slides prepared by Thomas Bishop
Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Preview
• What is money?
• Control of the supply of money
• The willingness to hold money
• A model of money and interest rates
• A model of money, interest rates, and
exchange rates
• Long run effects of changes in money supply
on prices, interest rates, and exchange rates
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14-2
Introduction
• In the next three lectures, we will build a
macroeconomic model that links exchange
rates, interest rates, inflation rates, and
output.
• Begin by examining how the supply and
demand for money affects interest rates and
exchange rates.
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What Is Money?
• It is a medium of exchange: a generally
accepted means of payment.
 Money eliminates the enormous search costs
connected with a barter system.
• Money is a unit of account: a widely
recognized measure of value.
• It is an asset or a store of value.
 Money is the most liquid of all assets because it
can be transformed into goods and services rapidly
without high transactions costs.
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What Is Money? (cont.)
• Money is currency and bank deposits on
which checks can be written.
• Money supply in this class will be M1: the
total amount of currency and checking
deposits held by households and firms.
 In 2006, the U.S. total money supply was $1.39
trillion (or 10.5% of GNP).
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Money Supply
• An economy’s money supply is controlled by
its central bank.
• In the US, the central banking system is the
Federal Reserve System.
 It directly regulates the amount of currency in
circulation. And it indirectly controls the amount of
checking deposits issued by private banks.
• For now, we assume that the central bank
simply sets the size of the money supply at
the level it desires.
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Money Demand
• Money demand represents the amount of
money (currency and checking deposits) that
people are willing to hold (instead of less
liquid assets like government bonds, a large
time deposit, or real estate).
 What influences willingness to hold money?
 We consider individual demand for money and
aggregate demand for money.
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What Influences Demand for Money by
Individuals and Institutions?
•
Individuals base their demand for any asset
(including money) on three characteristics:
1. Expected return (or interest rates): the difference
in rates of return between money and less liquid
assets is reflected by the market interest rate.
•
A rise in the interest rate raises the cost of holding money
(rather than interest-paying assets) and causes money
demand to fall.
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What Influences Demand for Money by
Individuals and Institutions? (cont.)
2.
Risk: the risk of holding money comes from
unexpected inflation, which reduces the purchasing
power of money.

3.
But many other assets also have this risk, so this risk is not
very important in defining the demand for money vs. nonmoney assets.
Liquidity: the main benefit of holding money comes
from its liquidity.
•
Households and firms hold money because it is the easiest
way to finance everyday purchases.
•
A rise in the average value of transactions carried out by a
household or firm causes its need for liquidity to rise and
thereby its demand for money to rise.
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What Influences Aggregate Demand for
Money?
•
Aggregate money demand is just the sum of all the
economy’s individual money demands.
•
Three main factors determine it:
1. The interest rate: money pays little or no interest,
so the interest rate on non-money assets like bonds,
loans, and time deposits is the opportunity cost of
holding money.

A higher interest rate means a higher opportunity cost of
holding money  lower demand for money.
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What Influences Aggregate Demand for
Money? (cont.)
2.
The price level: the prices of goods and services
bought in transactions will influence the willingness
to hold money to conduct those transactions.

3.
A higher level of average prices means a greater need for
liquidity to buy the same amount of goods and services 
higher demand for money.
Real national income: greater income implies
more goods and services can be bought, so that
more money is needed to conduct transactions.

A higher GNP means more goods and services are being
produced and bought in transactions, increasing the need for
liquidity  higher demand for money.
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Aggregate Money Demand
The aggregate demand for money can be expressed as:
Md = P x L(R,Y)
where:
P is the price level; Y is real national income
R is a measure of interest rates on non-money assets
L(R,Y) is the aggregate real money demand
Alternatively:
Md/P = L(R,Y)
Aggregate real money demand is a function of interest rates
and national income.
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Fig. 1: Aggregate Real Money Demand and the
Interest Rate
The downward sloping real
money demand schedule,
L(R,Y), shows that for a given
real income level, Y, real money
demand rises as the interest
rate falls.
Fig. 2: Effect on the Aggregate Real Money
Demand Schedule of a Rise in Real Income
An increase in real income
from Y1 to Y2 raises the
demand for real money
balances at every level of the
interest rate and causes the
demand schedule to shift
outward.
A Model of the Money Market
• The money market is in equilibrium when the
money supply set by the central bank equals
aggregate money demand.
• We examine how the interest rate is
determined by money market equilibrium,
given the price level and output, both of which
are temporarily assumed to be unaffected by
monetary changes.
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A Model of the Money Market (cont.)
• Equilibrium occurs when no shortages
(excess demand) or surpluses (excess
supply) of money exist:
Ms = Md
• Alternatively, equilibrium occurs when the
quantity of real money supplied equals the
quantity of real money demanded:
Ms/P = L(R,Y)
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A Model of the Money Market (cont.)
• Point 1 in Fig. 3 shows the equilibrium interest rate is
R1.
• Point 2 shows an interest rate R2 that is above R1.
• There is an excess supply of money and therefore an
excess demand for interest-paying assets like bonds.
• Individuals will attempt to reduce their liquidity by
using some money to buy interest-paying assets.
 E.g., Individuals buy bonds with cash or they lend out their
excess cash balances.
• The increased demand for interest-paying assets puts
pressure on the interest rate to fall.
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A Model of the Money Market (cont.)
• Alternatively, Point 3 shows an interest rate R3 that is
below R1.
• There is an excess demand for money and therefore
an excess supply of interest-paying assets like bonds.
• Individuals will attempt to increase their liquidity by
selling some interest-paying assets to acquire money.
 E.g., Individuals sell bonds for cash or they borrow to
increase their money holdings.
• The reduced demand for interest-paying assets puts
pressure on the interest rate to rise.
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Fig 3: Determination of the Equilibrium Interest
Rate
Point 1: equilibrium
Point 2: excess supply of money puts
pressure on interest rates to fall.
Point 3: excess demand for money
puts pressure on interest rates to rise.
A Model of the Money Market (cont.)
• In Fig. 4, the real money supply is increased because
the price level is given.
• Initially the money market is in equilibrium at point 1.
• The increased money supply temporarily creates an
excess supply of money (at point 1’) which causes
people to buy interest-paying assets.
• Interest rates are driven down to point 2 as individuals
buy bonds or lend money.
• 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.
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Fig 4: Effect of an Increase in the Money Supply
on the Interest Rate
1’
For a given price level, P,
and real income level, Y,
an increase in the money
supply from M1 to M2
reduces the interest rate
from R1 to R2.
A Model of the Money Market (cont.)
• In Fig. 5, an increase in output (holding MS and P
fixed) leads to an increase in aggregate real money
demand.
• Initially the money market is in equilibrium at point 1.
• The increased money demand temporarily creates an
excess demand for money (at point 1’) which causes
interest rates to rise (to point 2).
• An increase in real output raises the interest rate,
while a fall in real output lowers the interest rate,
given the price level and the money supply.
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Fig 5: Effect on the Interest Rate of a Rise in
Real Income
Given the real money
supply, a rise in real
income from Y1 to Y2 raises
the equilibrium interest rate
from R1 to R2.
Fig 6: Simultaneous Equilibrium in the U.S.
Money Market and the Foreign Exchange Market
The top diagram shows equilibrium in the
foreign exchange market.
The “return on dollar deposits” schedule
is the dollar interest rate, R1$, which is
determined in the money market (shown
in the bottom diagram).
The “expected return on euro deposits”
schedule has a negative slope because
a stronger dollar (↓ $/€ exchange rate),
given its unchanged expected future
level, makes euro deposits cheaper to
purchase today.
Point 1’ gives the equilibrium exchange
rate where interest parity holds.
Point 1 gives the equilibrium U.S.
interest rate.
Fig 7: Money Market/Exchange Rate Linkages
The Fed and ECB
determine the U.S. and
EU money supplies.
Given the P levels and
GNP of the two countries,
equilibrium in national
money markets leads to
the dollar and euro
interest rates.
These interest rates feed
into the foreign exchange
market where the current
exchange rate is
determined by interest
parity.
Fig 8: Effect on the $/€ Exchange Rate and Dollar
Interest Rate of an Increase in the U.S. MS
At point 1 and 1’ the U.S. money market and
foreign exchange market are in equilibrium.
An increase in the U.S. money supply creates
an excess supply of money which forces the
dollar interest rate down to a new equilibrium
(point 2).
Given the lower U.S. interest rate and the
current exchange rate (E1), the expected
return on euro deposits is greater than that on
dollar deposits. The dollar depreciates (to E2)
as holders of dollar deposits bid for euro
deposits.
The foreign exchange market reaches a new
equilibrium at point 2’.
Changes in the Domestic Money Supply
• An increase in a country’s money supply
causes interest rates to fall, rates of return on
domestic currency deposits to fall, and the
domestic currency to depreciate.
• A decrease in a country’s money supply
causes interest rates to rise, rates of return on
domestic currency deposits to rise, and the
domestic currency to appreciate.
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Changes in the Foreign Money Supply
• How would an increase in the supply of euros affect
the U.S. money market and foreign exchange
markets?
• An increase in the supply of euros reduces interest
rates in the EU, reducing the expected rate of return
on euro deposits.
• This reduction in the expected rate of return on euro
deposits causes the euro to depreciate.
• We predict no change in the U.S. money market due
to the change in the supply of euros.
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Fig 9: Effect of an Increase in the European
Money Supply on the $/€ Exchange Rate
At point 1 and 1’ the U.S. money market and
foreign exchange market are in equilibrium.
An increase in the European money supply
reduces the euro interest rate, which shifts the
“expected euro return” schedule inward.
Given the lower euro interest rate and the
current exchange rate (E1), the expected
return on dollar deposits is greater than that on
euro deposits. The euro depreciates (to E2) as
holders of euro deposits bid for dollar deposits.
The foreign exchange market reaches a new
equilibrium at point 2’.
The change in the European money supply
does not affect the U.S. money market.
Long Run and Short Run
• Our SR analysis of the link between countries’ money
markets and foreign exchange markets assumes that
price levels and exchange rate expectations were
given.
• We must now consider how monetary changes work
themselves out over the LR –when prices are
perfectly flexible and adjust to preserve full
employment.
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Long Run and Short Run (cont.)
• In the SR, prices do not have sufficient time to adjust
to market conditions.
 Our previous analysis has been a SR analysis.
• In the LR, prices of factors of production and of output
have sufficient time to adjust to market conditions.
 Wages adjust to the demand and supply of labor.
 Real output and income are determined by the amount of
workers and other factors of production—by the economy’s
productive capacity—not by the quantity of money supplied.
 (Real) interest rates depend on the supply of saved funds
and the demand for saved funds.
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Long Run and Short Run (cont.)
• In the LR, the quantity of money supplied
does not influence the amount of output, (real)
interest rates, and therefore the aggregate
real money demand, L(R,Y).
• However, the quantity of money supplied is
predicted to make the level of average prices
adjust proportionally in the LR.
 The equilibrium condition Ms/P = L(R,Y) shows that
P adjusts proportionally when Ms changes because
L(R,Y) does not change.
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Long Run and Short Run (cont.)
• E.g., a doubling of the money supply has the same
LR effect as a currency reform in which each unit of
“old currency” is replaced by two units of “new
currency.”
• If the economy is initially fully employed, every money
price eventually doubles, but real GNP, the (real)
interest rate, and all relative prices return to their LR
levels. Why?
• Full-employment GNP is determined by the
economy’s endowments of factors, so LR real output
does not depend on the money supply.
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Long Run and Short Run (cont.)
• The (real) interest rate is independent of the money
supply in the LR.
• If the money supply and all prices double
permanently, there is no reason why people
previously willing to borrow or lend at 10% would not
be willing to do so afterward.
• Relative prices also remain the same if all money
prices double.
• Thus, money supply changes do not change the LR
allocation of resources! Only the absolute value of
money prices change.
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Long Run and Short Run (cont.)
• A doubling of the U.S. money supply would cause the
$/€ exchange rate to double. So the U.S. dollar would
depreciate by 50% against the euro.
• A permanent increase in a country’s money supply
causes a proportional LR depreciation of its currency
against foreign currencies.
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Short-run Price Rigidity
• Our SR analysis has assumed that prices (unlike
exchange rates) do not change immediately. Why?
• Many prices (like wages) are written into long-term
contracts and cannot be changed immediately when
the money supply changes.
• Wages comprise 70% of production costs and
therefore strongly influence output prices.
• Output prices are “sticky” in the SR because wages
are “sticky” in the SR.
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Fig 10: Monthly Variability of the Exchange Rate
and of U.S./Japan Price Level Ratio, 1974–2007
The SR “stickiness” of
price levels is shown
here. Price levels
(influenced by sluggish
wages) are much less
volatile than exchange
rates.
Exchange rates are
influenced by interest
rates and expectations
which may change
rapidly.
Source: International Monetary Fund, International Financial Statistics
Money and Prices in the Long Run
•
Although price levels are sticky in the SR, an
increase in the money supply creates
immediate demand and cost pressures that
eventually lead to future increases in the
price level.
•
These pressures come from three main
sources.
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Money and Prices in the LR (cont.)
1.
Excess demand for output and labor: a higher
quantity of money supplied implies that people have
more funds available to pay for goods and services.

To meet high demand, producers hire more workers or
make existing employees work harder.

Wages rise to attract more workers or to compensate
workers for overtime.

Prices of output will eventually rise to compensate for
higher labor costs.
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Money and Prices in the LR (cont.)
2. Inflationary expectations:

If workers expect future prices to rise due to an increase in
the money supply, they will insist on higher wages.

And if producers expect the same, they are more willing to
raise wages.

Producers will be able to match higher wage costs if they
expect to raise output prices.

Result: if everyone expects the price level to rise in the
future, their expectations will increase the pace of inflation
today.
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Money and Prices in the LR (cont.)
3.
Raw materials prices:
•
Many raw materials (like oil and metals) used in the
production of goods are sold in markets where prices
adjust rapidly, even in the SR.
•
By causing the prices of such materials to jump upward, a
money supply increase raises production costs.
•
Eventually producers will raise output prices to cover their
higher materials costs.
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Money, Prices, Exchange Rates, and
Expectations
• We now apply our analysis of inflation to study the
adjustment of the $/€ exchange rate following a
permanent increase in the U.S. money supply.
• We begin our analysis by assuming that the economy
starts with all variables at their long-run levels and
that output remains constant as the economy adjusts
to the money supply increase.
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Money, Prices, and Exchange Rates in the
Long Run (cont.)
• Fig. 11 shows the SR and LR effects of an increase in
the U.S. money supply on the interest rate, price
level, and exchange rate.
• The LR interest rate is R1 (point 1).
• An increase in the MS at fixed prices (P1) leads to a
higher real MS and thereby a lower SR interest rate,
R2 (at point 2).
• The lower interest rate reduces the return on dollar
deposits which causes the exchange rate to
appreciate (i.e., the dollar depreciates) from E1 to E3
(point 1’ to point 3’).
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Money, Prices, and Exchange Rates in the
Long Run (cont.)
• So far we have repeated our earlier SR analysis
which held prices and exchange rate expectations
fixed.
• But people will now expect a LR increase in all dollar
prices (including the $/€ exchange rate).
• Recall that a rise in the expected future $/€ exchange
rate (i.e., a future euro appreciation) raises the
expected dollar return on euro deposits which shifts
the “expected euro return” schedule outward.
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Money, Prices, and Exchange Rates in the
Long Run (cont.)
• Notice that the dollar depreciation is greater (E1 to E2)
than it would be if the expected future exchange rate
stayed fixed (E1 to E3).
• If the expected exchange rate did not change, the
new SR equilibrium would be at point 3’ rather than
point 2’.
• Panel (b): the price level begins to rise from P1 to its
new LR level of P2.
• The real money supply has not changed in the LR
because the price level has risen in proportion to the
increase in the nominal money supply.
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Money, Prices, and Exchange Rates in the
Long Run (cont.)
• Since the real money supply has fallen to its initial
level, the equilibrium interest rate must increase to R1
in the LR (point 4).
• The dollar appreciates against the euro (from E2 to
E3) in this adjustment because the U.S. interest rate
has increased from R2 to R1.
• The LR equilibrium exchange rate is E3 at point 4’.
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Fig 11: SR and LR Effects of an Increase in the
U.S. Money Supply (Given Real Output, Y)
LR interest rate
E3$/€
LR interest rate
Money, Prices, and Exchange Rates in the
Long Run (cont.)
• A permanent increase in a country’s money supply
causes a proportional LR depreciation of its currency.
 However, the dynamics of the model predict a large
depreciation first and a smaller subsequent appreciation.
• A permanent decrease in a country’s money supply
causes a proportional LR appreciation of its currency.
 However, the dynamics of the model predict a large
appreciation first and a smaller subsequent depreciation.
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Money, Prices, and Exchange Rates in the
Long Run (cont.)
• Fig. 12 shows the time paths of U.S. economic
variables after a permanent increase in the U.S.
money supply.
• After the MS increases at t0 in panel (a), the interest
rate falls immediately to R2 but begins rising back to
its LR level (R1) as prices eventually rise from P1 to P2
which reduces the real MS.
• Panel (d) shows the initial jump in the exchange rate
from E1 to E2. The exchange rate overshoots in the
SR before settling at its LR level of E3.
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Fig 12: Time Paths of U.S. Economic Variables
After a Permanent Increase in the U.S. MS
Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its
LR response.
• Overshooting is predicted to occur when monetary
policy has an immediate effect on interest rates, but
not on prices and (expected) inflation.
• Overshooting helps explain why exchange rates are
so volatile.
• Overshooting is a direct consequence of the SR
rigidity of prices.
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Exchange Rate Overshooting (cont.)
• In a pretend world where the price level could adjust
immediately to its new LR level after a money supply
increase, the dollar interest rate would not fall
because prices would adjust immediately to stop the
real money supply from rising.
• There would be no need for overshooting to maintain
equilibrium in the foreign exchange market.
• The exchange rate would jump to its new LR
equilibrium immediately.
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