Money, Interest Rates, and
Exchange Rates

• What is money?
• Control of the supply of money
• The demand for money
• A model of real money balances +interest rates
• A model of real money balances +interest rates
+exchange rates
• Long run effects of changes in money on prices, interest rates and exchange rates
2

• Money is an asset that is widely used and accepted as a means of payment.
– Our definition of Money: Currency + checking accounts (bank deposits in the FX market excluded from this definition).
• Characteristics of money (M)
– very liquid : it can be easily and quickly used to pay for goods and services.
– pays little or no rate of return .
• Group assets into money (liquid assets) and all other assets
(illiquid or less liquid assets).
– All other assets are less liquid but pay a higher return
3

• Money Supply (MS)= the quantity of money that circulates in an economy.
• Central banks determine the money supply.
– In the US: 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.
4

Money Demand
• Money demand = the amount of assets that people are willing to hold as money (instead of illiquid assets).
• What influences individuals’ willingness to hold money?
– Expected returns/interest rate on money relative to the expected returns on other assets.
– Risk : from unexpected inflation, which unexpectedly reduces the purchasing power of money. But many other assets have this risk too, so this risk is not very important in money demand.
– Liquidity : A need for greater liquidity occurs when either the price of transactions (P) increases or the quantity of goods bought in transactions increases.
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1. Interest rates : ↑R then ↓MD
Why?
money pays little or no interest, so R is the opportunity cost of holding money instead of other assets, like bonds, which have a higher expected return/interest rate, R.
2. Prices : ↑ P then ↑ MD
Why? higher price level means a greater need for liquidity to buy the same amount of goods and services
 higher money demand.
3. Income : ↑ Y then ↑ MD
Why?
greater income implies more goods and services can be bought, so that more money is needed to conduct transactions.
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The aggregate demand for money can be expressed by:
M d = P x L ( R,Y ) where:
P is the price level
Y is real national income
R is a measure of interest rates
L ( R,Y ) is the aggregate real money demand
Or: M d /P = L ( R,Y )
Aggregate real money demand is a function of Y and R.
Real MD {is negatively related to R.
{shifts with a change in P or Y
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For a given level of income, real money demand decreases as the interest rate increases.
8

(cont.)
When income increases, real money demand increases at every interest rate.
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• The condition for equilibrium in the money market is: M s = M d
Using the supply of real money and the demand for real money (by dividing both sides by the price level):
M s /P = L ( R,Y )
• This equilibrium condition will yield an equilibrium interest rate, R.
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• XS of money → XD for interest bearing assets (bonds).
– People with an excess supply of money are willing to acquire bonds by selling their supply of money at a lower R.
– Potential money holders are more willing to hold additional quantities of M as R (the opportunity cost of holding M) falls.
• XD for money → XS of interest bearing assets.
– People who desire money but do not have access to it are willing to sell assets with a higher R in return for the money balances that they desire.
– Those with money balances are more willing to give them up in return for interest bearing assets as the R on these assets rises and as the opportunity cost of holding money (the interest rate) rises.
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• R2: XS of M (liquidity).
Purchases of bonds, price of bonds P b
↑, R↓, opportunity cost of M lower, hence L, M demand, starts to ↑ (move down along the L curve), and
XS of M ↓ until we reach R1
• R3: XD for M (shortage of liquidity). Sell bonds, price of bonds P b
↓, R ↑, opportunity cost of holding M rises, L starts to ↓ (move up along the curve),
XD for M ↓.
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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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An increase in national income increases equilibrium interest rates for a given price level.
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Linking the Money Market to the FX Market
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Linking the Money Market to the FX Market
Interest rate, R
Aggregate real money supply
R 1
Aggregate real money demand,
L(R,Y)
M S
P
Real money holdings
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Effect on the Dollar/Euro ER and the $R of a Rise in the U.S. MS
E
$/ €
E 2
$/ €
E 1
$/
€
0
M 1
US
P
US
M 2
US
P
US
U.S. real money holdings
Return on $ deposits
2'
1'
R 2
$
R 1
$
Expected return on euro deposits
Rates of return
(in $ terms)
L(R
$
, Y
US
)
U.S. real MS
Increase in U.S.real MS
1
2
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• An increase in the EU MS ↓ interest rates in the
EU → ↓ the expected return on euro deposits
→ depreciation of €: E↓ ($ appreciates)
• A decrease in the EU MS ↑ interest rates in the
EU → ↑ the expected return on euro deposits
→ appreciation of €: E↑ ($ depreciates).
• The change in the EU MS does not change the
US money market equilibrium.
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E 1
$/ €
E 2
$/ €
0
M S
US
P
US
Effect of an Increase in European MS on th$/Euro Exchange Rate
E
$/ €
↑EU MS reduces expected return on EU deposits→$ appreciates, eq’m in FX market shifts from 1’ to 2’, eq’m in MM doesn’t change.
$ return
1'
2'
Increase in European MS
Expected euro return
L(R
$
, Y
US
)
U.S. real MS
Rates of return
(in d o llar terms)
1
R 1
$
U.S. real money holdings
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• In the short run , the price level is fixed at some level.
– the analysis heretofore has been a short run analysis.
• In the long run , price of output (P), price of factors of production (ex. wages) and interest rates have adjusted to eliminate XD or XS and bring Y to its full employment level Y
FE
.
– R is also fixed and independent of MS (depends on the supply and demand of saving in the economy and the inflation rate).
** In the LR, the level of the MS does not influence the amount of real output nor the interest rate **
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Long Run (LR) and Short Run (SR)
In the LR prices a djust proportionally to changes in the MS
P = M s / L ( R* , Y
FE
)
Since R* and Y
FE do not change as M s changes, then neither does L (.). Hence, P must respond one-forone to permanent changes in M s in the LR. In other words, the inflation rate (the rate of increase of prices) should equal the growth rate of money in the LR

P / P =

M s / M s .
This is called longrun “neutrality of money
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How does a rise in money supply lead to an increase in the price level?
By creating pressure on prices through 3 main channels:
– it creates demand for output and labor;
– it creates demand for commodities and other raw materials;
– it raises inflationary expectations, which affect current prices (If workers expect future prices to ↑ due to an expected
MS ↑, they will want higher wages to be compensated. To match higher costs, producers will raise prices.
Empirically, long-term changes in money supplies and price levels show a positive correlation:
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– If a permanent ↑ in a country’s MS causes a proportional LR ↑ in P, it is intuitive that it should cause a LR depreciation of the currency:
• High inflation countries tend to exhibit depreciating
(‘weaker’) currencies.
• The depreciation is necessary to keep prices measured in a common currency in line across countries (this is the theory of Purchasing Power
Parity discussed in the next chapter).
– Therefore, when studying the E.R. effects of a change in MS, we must consider the adjustment in the expected future exchange rate E e (which we have, so far, taken as given): a permanent ↑ in
MS→E e ↑ in the SR.
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• Immediate SR:
– P and E e fixed, E and R do all the adjustment to bring markets to equilibrium.
• Adjustment towards new LR:
– P is allowed to adjust.
– E e is allowed to adjust if policy is permanent.
• New LR
– Expected spot rate is equal to actual spot rate: E e =E
– Thus R=R*
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SR and LR Effects of a Permanent Increase in U.S. MS
(a) SR effects
E
$/ €
E 2
$/ €
E 1
$/ €
0
M 1
US
P
M
1
US
2
US
P 1
US
R$
2'
3'
1' Expected euro return
2
R 2
$
1
R 1
$
L(R
$
, Y
US
)
M/P
M/P
•The $ is expected to depreciate, increasing the return on deposits in €s.
E 2
$/ €
E 3
$/ €
0
M 1
US
P
M
1
US
2
US
P 1
US
(b) Adjustment to LR equilibrium
E
$/
€
R$
2'
4'
Expected euro return
2
R 2
$
4
R 1
$
L(R
$
, Y
US
)
M/P
ROR(in $ terms)
M/P
As P ↑, M s /P ↓ and R returns to its LR level.
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• A permanent ↑ in a country’s MS→a proportional LR depreciation of its currency.
– But the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation .
• A permanent ↓ in a country’s MS→a proportional LR appreciation of its currency.
– But the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation .
• E is said to overshoot when its immediate response to a change > its LR response.
– We assume that changes in the MS have immediate effects on R and E.
– We assume that people change their expectations about inflation immediately after a change in the MS.
• Overshooting helps explain why ERs are so volatile .
• Overshooting occurs in the model because prices do not adjust quickly, but expectations about prices do.
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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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1. Real money demand depends negatively on the opportunity cost of holding money (R) and positively on the volume of transactions in the economy (Y).
2. The money market is in equilibrium when the real money supply =real money demand.
3. In the SR, an increase in MS causes a fall in the domestic interest rate (in the money market) and a depreciation of the domestic currency (in the FX market) .
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Summary (cont’d)
• In the long LR, permanent increases in MS cause:
– a proportional increase in the P level;
– no change in real income, Y;
– no change in interest rate, R.
• In the SR, an increase in the MS can cause the
E to overshoot its LR level because expectations about inflation adjust quickly, but P adjusts only in LR.
– Overshooting occurs when the immediate response of
E due to a change is > its LR response to the change.
– Overshooting helps explain why ERs are so volatile
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