Ch. 14: Money, Interest
Rates, and Exchange Rates
1
The Outline
We learned that exchange rates depend
on interest rates on the deposits of
currencies and the expected future
exchange rate.
 What affects interest rates and
expectations is our next concern.

2
Money
Nominal interest rate in a country is closely
related to the supply and demand of money.
 Future price level in a country is closely
related to the supply and demand of money.
 Future prices of products affect the
expected exchange rate.
 Since supply and demand of money is so
influential in determining exchange rates, we
start with it.

3
What Is Money?
Money is anything that is accepted in a
society in return for goods and services
and settlements of debts.
 Money fulfills three functions.

Money is a unit of account.
 Money is a medium of exchange.
 Money is a store of value.

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What Is Money?
Currency and checking deposits fulfill all
three functions.
 Saving deposits are not a medium of
exchange, although the ease with which
they can be transferred to checking
deposits make them closer to money.
 For simplicity, we will define money as
currency plus demand deposits.

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Money Supply
The amount of money supplied to the
economy, therefore, depends on the
available currency outside of the banks
and the holdings of checking deposits.
 The Federal Reserve, the Central Bank
of US, controls the money supply by
manipulating the reserves available for
banks.

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Money Demand
Currency and demand deposits are
assets for holders.
 The theory of asset demand says three
factors determine the demand for an
asset.

Expected return of an asset compared to
returns from other assets.
 Riskiness of an asset’s returns.
 Liquidity of an asset.

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Expected Return



Currency has no return. In the absence of
inflation, $1 bill is worth the same a year from
now as today.
Checking deposits may or may not pay interest.
Typically, the interest paid is lower than saving
deposits or bonds. The difference in interest paid
between checking deposits and bonds is the
opportunity cost of holding money.
When interest rates rise, the opportunity cost of
holding money rises and people hold less money.

The demand for money falls.
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Riskiness
The riskiness of money is the
unexpected loss of its value due to
inflation.
 Bonds and saving accounts lose their
value with inflation, too.
 Inflation, therefore, will not change a
person’s portfolio between money and
bonds.

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Liquidity
In order to carry out purchases, people
need to hold an inventory of money.
 The higher the value of transactions a
person expects to conduct per period,
the higher is the demand for money.

10
Additional Variables for the
Demand for Money

Income of the individual


The higher the income, the higher is the
demand for money.
Price level

Likewise, the higher is the price level, the
higher is the demand for money.
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The Demand for Money
The demand for money will fall as
interest rates rise.
 The demand for money will rise as real
income rises.
 The demand for money will be
proportional to the price level, rising by
the same percentage.

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The Demand for Money
Md = P L(R,Y)
Md/P = L(R,Y)
Real money demand depends on interest rate
and real income.
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The Demand for Money
R
Increase in Y shifts demand
right.
M/P
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The Demand for Money
R
M/P
If R and Y are kept constant, any % increase in P has to be
matched by an equal % increase by M.
15
The Demand for Money
R
M/P
If R is allowed to change but Y is kept constant, any increase in
P will increase interest rates as well.
16
Equilibrium Interest Rate
What happens at R1?
R
Real Money Supply
R1
R0
Real Money
Demand
There is excess supply. People
want to hold less money. They
try to exchange their money for
interest bearing assets, like bonds.
Every one trying to buy bonds,
raises the price of bonds and
lowers the interest rate until
equilibrium is reached.
M/P
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Equilibrium Interest Rate
If there is excess real money supply,
interest rates fall.
 If there is excess real money demand,
interest rates rise.
 If income (output=Y) increases, interest
rates rise.
 If real money supply increases, interest
rates fall.

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Changes in the Money Supply
A decrease in the
money supply raises
the interest rate for a
given price level.
An increase in
the money supply
lowers the interest
rate for a given
price level.
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Changes in National Income
An increase in
national income
increases equilibrium
interest rates for a
given price level.
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Linking the Money Market to the
Foreign Exchange Market
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Interaction of Monetary Sector
and FX Market
R
R
R0
R1
R
M/P
$/€
E1
E0
Expected $ return
on euro deposits
Return in $
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Application
In each following case assume that
nothing else changes: ceteris paribus.
 What happens to USD exchange rate if
the Fed raises the interest rate?
 What happens to USD exchange rate if
US economy grows?

In both cases USD appreciates.
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Application

What happens to the exchange rate
between $ and €, if the ECB lowers the
interest rate?
If you said USD appreciates and € depreciates,
you were right.
How do you show this in the related
markets of money and FX?
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Interaction of Monetary Sector
and FX Market
R
R
R0
R
M/P
$/€
E0
E1
Expected $ return
on euro deposits
Return in $
27
Changes in the Foreign Money Supply

How would a change in the euro money supply
affect the US money market and foreign
exchange market?

An increase in the EU money supply causes a
depreciation of the euro (appreciation of
the dollar).

A decrease in the EU money supply causes an
appreciation of the euro (a depreciation of the
dollar).
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29
Short Run to Long Run
In the short run, both output (Y) and
price level (P) will remain constant.
 In the medium run, output will change
but price level will not.
 Long run is when the price level is
allowed for full adjustment.

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Long Run
The long run position of an economy is
when full employment is reached.
 Full employment in an economy occurs
when all markets clear and resources are
allocated efficiently.
 To have clearance in all markets means
prices and wages have adjusted fully.
 An economy with perfect flexibility in prices
and wages always operates in full
employment.

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Short Run
In the short run equilibrium in the
monetary sector happens with the
adjustment of interest rates.
 MS = M D
 M D = P L(Y,R)
 P and Y are constant in the short run.
 MS increase will have to be matched by
R decrease.

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Short Run
R
R1
R2
(M/P)
(M/P)’
M/P
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Medium Run
Lower interest rates spur more
investment activities by firms.
 As firms expand operations, income (Y)
increases.
 Higher Y pushes the demand for money
outward.
 Interest rates rise.

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Medium Run
R
R1
R3
R2
(M/P)
(M/P)’
M/P
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Long Run
In the long run, prices adjust to the higher
level of money supply.
 Long run is also characterized by actual
inflation being equal to expected inflation.
 In the long run, interest rates will be equal
to real interest rates plus actual inflation.
 As price level rises, real demand for
money will drop.

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Long Run
R
R1, R3
R2
(M/P)
(M/P)’
M/P
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Long Run
Real interest rates are determined by
the interaction of investments (demand
for loanable funds) and savings (supply
of loanable funds).
 Nominal interest rates are equal to real
interest rates in the absence of inflation.
 Income (Y) in the long run is determined
by available capital, labor, and
technology, all fully employed.

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Long Run
Changes in money supply will have no
effect on real variables in the long run.
 I=S will determine R.
 K, L, A will determine Y.
 Rate of increase of M will be exactly
matched by the rate of increase in P.

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Long Run and Short Run

In the long run, there is a direct relationship
between the inflation rate and changes in the
money supply.

Ms = P x L(R,Y)

P = Ms/L(R,Y)

P/P = Ms/Ms - L/L

The inflation rate equals growth rate in money supply
minus the growth rate for money demand.
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Money and Prices in the Long Run
1.
Excess demand: an increase in the money supply
implies that people have more funds available to pay
for goods and services.

To meet strong demand, producers hire more workers, creating
a strong demand for labor, 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
costs.

Alternatively, for a fixed amount of output and inputs, producers
can charge higher prices and still sell all of their output due to
the strong demand.
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Money and Prices in the Long Run
2.
Inflationary expectations:

If workers expect future prices to rise due to an
expected money supply increase, they will want
to be compensated.

And if producers expect the same, they are more
willing to raise wages.

Producers will be able to match higher costs if
they expect to raise prices.

Result: expectations about inflation caused by an
expected money supply increase leads to actual
inflation.
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Exchange Rate in the Long Run
When the amount of money doubles
under full employment, we expect the
price level to double, too.
 The price of foreign currency, therefore,
should double, too.
 If the price of euros were $1 per euro, it
will become $2 per euro.

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Money, Prices and the
Exchange Rates and Expectations

When we consider price changes in the long
run, inflationary expectations will have an effect
in the foreign exchange market.

Suppose that expectations about inflation
change as people change their minds, but actual
adjustment of prices occurs afterwards.
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Inflationary Expectations in the
Long Run
R
R
R0
M/P
If M and P grow at the same $/€
rate, M/P will remain constant.
However, inflation in the future E1
E0
should boost the expected
appreciation of euro. USD
depreciates.
R
Expected $ return
on euro deposits
Return in $
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Seeming Paradox
In the short run, money supply increase
lowers the interest rate and depreciates
the currency.
 An increase in the growth rate of money
increases inflationary expectations and
hence raises the nominal interest rate
(Fisher effect).



This raises the expected appreciation of
foreign currency and depreciates the spot
value of domestic currency.
An increase of money supply leads to
exchange rate overshooting.
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Short Run Effect of Money
Supply Increase in US
R
R
R0
R1
M/P
Increase of M in
US changes expectations
about future exchange
rates. Euro is expected
to appreciate.
R
$/€
E1
E0
Expected $ return
on euro deposits
Return in $
48
Long Run Effect of Money
Supply Increase in US
R
R
R0
R1
M/P
Price increases shift
M/P to the left. Higher
R in US appreciates
USD.
R
$/€
E1
E2
E0
Expected $ return
on euro deposits
Return in $
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Change in expected
return on euro deposits
The expected return on
euro deposits rises because
of inflationary expectations:
•The dollar is expected to
be less valuable when
buying goods and services
and less valuable when
buying euros.
•The dollar is expected to
depreciate, increasing the
return on deposits in euros.
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As prices increases,
the real money
supply decreases
and the domestic
interest rate returns
to its long run rate.
Original
(long run)
return
on dollar
deposits
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Money, Prices and the
Exchange Rates in the Long Run

A permanent increase in a country’s money supply
causes a proportional long run 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 long run appreciation of its
currency.

However, the dynamics of the model predict a large appreciation
first and a smaller subsequent depreciation.
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Overshooting

A permanent increase in M first
lowered R$
 raised E0 to E1


In time,
price level rose.
 R$ rose.
 E1 dropped to E2


Exchange rate overshooting refers to the
movement of E away from its long run
value.
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54
Exchange Rate Overshooting

The exchange rate is said to overshoot when its
immediate response to a change is greater than its
long run response.

We assume that changes in the money supply have
immediate effects on interest rates and exchange rates.

We assume that people change their expectations about
inflation immediately after a change in the money supply.

Overshooting helps explain why exchange rates are
so volatile.

Overshooting occurs in the model because prices do
not adjust quickly, but expectations about prices do.
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Exchange Rate Volatility
Changes in price
levels are less
volatile, suggesting
that price levels
change slowly.
Exchange rates are
influenced by
interest rates and
expectations, which
may change rapidly,
making exchange
rates volatile.
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