Chapter 3: Money, Interest Rates
and the Exchange Rate (Part 1)
(Chapter 15 of the textbook)
FACULTY OF INTERNATIONAL BUSINESS AND ECONOMICS
UNIVERSITY OF ECONOMICS AND BUSINESS, VNU
OBJECTIVE
To acquire and remember
the functions of money and
the determinants of the
money demand
To understand the effects of
money supply and demand
on the exchange rate in the
short-run
CONTENT
Money demand, money supply and the
equilibrium in the money market
The relation between money demand
and supply and the exchange rate in
the short-run
Money demand, money supply and the equilibrium in the
money market
Functions of Money- Money as a medium of exchange
• Money is a medium of exchange, and is generally accepted
as a means of payments
•In a barter economy, goods were directly traded. It would
take time and high cost to search for consumers or
producers who need the goods
•In modern economy, money is widely used as a medium of
exchange, thus reducing the transaction cost and
stimulating trade.
Money demand, money supply and the equilibrium in
the money market
Functions of Money- Money as a unit of account
•Money is widely recognized as a measure of value
•In modern economy, all prices are expressed in terms of
money.
•Quoting prices in terms of money makes it easy to compare
prices between commodities and countries
• Money prices denominated in different currencies can be
translated into comparable terms using the exchange rate.
Money demand, money supply and the equilibrium in
the money market
Functions of Money- Money as a store of value
• Since money is a widely recognized medium of exchange, it
has a purchasing power and can be used as a store of value
•Money is the most liquid asset since it can be transformed
into other goods and assets without transaction costs and
fees
•Money sets a standard against which the liquidity of other
assets is judged.
Money demand, money supply and the equilibrium in
the money market
Money supply
• The money supply can be defined in broad terms of narrow
terms
• In a narrow term (M1), the money supply consists of high
liquid assets widely used in daily transaction, that is cash and
checking deposit.
• In a broader term (M2), the money supply consists of M1
components and some less liquid assets such as term deposits
•The supply of money is controlled by the central bank
Money demand, money supply and the equilibrium in
the money market
Money demand
• The demand of money is the amount of money that
individuals and organizations wish to hold for daily
transactions
•The demand for money depends of three factors:
1) The expected return to money (relative to other assets)
2) The degree of risk
3) The liquidity
Money demand, money supply and the equilibrium in
the money market
Money demand- Expected return to money
• Currency and checking deposits pay no interest rates or
only low interest rates. Other assets with less liquidity offer
higher rates of return
•The opportunity cost of holding money is the rate of return
on other less liquid assets
•When the interest rate increases, the opportunity cost of
holding money rises and reduces the demand for money.
Money demand, money supply and the equilibrium in
the money market
Money demand- Degree of risk
• An increase in the prices of goods and services reduces the
purchasing power of money and poses a risk to the holding
of money.
•The inflation does not only reduce the value of money, but
also the value of assets denominated in the same currency
Money demand, money supply and the equilibrium in
the money market
Money demand- Liquidity
• Since money is high liquid assets that is held mainly for
daily transaction
•The demand for liquidity depends on the amounts of daily
transaction
•When the demand for daily transactions increases, people
want to keep for money and the demand for money
increases.
Money demand, money supply and the equilibrium in
the money market
Money demand- Aggregate money demand
• The aggregate demand for money is the sum of individual
demand for money by all households and firms in an
economy.
•The aggregate demand for money depends on three
factors:
1) The interest rate
2) The price level
3) Income
Money demand, money supply and the equilibrium in
the money market
Money demand- Aggregate money demand
The interest rate
• A higher interest rate reduces the individual demand for money and the aggregate
demand for money
The price level
• When inflation rates increases, people tend to spend money to purchase the same
amount of goods and services, thus raising the demand for money
Income
• The increase in income enhance the demand for goods and services, thus raising the
demand for money
Money demand, money supply and the equilibrium in
the money market
Money demand- Aggregate money demand
• The aggregate demand for money can be expressed as
follows:
Md = P*L(Y,R)
➢P denoted for the price level
➢Y is the real income
➢R is the interest rate
• The real aggregate demand for money can be written as
Md / P = L (Y,R)
➢L (Y,R) is the real aggregate demand for money
Money demand, money supply and the equilibrium in
the money market
Money demand- Aggregate money demand
Aggregate Real Money Demand and the Interest Rate
The downward sloping
real
money
demand
schedule shows that for a
given real income level Y,
real money demand rise
as interest rate decreases.
Money demand, money supply and the equilibrium in
the money market
Money demand- Aggregate money demand
Effect on the Aggregate Real Money Demand Schedule Rise in Real Income
An increase in real income
from Y1 to Y2 raises the
demand for real money
balance at every level of
the interest rates and
cause the whole demand
schedule to shift upward.
Money demand, money supply and the equilibrium in
the money market
Equilibrium in the money market
• The condition for equilibrium in the money market
1) MS = Md
2) MS / P = L (Y,R)
Money demand, money supply and the equilibrium in
the money market
Equilibrium in the money market
Determination of the Equilibrium Interest Rate
•
•
The interest rate the brings the
demand for money into the equality
with the supply of money is called as
the equilibrium interest rate
The interest rate tends to settle at
the equilibrium level
• The interest rate rises if there is
an excess demand for money
• It falls is there is excess supply of
money
Money demand, money supply and the equilibrium in
the money market
Equilibrium in the money market- Increase in the money supply
Effect of an Increase in the Money Supply on the Interest Rate
•
•
•
An increase in the money supply
cause the Ms schedule to shift right
At the initial interest rate R1 there is
an excess supply of money, putting
a downward pressure on the
interest rate
The new equilibrium in the money
market is at point 2 with lower
interest rate.
Money demand, money supply and the equilibrium in
the money market
Equilibrium in the money market- Increase in the real income
•
•
•
An increase in income or output
raises the demand for money ( L(R,Y)
schedule shifts upward)
At the initial interest rate R1, there is
an excess demand for money, putting
an upward pressure on the interest
rate
The new equilibrium in the money
market is at point 2 with higher
interest rate.
Effect on the interest rate of a rise in real income
Money demand, money supply and the equilibrium in
the money market
Equilibrium in the money market
Supply of money: an increase in the
supply of money creates an excess
supply and put a downward
pressure on the interest rate
Income: an increase in income or
output raises the demand for
money and put an upward pressure
on the interest rate
The equilibrium interest rate is affected by the
changes in the supply of money and income
The relation between money demand and supply and
the exchange rate in the short-run
The short-run and the long-run
In the
short-run
Prices and wage rate are sticky, and output may fall below
the full-employment level
In the
long-run
Long-run equilibrium is the position in which prices and wages
have enough time to adjust to their market-clearing levels
In the long-run, prices adjust in line with the money supply
and output is assumed at the full-employment level
The relation between money demand and supply and
the exchange rate in the short-run
Money, the interest rate and the exchange rate
• The change in money supply can affect the short-run
exchange rate through its effect on the interest rate
•The change in the money supply affects the equilibrium
interest rate in the money market (assume prices and
output remain unchanged)
•Given an expected exchange rate, the change in the
interest rate affects the exchange rate through the interest
parity condition.
The relation between money demand and supply and
the exchange rate in the short-run
Money and the exchange rate linkage in money market
The relation between money demand and supply and
the exchange rate in the short-run
Money and the exchange rate linkage in money market
Simultaneous equilibrium in the money market and foreign exchange market
The relation between money demand and supply and
the exchange rate in the short-run
Increase in the US Money Supply
An increase in the US Money Supply
• The expansion in the US money supply
creates an excess supply of money
and reduces the US interest rate
• The expected return on dollardenominated assets falls due to the
lower US interest rate and causes a
portfolio to shift toward eurodenominated assets
• The higher demand for Euro in turn
causes a depreciation of the US dollar
The relation between money demand and supply and
the exchange rate in the short-run
Increase in the the EU Money Supply
Increase in the EU money supply
• The expansion in the European money
supply creates an excess supply of money in
Europe and reduces the European interest
rate
• The lower European interest rate reduces
the expected return on euro-denominated
assets, thus lowering the demand for euro
and causing a depreciation of euro against
US dollar
• In summary, monetary expansion in a
foreign country will lead to an appreciation
of domestic currency