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International Econ II Chapter 2

MAY 2020.
⇰ After completing this chapter students are expected to understand the following:
 Money Market:
Money Demand,
Money Supply and
Interest Rate Determination
 Money and Exchange Rate in the Short Run
 Price and Exchange Rate in the Long Run:
To understand fully the determination of exchange rates we have to learn how interest rates
themselves are determined and how expectations of future exchange rates are formed. In the
subsequent lessons we examine these topics by building an economic model that links exchange
rates, interest rates, and other important macroeconomic variables such as the inflation rate and
The first step in building the model is to explain the effects of a country's money supply and of the
demand for its money on its interest rate and exchange rate. Because exchange rates are the relative
prices of national currencies, factors that affect a country's money supply or demand are among
the most powerful determinants of its exchange rate against foreign currencies. It is, therefore,
natural to begin a deeper study of exchange rate determination with a discussion of money supply
and money demand.
Monetary developments influence the exchange rate both by changing interest rates and by
changing people's expectations about future exchange rates. Expectations about future exchange
rates are closely connected with expectations about the future money prices of countries' products;
these price movements, in turn, depend on changes in money supply and demand. In examining
monetary influences on the exchange rate, we therefore look at how monetary factors influence
output prices along with interest rates.
Once the theories and determinants of money supply and demand are laid out, they can be used to
examine how equilibrium interest rates are determined by the equality of money supply and money
demand. Then we combine our model of interest rate determination with the interest parity
condition to study the effects of monetary shifts on the exchange rate, given the prices of goods
and services, the level of output, and market expectations about the future. Finally, we take a first
look at the long-term effects of monetary changes on output prices and expected future exchange
2.1. Brief Review of the Money Market
Money Demand, Money Supply and Interest Rate
Demand for Money
Money demand can be defined as the desire of individuals to hold it for the following functions it
Money as a Medium of Exchange: The most important function of money is to serve as a medium
of exchange, a generally accepted means of payment. It would be time-consuming for
people to purchase goods and services in a world where theonly type of trade possible was
barter trade—the trade of goods or services for other goods or services.
Money eliminates the enormous search costs connected with a barter system because itis
universally acceptable. A complex modern economy would cease functioningwithout
some standardized and convenient means of payment.
Money as a Unit of Account: money also functions as a unit of account, that is, as a widely
recognized measure of value. Prices of goods, services, and assets are typically expressed
in terms of money. Exchange rates help us to translate different countries' money prices
into comparable terms.
The convention of quoting prices in money terms simplifies economic calculations by
making it easy to compare the prices of different commodities.
Money as a Store of Value: Because money can be used to transfer purchasing power from the
present into the future, it is also an asset, or a store of value. Money's usefulness as a
medium of exchange automatically makes it the most liquid of all assets (i.e. it can be
transformed into goods and services rapidly and without high transaction costs).
Aggregate Money Demand
Aggregate money demand is the total demand for money by all households and firms in the
economy. It is just the sum of all the economy's individual money demands.
Three main factors determine aggregate money demand:
a) The interest rate: a rise in the interest rate causes each individual in the economy to reduce
their demand for money. All else equal, aggregate money demand falls when the interest rate
b) The price level: if the price level rises, individual households and firms must spend more
money than before to purchase the usual quantities of goods and services. To maintain the
same level of liquidity as before as the price levelincrease, individuals will therefore have to
hold more money.
c) Real national income: when real national income (GNP) rises, more goods andservices are
being sold in the economy. This increase in the real value of transactionsraises the demand for
money, given the price level.
Mathematically, therefore, the aggregate money demand can be expressed as:
= • ( , )
The equation above in the equivalent form is
= ( , ) … .aggregate real money demand
is desired money holdings measured in terms of a typical reference quantities of
commodities—the amount of purchasing power people would like to hold in liquid form.
Aggregate real money demand is affected by the interest rate for a fixed level of real income, Y.
The aggregate real money demand schedule L(R, Y) slopes downward because a fall in the interest
rate raises the desired real money holdings of each household and firm in the economy (refer to
the graph below, panel a)
Fig: 2.1 (a): Aggregate Real
Money Demand and the Interest
Fig 2.1 (b): Aggregate Real Money
Demand and Real Income, GNP
For a given level of real GNP, changes in interest rates cause movements along the L(R, Y)
schedule. Changes in real GNP, however, cause the schedule itself to shift (refer to the graph above
panel b)
Supply of Money
Currency and bank deposits on which checks may be written certainly qualify as money. These
are widely accepted means of payment that can be transferred between owners at low cost.
Households and firms hold currency and checking deposits as a convenient way of financing
routine transactions as they arise. Assets such as real estate do not qualify as money because, unlike
currency and checking deposits, they lack the essential property of liquidity.
When we speak of the money supply we are referring to the monetary aggregate the Central Bank
calls Ml, that is, the total amount of currency and checking deposits held by households and firms.
The large deposits traded by participants in the foreign exchange market are not considered as part
of the money supply. These deposits are less liquid than money and are not used to finance routine
Determination of Money Supply
An economy's money supply is controlled by its central bank. The central bank directly regulates
the amount of currency in existence and also has indirect control over the amount of checking
deposits issued by commercial banks. The procedures through which the central bank controls the
money supply are complex, and we assume for now that the central bank simply sets the size of
the money supply at the level it desires.
Equilibrium Interest Rate
The money market is in equilibrium when the money supply set by the central bank equals
aggregate money demand. And 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
… condition for money market equilibrium
By dividing both sides of this equality by the price level, we can express the money market
equilibrium condition in terms of aggregate real money demand as:
( , )
Fig 2.2: Determination of Equilibrium Interest Rate
Given the price level, P, and output, Y the equilibrium interest rate is the one at which aggregate
real money demand equals the real money supply.
Referring to Fig 2.2 above, the aggregate real money demand schedule intersects the real money
supply schedule at point 1 to give an equilibrium interest rate of R1. The money supply schedule
⁄ because
is vertical at
is set by the central bank while P is taken as given.
Once equilibrium is achieved the interest rate tends to settle at its equilibrium level. Consider the
following non-equilibrium cases:
At point 2 the demand for real money holdings falls short of the supply by Q1 – Q2, so there is an
excess supply of money. If individuals are holding more money than they desire given the interest
rate of R2, they will attempt to reduce their liquidity by using some money to purchase interestbearing assets. In other words, individuals will attempt to get rid of their excess money by lending
it to others. Since there is an aggregate excess supply of money at R2, however, not everyone can
succeed in doing this: there are more people who would like to lend money to reduce their liquidity
than there are people who would like to borrow it to increase theirs. Those who cannot unload their
extra money try to tempt potential borrowers by lowering the interest rate they charge for loans
below R2. The downward pressure on the interest rate continues until the rate reaches R1. At
R1anyone wishing to lend money can do so because the aggregate excess supply of money has
disappeared; that is, supply once again equals demand. Once the market reaches point 1, there is
therefore no further tendency for the interest rate to drop.
Similarly, if the interest rate is initially at a level R3 below R1, it will tend to rise. As can be seen
from the figure above, there is excess demand for money equal to Q2 – Q1 at point 3. Individuals
therefore attempt to sell interest-bearing assets such as bonds to increase their money holdings
(that is, they sell bonds for cash). At point 3, however, not everyone can succeed in selling enough
interest-bearing assets to satisfy his or her demand for money. Thus, people bid for money by
offering to borrow at progressively higher interest rates and push the interest rate upward toward
R1. Only when the market has reached point 1 and the excess demand for money has been
eliminated does the interest rate stop rising.
To sum up, the market always moves toward an interest rate at which the real money supply equals
aggregate real money demand. If there is initially an excess supply of money, the interest rate falls,
and if there is initially an excess demand, it rises.
Money Supply and Interest Rate
Consider the graph below:
Fig 2.3: Effect of Change in Money Supply on the Interest Rate
Initially the money market is in equilibrium at point 1, with a money supply Ml/P and an interest
rate R1. Where P held constant, a rise in the money supply to M2/P increases the real money supply
and point 2 is the new equilibrium and R2 is the new, lower interest rate that induces people to
hold the increased available real money supply.
When MS is increased by the central bank, there is initially an excess real supply of money at the
old equilibrium interest rate, R1, which previously balanced the market. Since people are holding
more money than they desire, they use their surplus funds to bid for assets that pay interest. The
economy as a whole cannot reduce its money holdings, so interest rates are driven down as
unwilling money holders compete to lend their excess cash balances. At point 2 in Figure 2.3
above, the interest rate has fallen sufficiently to induce an increase in real money demand equal to
the increase in the real money supply.
Similarly, we can also imagine how a reduction of the money supply forces interest rates upward.
A fall in MS causes an excess demand for money at the interest rate that previously balanced supply
and demand. People attempt to sell interest-bearing assets—that is, to borrow—to rebuild their
depleted real money holdings. Since they cannot all be successful when there is excess money
demand, the interest rate is pushed upward until everyone hold the smaller real money stock.
We conclude that an increase in the money supply lowers the interest rate, while a fall inthe money
supply raises the interest rate, given the price level and output.
Output and Interest Rate
Referring to Figure 2.4 below, it can be observed that an increase in output causes the entire
aggregate real money demand schedule to shift to the right, moving the equilibrium away from
point 1. At the initial equilibrium interest rate, R1, there is an excess demand for money equal to
Q2 — Q1 (point 1'). For a given real money supply, the interest rate is bid up until it reaches the
higher new equilibrium level R2 (point 2). A fall in output has opposite effects, causing the
aggregate real money demand schedule to shift to the left and therefore causing the equilibrium
interest rate to fall.
We conclude that 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.
Fig 2.4: Effect of Real Income on the Interest Rate
2.2. MoneySupply and Exchange Rate in the Short Run
In the preceding chapter we have seen that interest rate movements influence the exchange rate.
Again we know how shifts in a country's money supply affect the interest rate on non-money assets
and thus, we can link monetary changes and the exchange rate.
To analyze the relation between money and the exchange rate in the short run let’s combine two
diagrams as presented below.
Fig 2.5: Simultaneous Equilibrium in the Money Market and the Foreign-Exchange Market
The upper panel of figure 2.5 shows equilibrium in the foreign exchange market and how it is
determined given interest rates and expectations about future exchange rates. The dollar interest
rate, [ . .
which is determined in the money market, defines the vertical schedule.
The downward-sloping expected euro return graph shows the expected return on euro deposits,
measured in dollars. The graph slopes downward because of the effect of current exchange rate
changes on expectations of future depreciation: a strengthening of the dollar today (a fall in $ )
relative to its given expected future level makes euro deposits more attractive by leading people to
anticipate asharper dollar depreciation in the future.
At the intersection of the two schedules (point 1'), the expected rates of return on dollar and euro
deposits are equal, and therefore interest parity (i.e. how interest rate movements influence the
exchange rate) holds.
is the equilibrium exchange rate.
The bottom diagram shows how a country's equilibrium interest is determined in its money market.
For convenience, however, the figure has been rotated clockwise by 90 degrees so that dollar
interest rates are measured from 0 on the horizontal axis and the U.S. real money supply is
measured from 0 on the descending vertical axis. Money market equilibrium is shown at point 1,
where the dollar interest rate
money supply,
induces people to demand real balances equal to the U.S. real
Figure 2.5 emphasizes the link between the U.S. money market (bottom panel) and the foreign
exchange market (upper panel)—the U.S. money market determines the dollar interest rate, which
in turn affects the exchange rate that maintains interest parity.
The U.S. and European central banks determine the U.S. and European money supplies,
, respectively.Given the price levels and national incomes of the two countries,
equilibrium in national money markets leads to the dollar and euro interest rates R$ and R€. These
interest rates feed into the foreign exchange market where, given expectations about the future
dollar/euro exchange rate, the current rate $ is determined by the interest parity condition. This
is diagrammatically shown as follows:
European Central Bank
US Money Supply
Eurpean Money Supply
US Central Bank
US Money Market
Dollar Interest Rate
European Money Market
Foreign Exchange
[$/€ Exchange Rate]
Euro Interest Rate
Diagram 2.1: Money-Market/Exchange Rate Linkages
From the diagram above we can see that monetary policy actions by the US central bank (the
Federal Reserve) affect the dollar interestrate, changing the dollar/euroexchange rate that clears
theforeign exchange market. Similarly, the European (system of) central bank can also affect the
exchangerate by changing the Euromoney supply and interest rate.
2.3. The Price Levels and Exchange Rates in the Long Run
In the long run, national price levels play a key role in determining both interest rates and the
relative prices at which countries' products are traded. A theory of how national price levels
interact with exchange rates is thus central to understanding why exchange rates can change
dramatically over periods of several years. We begin our analysis by discussing thelaw of one
price (LOOP) and the theory of purchasing power parity (PPP), which explains movements in
the exchange rate between two countries' currencies by changes in the countries' price levels.
2.3.1. The Law of One Price (LOOP)
The law of one price states that in competitive markets free of transportation costs and official
barriers to trade (such as tariffs), identical goods sold in different countries must sell for the same
price when their prices are expressed in terms of the same currency.
 For example, if the dollar/Birr exchange rate is $1/Birr 25, a sweater that sells for $5 in New
York must sell for Birr 125 in Ethiopia. The dollar price of thesweater when sold in Ethiopia
is then Birr 125/Birr 25 = $5 persweater, the same as its price in New York.
 If now the Dollar/Birr exchange rate become $1/Birr 27, one could buy a sweater in Ethiopia
by converting $4.63 (= Birr 125/Birr27) into Birr 125 in the foreign exchange market. Thus,
the dollar price of a sweater in Ethiopia would be only $4.63. If the same sweater were selling
for $5 in New York, U.S. importers and Ethiopian exporters would have an incentive to buy
sweaters fromEthiopia and ship them to New York, pushing the Ethiopian price up and the
New York price down until prices were equal in the two countries.
 Similarly, at an exchange rate of $1/Birr 23, the dollar price of sweaters in Ethiopia would be
$5.43 (Birr 125/23), $0.43 more than in New York. Sweaters would be shipped from New
York to Addis Ababa until a single price prevailed in the two countries.
The law of one price is a restatement, in terms of currencies, of a principle that states when trade
is open and costless, identical goods must trade at the same relative prices regardless of where they
are sold.
As has been considered in the above scenario the law of one price provides one link between the
domestic prices of goods and exchange rates.
be the dollar price of good when sold at the New York,
bethe corresponding Birr price atAddis Ababa.
Then the law of one price implies that the dollar price of good is the same wherever it is sold.
Or equivalently, the dollar/Birr exchange rate,
, is the ratio of good 's U.S. and Addis Ababa
money prices. That is,
The Purchasing Power Parity (PPP)
The theory of purchasing power parity states that the exchange rate between two countries'
currencies equals the ratio of the countries' price levels.
It is to be recalled that the domestic purchasing power of a country's currency is reflected in the
country's price level, the money price of a reference basket of goods and services. The PPP theory,
therefore, predicts that a fall in a currency's domestic purchasing power (as indicated by an increase
in the domestic price level) will be associated with proportional currency depreciation in the
foreign exchange market. Symmetrically, PPP predicts that an increase in the currency's domestic
purchasing power will be associated with a proportional currency appreciation.
Economists popularizedPPP by making it the centerpiece of a theory of exchange rates. While
there hasbeen much controversyabout the general validity of PPPtheory, it highlights
importantfactors behind exchange rate movements.PPP theory can be symbolized as:
thedollar price of a reference commodity basket sold in the United States (at New
the pound price of the same commodity basket sold in Ethiopia (at Addis Ababa)
If, for example, the reference commodity basket costs $50 in the United States and Birr 1,350 in
Ethiopia, PPP predicts a dollar/Birr exchange rate of $1/Birr 27(= $50 per basket/Birr 1,350 per
basket). If the U.S. price level were to triple (to $150 per basket), the PPP would imply an exchange
rate of $1/Birr 9 (= $150 per basket/Birr 1,350 per basket).
Re-arrangement of the above expression can give:
From this one can conclude that these two prices are the same if PPP holds. PPP thus asserts that
all countries' price levels are equal when measured in terms of the same currency.
The Relationship between PPP and the Law of One Price
Though the PPP given by equation 2.3 looks like the law of one price given by equation 2.2, there
is a difference between PPP and the law of one price, however as explained hereunder:
 The LOOP applies to particularprice level (such as commodity i), while PPP applies to the
general price level, which is a composite of the prices of all the commodities that enter into the
reference basket.
 If LOOP holds true for every commodity, of course, PPP must hold automatically as long as
the reference baskets used to count different countries' price levels are the same. Proponents
of the PPP theory argue, however, that its validity (in particular, its validity as a long-run
theory) does not require the law of one price to hold exactly.
2.3.2. TheAbsolute Purchasing Power Parity
The absolute purchasing-power parity theory postulates that the equilibrium exchange rate
between two currencies is equal to the ratio of the price levels in the two nations. That is,
For instance, if the price of one sweater is $5 in New York and Birr 125 in Ethiopia, then the
exchange rate between the Dollar and the Birr should be $1/Birr 25. That is, according to the law
of one price, a given commodity should have the same price (so that the purchasing power of the
two currencies is at parity) in both countries when expressed in terms of the same currency.
One can consider when a dollar price of a sweater in Ethiopia decreased to $4.63 traders would
purchase sweater from Ethiopia and resell it in New York, at a profit. This commodityarbitrage
would cause the price of sweater to fall in New York and rise in Ethiopia until the prices were
equal in both economies. Commodity arbitrage thus operates just as does currency arbitrage in
equalizing commodity prices throughout the market.
However, this version of the PPP theory can be very misleading for the following reasons:
1st. First, it appears to give the exchange rate that equilibrates trade in goods and services while
completely disregarding the capital account. Thus, a nation experiencing capital outflows
would have a deficit in its balance of payments, while a nation receiving capital inflows
would have a surplus if the exchange rate were the one that equilibrated international trade
in goods and services.
2nd. This version of the PPP theory will not even give the exchange rate that equilibrates trade
in goods and services because of the existence of many non-traded goods and services.
Non-traded goods include products, such as cement and bricks, for which the cost of
transportation is too high for them to enter international trade, except perhaps in border
areas.Most services, including those of mechanics, hair stylists, family doctors, and many
others, also do not enter international trade (are non-traded services)
International trade tends to equalize the prices of traded goods and services among nations
but not the prices of non-traded goods and services. Since the general price level in each
nation includes both traded and non-traded commodities, and prices of the latter are not
equalized by international trade, the absolute PPP theory will not lead to the exchange rate
that equilibrates trade.
Thus, the absolute PPP theory cannot be taken too seriously. Whenever the purchasing-power
parity theory is used, it is usually in its relative formulation.
2.3.3. The Relative Purchasing Power Parity
The more refined relative purchasing-power parity theory postulates that the change in the
exchange rate over a period of time should be proportional to the relative change in the price levels
in the two nations over the same time period.
Mathematically, if we let the subscript 0 refer to the base period and the subscript 1 to a subsequent
period, the relative PPP theory postulates that
ER1 and ER0
P1 and P0
P1* and P0*
Exchange Rates in period 1 and in the base period
General Prices in period 1 and in the base period in the domestic
General Prices in period 1 and in the base period in the foreign economy
For example, if the general price level does not change in the foreign nation from the base period
to period 1 (i.e., P1* / P0* = 1), while the general price level in the home nation increases by 50%,
the relative PPP theory postulates that the exchange rate (defined as the home-currency price of a
unit of the foreign nation’s currency) should be 50% higher (i.e., the home nation’s currency should
depreciate by 50 percent) in period 1 as compared with the base period.
Note that if the absolute PPP held, the relative PPP would also hold, but when the relative PPP
holds, the absolute PPP need not hold. For example, while the very existence of capital flows,
transportation costs, other obstructions to the free flow of international trade, and government
intervention policies leads to the rejection of the absolute PPP, only a change in these would lead
the relative PPP theory wrong direction.
2.3.4. Flexible-Price Monetary Model of Exchange Rate
The monetary model states that the value of a currency is dependent on money supply, income
levels, interest rates, and inflation rate.
According to this model the domestic currency will depreciate following:
an increase in money supply,
decrease in income
- increase in the inflation level
And conversely, the domestic currency will appreciate when there is:
a decrease in money supply,
an increase in income
- a decrease in the inflation level
The model thus, tries to link the money supply with inflation and a argue that a stable monetary
policy help in increase in the value of domestic currency. And similarly, unstable monetary policy
results in a decrease in the value of domestic currency.
Assumptions of the model:
The PPP true, i.e. if domestic price rise (inflation), the currency fall in value and if domestic
price fall the value of the currency will rise.
This model tells that there is a proportional relation between money supply and exchange rate.
That is, increase in money supply leads to increase in exchange rate – depreciation of domestic
This model is the hybrid of the quantity theory of money (QTM) and PPP, both of which follow
the property of proportionality.
QTM states that an increase in money supply leads to a proportional increase in price and the PPP
theory states increase in price leads to a proportional increase in exchange rate.
The Flexible Price Monetary Model of Exchange Rate
This model states that the PPP is continuous or prices have an immediate interaction to economic
Exercise questions to the first & second chapters of international economics II
(On- line learning)
By: Mekonnen L.
May 2020
The exercise questions has three parts. Part I contains 5 True/false items, part II has 10 multiple
choices and there are three essay type items at the end.
Write true if the statement is correct and false if the statement is not correct.
1) Under fixed exchange rate regime the rise or fall in the value of currencies determined
through market force.
2) Increasing quantity of domestic currency to buy one more unit of foreign currency is
named as domestic currency appreciation.
3) If the value of birr is increased against dollar then dollar is said to be depreciated.
4) Domestic inflation will make domestic currency to appreciate in foreign exchange
5) Other factors kept constant increase in income of real income of domestic consumers
will shift the currency demand schedule inward.
Choose the correct answer from the given alternatives under each item.
6) The foreign currency exchange supply curve is upward sloping because:
A) Domestic goods became cheaper to foreign consumers as dollar appreciates.
B) Domestic goods became expensive to foreign consumers as dollar appreciates.
C) Supply of foreign currency increases to consume more of domestic goods as
dollar appreciates.
D) All except B
E) None
7) If the prevailing exchange rate is high and speculators believe that it will be higher in
the future, their current action & the role they played
A) Purchase of foreign currency & stabilizing effect.
B) Selling of foreign currency & destabilizing effect.
C) Purchase of foreign currency & destabilizing effect.
D) Selling of foreign currency & stabilizing effect.
E) None
8) What will happen to the foreign currency supply curve if, domestic goods lost its
preference in the foreign market?
A) The curve shifts outward.
B) The curve shifts inward.
C) The curve remains unchanged.
D) Unpredictable.
E) None
9) The following factors have similar effect on aggregate money demand except one.
Which one is it?
A) Rise in interest rate.
C) Rise in general price.
B) Rise in real national income.
D) None.
10) The downward slopping aggregate money demand curve indicates that:
A) People are demanding to hold more money as interest rate falls.
B) People are demanding to hold more money as general price rises.
C) People are demanding to hold more money as real national income grows.
D) All
E) None
11) The effect of increasing real money supply on interest rate for the market once at
equilibrium is:
A) Increases market interest rate.
C) Interest rate not affected.
B) Decreases market interest rate.
D) None
12) Identify the impact of increasing real national income demand schedule for money &
market interest rate.
A) The demand schedule shifts outward & interest rate rises.
B) The demand schedule shifts inward & interest rate rises.
C) The demand schedule shifts outward & interest rate falls.
D) The demand schedule shifts inward & interest rate falls.
E) None
13) According to flexible price monetary model of exchange rate all of the following
results in currency depreciation except:
A) An increase in money supply
C) A decrease in real national income
B) An increase in general price
D) an increase in real national income
14) If the prevailing exchange rate is low and speculators believe that it will be higher in
the future, their current action & the role they played
A) Purchase of foreign currency & stabilizing effect.
B) Selling of foreign currency & destabilizing effect.
C) Purchase of foreign currency & destabilizing effect.
D) Selling of foreign currency & stabilizing effect.
E) None
15) Which of the followings is correct about law of one price & purchasing power party?
A) Low of one price applies to particular price level.
B) Purchasing power party applies to general price level.
C) Low of one price holds true for every commodity.
D) Purchasing power party holds true for a given basket of commodities.
E) All
Briefly describe the following questions by focusing on very important points
not each & every details.
16) Define what mean by low of one price and clearly show how exchange rate came back
to the prevailing exchange when there is a tendency of variation from it. Use examples
to explain.
17) Explain how money market has come back to equilibrium when there is a tendency of
variation from equilibrium interest rate. Use a graph to explain it.
18) List out the major participants in foreign exchange market & briefly describe their
roles in the market.