Money, Interest Rates, and the Exchange Rate.
A. INTRODUCTION.
B. MONEY DEFINED: A REVIEW.
1. Note the book’s distinction: what it is (hard to define), what
it does (easier to define).
2. Earlier, we had the definition: M = C + D. But that’s no
definition: M is part C and part D? It’s not even always true.
3. So, money is a stock of things that the people in the economy
use to make exchanges work more smoothly. Metals: gold &
silver emerged early. But the people have to agree, at least
implicitly, that some “thing” is acceptable. Unopened packs
of cigarettes and bottles of brandy in post WWII Germany.
4. What does it do?
a. Medium of exchange.
b. Unit of account.
c. Store of value.
C. THE SUPPLY OF MONEY. The total amount of money in an
economy. But we just barely know what money is!
1. Narrow money: M1 = C + D, where D = demand deposits.
Narrow money is immediately spendable, therefore
acceptable, in most transactions. Nonsense: you can’t spend
too many coins, nor are checks uniformly accepted. Checks
are a big deal in USA, but are not widely used in Japan or
Europe. Vive la difference!
2. Near monies: savings accounts, time deposits & short-term
government securities. It takes very little time, but not zero
time, to transform these assets into M1.
3. Broad money: M2 = M1 + near monies. Note that near
monies store value; they do some things that money is
supposed to do.
4. Not-so-near monies: stocks, real estate, other real assets,
many large accounts, etc. They store value too. However, it
takes lots more time, risk and effort to transform these assets
into M1.
5. In several years, after you have become fabulously successful
in business, you decide to buy Microsoft (think big!). How do
you pay for that transaction?
6. Monetary base = B = H = high-powered money. It is equal to
C + R. No difference except in name.
7. Money multiplier. First, note that r = R/D, the latter being
my notation in MoneyMatters. However, the book ignores
C/D, where k = C/D. The money multiplier here is therefore
larger than that resulting from 10.40.
8. Tools of monetary policy: how can the central bank alters the
money supply?
a. Discount rate changes: the discount rate is the interest
rate banks pay the FED to borrow reserves. Banks
borrow more at lower discount rates than at higher.
Borrowed reserves are just as good as other reserves:
more borrowing => B is up and so is M, by an uncertain
amount. [Note that this interest rate (in addition to a
closely related rate called the Federal Funds rate, to be
discussed later) are the rates, and the only rates, that
Greenspan and his Board of Governors can and do
change in those highly publicized announcements.
b. Reserve requirement changes (r): If r is reduced, some
currently existing reserves become excess reserves and
can back additional lending (M rises & the money
multiplier rises). If r is increased, currently existing
reserves are insufficient and current lending rates &
loans outstanding must be reduced (M falls & the
money multiplier falls). The money multiplier rises &
falls with or without the addition of k in the formula.
c. Open market operations (OMOs): These operations are
the best, most flexible and least understood of the tools.
They also depend on the existence of a large & active
market for suitable bonds. In this operation, the FED
purchases (or sells) bonds in the open market. They pay
for these bonds, or are paid, with B or H. In an
expansion, the FED buys bonds from the commercial
banks (R rises) or from households/firms (C rises).
d. When G’span & the BOGs (OK, Greenspan and the
Board of Governors, or the controlling group of any
central bank) announce an increase in interest rates,
they mean they have increased the discount rate, but
they have also sold bonds in an OMO. The rate change
is easy to understand; the OMO is not. Think about it
and fire questions at me; this is an important point.
e. In section 5, while I rambled on about Europe, a
student asked about the European Central Bank (ECB)
and its ability to do OMOs. For the FED it is easy: there
is a huge market for securities, highly substitutable
because of identical risk factors, and denominated only
in one currency, the dollar. But the Euro system is new.
The existing bond markets contain DM bonds, FF
bonds, etc. Until all of those bonds are completely
redeemed, and replaced by a wholly new set of
Eurobonds, the ECB must buy & sell according to a
formula linking all the currencies in exact ratios. The
risk factors are not, however, identical or linked, so the
bonds are not perfect substitutes in the markets.
D. THE DEMAND FOR MONEY
1. You already hold some assets, including money, clothes,
electronic equipment, etc. But let’s look at a typical
established household or firm. The portfolio of assets would
include, for example:
a. Money.
b. Near-monies.
c. Less negotiable financial assets (stocks, insurance,
etc.).
d. Automobiles, furniture, etc.
e. Real estate, gold, etc.
f. Other assets.
Note that money is highly substitutable for GDP items: food
and other goods & services, but that the other assets are not.
With a given level of total wealth, more money in your
portfolio means less of something else. Your demand for
money, like your demand for anything else, involves a sacrifice
or opportunity cost in terms of other assets or goods. Portfolio
management features growth, but it also features
rearrangement of content to maximize advantages.
2. The demand for money is determined by
a. Interest rates.
b. The price level.
c. Income.
3. That’s not enough to explain very much. Let’s go back over
it. The demand for money is determined by
a. Interest rates. Above I mentioned substitutability
between assets. The interest rate is related mostly to
near-monies, like securities. A good interest rate makes
securities attractive relative to money. Why hold low or
no interest money if you can earn interest on bonds?
Sure, transaction costs are important, but a high
interest rate may make them seem trivial. Similarly, a
low interest rate makes money seem more attractive:
not much foregone interest, but the convenience of
immediately spendable money is attractive too.
But there is another motive working here. Securities are
attractive for two reasons: the expected flow of interest
income and the possibility of capital gain if the
securities’ prices rise. Securities are strange animals,
but tamed they become very useful. Securities, to
simplify, have a face value, say, $25. If you buy one
brand new, you won’t get that $25 for, say, 7 years.
Mathematically, if you pay about $12.50 now, the
interest rate is about 10%. Trust me: a 10% growth
rate causes anything to double in about 7 years. If you
pay $6.25 now, the interest rate is slightly above 20%. If
you pay face value of $25, the interest rate is zero. To
generalize, a high price means a low rate of interest, and
vice-versa. But high prices are attractive only to sellers.
Moreover, a high price means little probability of
capital gain: high prices in free markets are more likely
to fall than rise. Holders want to sell, but buyers don’t
want to buy. On the other hand, a low price has more
promise of capital gains. So, when interest rates are
high and security prices are low, portfolio managers
(that’s all of us) are willing to sacrifice the convenience
of money for the income earning promise of nearmonies: the demand for money is relatively low. The
reverse is also true. This is what is known as the
speculative demand for money. Sure is easy to say, but
difficult to carry out in practice. Ouch! Not easy, is it?
b. The price level. What did your book say? That the
demand for money is directly related to the price level.
True, but let’s be more sophisticated. That statement is
purely static. Double all prices and all transactions will
require twice as much money. So, cash balances will be
twice as large. OK without inflation or deflation, but if
prices have been rising, do you really want to tie up the
liquid end of your portfolio with a lot of value losing
dollar bills? You need some for all necessary
transactions (the transactions demand for money), and
you probably want to squirrel away some more
(precautionary demand for money) for life’s
unavoidable trials & tribulations (of which inflation is
certainly a painful one), but durable goods, gold & real
estate are going to gain value as money loses it. So you
will cut back on money holding to the extent possible.
But, can you be sure that inflation will continue at
present rates? No, but you can guess, or formulate
expectations, and that is exactly what people do. I keep
haranguing you on how you come to class & read this
material because you expect to learn something that will
one day be profitable. In sum, the demand for money is
dependent on the price level, if it is constant, and on
expected inflation if it is not.
c. Income. Sorry, this is not so easy either. Current
measured or received income tends to fluctuate. Some
people receive high income today and low income
tomorrow, depending on market conditions or on who is
paying the bills, when. So, income should be interpreted
as a long-run average, rather than what the tables
currently show. More accurately, we know that people
at different ages, elderly, young, middle age, have
differing motives. They are said to be on a life-cycle
curve, meaning roughly predictable but changing
relative demands for goods, services, assets, real estate,
money, near-monies, etc. If all that is so, imagine what
may be happening to the demand for money in Japan
where unusual proportions of people are becoming
elderly. Another theory posits an expected average
income, “permanent income” as the ruling force. The
authors of both theories won Nobel Prizes, so we can be
sure they spent a lot of effort demonstrating a close
relationship between their ideas and reality. Once
again, using measured current income, which can be
obtained from national statistics, often replaces
permanent or life-cycle income in discussions, because it
is easier and not always inaccurate.
4. The equilibrium interest rate: the interaction of money
supply and money demand
a. The supply of money is given as a vertical curve that is
inelastic with respect to the interest rate. This is good
enough for our purposes
b. The demand for money, with the interest rate on the
vertical axis, is downward sloping
c. The authors make no special assumptions as to the
elasticities of those curves. That’s OK for now. We may
want to add assumptions in later analysis. For example,
Paul Krugman as a Keynesian economist might want to
assume high elasticity (flat curve). An economist closer
to the monetarist school would want a steeper, low
elasticity curve. I’ll let you guess where my sympathies
lie.
d. Now, be very careful in interpreting x and the first full
paragraph on. They are correct in a static sense: price
level differences determine different demand curves as
shown. But in the more dynamic (realistic) sense with
inflation and expected inflation, rising prices push the
demand curve in the opposite direction. Ouch again!
Let’s talk about this in class; and fire away with
questions. A lot has to do with the real and nominal
quantity of money.
e. Finally, there is an animal known as “liquidity
preference,” a synonym for demand for money.
Remember the portfolio: increasing liquidity preference
means shifting demand from all else and to money
itself; decreasing liquidity preference means the
opposite movement. Krugman speaks of the black hole
of monetary economics: the liquidity preference trap.
But when this animal is trapped, everybody hurts. More
later.
E. THE INTEREST RATE AND THE EXCHANGE RATE IN THE
SHORT RUN.
1. Interest arbitrage.
a. Let’s start with a note of concrete reality. The dollar
bought 360 yen in 1971. It buys about 112 now. Get out
your calculators or computers; that means the dollar
depreciated about 4% per year, with lots of fluctuation,
for that period. That is a powerful track record that
many market participants believe will continue, also
with fluctuation. That is a given: the dollar is expected
to depreciate by 4%; the yen is expected to appreciate
by 4%. Does anybody have any better information? But
think about it. If you expect the dollar to depreciate,
what would make you willing to buy dollar
denominated securities?
b. Given that historical fact, let’s assume that the interest
rate in the United States is 5%; we should therefore
expect the interest rate in Japan to be about 1%. Aren’t
these two numbers fairly close to accurate? Maybe
that’s what would induce you to hold dollars. Why not?
c. Remember, there is rapid and easy capital mobility and
both US & Japanese markets are relatively free from
influences other than supply and demand. Risk factors
may be somewhat different, but we can ignore them
without much inaccuracy.
d. The law of one price should prevail: the interest rates
on equivalent Japanese and US securities should be
equal. But they differ at 1% & 5%.
e. From the US perspective, suppose we have a wad of
dollars valued at 100 currency units. If we buy US
securities, we will end up with 105 units next year.
f. But now let’s buy Japanese securities. First we buy
Japanese currency, say 100 units there too. Then we
buy Japanese securities which accrue interest giving us
101 units next year.
g. But, if our expectations are correct, the exchange rate
will have changed such that the Japanese currency has
4% more purchasing power over the dollar. Hence, the
101 units will buy approximately 105 units of US
currency. We gain 5% either way. If it isn’t true, supply
and demand will make it so.
h. From the Japanese perspective, take 100 units of their
currency and end up with 101 units next year. Or, buy
100 units of US currency now, invest it at 5% and end
up with 105 units of US currency next year. But that
105 will have lost about 4% in value, so it buys only 101
units of Japanese currency at the end of the year.
i. This was based on expectations; we can’t be sure it will
happen. It ain’t over ‘til it’s over. But markets respond
to such phenomena. If the expected 4% is widespread, it
will be possible to buy a forward contract that locks in
the 4% depreciation. Of course someone out there must
be willing to sell you that contract and take on the risk,
expecting to be able to profit from it.
j. But these are just nominal interest rates. Suppose
inflation in the US is expected to be about 2%. This
would reduce the real value of the US interest rate from
5% to 3%. Japan is undergoing deflation at about 2%;
prices are falling at about that rate. This increases the
real rate of interest from 1% to about 3%.
k. Real rates are equal! The law of one real price! These
numbers are all approximate, but aren’t they all
approximately accurate?
2. Interest rates, the exchange rate, and the balance of
payments.
a. The quotation refers to the period 1980 -1985, during
which the dollar rose from about ¥140 to a peak of ¥250.
The FED initiated an inflation fighting tight monetary
policy (in our simplified analysis, the supply of money
fell), interest rates, real and nominal, soared, and net
capital inflows soared as well.
b. This interest rate increase induced the major rise in
capital inflows as well as the major increase in the value
of the dollar. Tokyo was bargain city!
c. Because the capital account surplus was so much
higher, the current account deficit was correspondingly
larger. Expensive dollar => noncompetitive exports;
cheap yen => very competitive imports.
d. But what about right now? The US CA deficit and the
Japanese CA surplus are soaring again. Now the cause
is strongly related to income. US income is rising =>
imports rise; Japanese and other incomes are stagnate
or falling => US exports (their imports) fall.
e. But even more important is that US markets are
currently the best for investment. The capital account
surplus is bigger than ever. Similarly, Japan & Europe
are not good places for investment; so they contribute to
our capital account surplus & current account deficit.