Chapter 15
Money, Interest
Rates, and
Exchange Rates
November 2011
Preview
• What is money?
• The supply of money
• The demand for money
• Equilibrium in the money market
15-2
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

The value of all checking accounts
• 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
15-3
What Is Money? No Return
• We can classify all assets into:
 Money, which earns no return
• Currency with the public, checking accounts
 Assets that earn a return
• Stocks, bonds, real estate, etc.
15-4
What Is Money? High Liquidity
• 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
15-5
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 System.

The Federal Reserve directly regulates the amount of
currency in circulation.

It indirectly controls the amount of checking deposits issued
by private banks.
15-6
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
return).
• What influences our willingness to hold money?
15-7
What Influences Aggregate
Demand for Money?
1. Interest rates: money pays little or no interest. So,
the interest rate on non-money 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.
2. Prices: the prices of goods and services bought in
transactions will influence the willingness to hold
money to conduct those transactions.

A higher price level means a greater need for liquidity to
buy the same amount of goods and services  higher
money demand.
15-9
What Influences Aggregate
Demand for Money? (cont.)
3. 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.
14-10
A Model of Aggregate Money Demand
The aggregate demand for money can be expressed by:
Md = P x L(R,Y)
(15-1)
where:
P is the price level
Y is real national income
R is the interest rate
L(R,Y) is the aggregate real money demand (Md/P)
15-11
Functional Notation
• L is the real aggregate demand for money (Md/P)
• L(R,Y) is a concise mathematical way of saying “L
depends on R and Y.”

Some people say, “L is a function of R and Y.” This is why
L(R,Y) is said to be an instance of functional notation.
• If Y is constant, L and R are inversely related: when
one increases the other decreases
• If R is constant, L and Y are directly related: when one
increases so does the other
15-12
A Model of Aggregate Money Demand
From Md = P x L(R,Y)
we get
Md/P = L(R,Y)
(15-2)
This is the aggregate real money demand. It is
directly related to GNP and inversely related to
the interest rate.
15-13
A Model of Aggregate Money Demand
•
15-14
Fig. 15-1: Aggregate Real Money
Demand and the Interest Rate
For a given level of
income, real money
demand (Md/P)
decreases
as the interest rate
increases.
14-15
Fig. 15-2: Effect on the Aggregate Real
Money Demand Schedule of a Rise in Real
Income
When income
increases, real money
demand increases at
every interest rate.
15-16
The Money Market
• Equilibrium in the money market requires:
Ms = Md
(15-3)
• Alternatively, equilibrium requires the supply of real
money be equal to the demand for real money (by
dividing both sides by the price level):
Ms/P = L(R,Y)
(15-4)
15-17
Fig. 15-3: Determination of the
Equilibrium Interest Rate
s
M
 L ( R, Y )
P
15-18
Two markets: foreign exchange and money
• So far, we have seen the equilibrium conditions
for the two asset markets
 The foreign exchange market, and
 The money market
RR 
*
E
s
e
E
1
M
 L ( R, Y )
P
15-19
What’s next?
• Next, we will look at the equilibrium equation
for the goods market
• Read chapter 17, up to the section “How
Output is Determined in the Short Run”
• In that chapter, the two equations in the
previous slide are used to derive a link,
between the exchange rate (E) and output (Y),
called the AA curve.
15-20