The Goods Market, Money,
and Foreign Exchange
The Linkages
Macroeconomic Measures
• The national income analysis is generally
done in terms of real goods and services.
• Most economic aggregate measures are
more conceptual than real:
•
•
•
•
•
•
The real market value of the economy’s output
The overall price index
Labor force and employment measures
The interest rate as the price of capital
Money stock
Demand for money
• Often we use proxy indicators to measure
macroeconomic aggregates
The Two Dimensions of Macroeconomics: The
“Real” Economy and the Monetary Economy
• The Real Economy and The Goods Market
• The Monetary Economy and the Money
Market
• The linkages between the two markets:
The overall price and wage levels
The Interest rate
The foreign exchange rate (through
its impact on BOP)
The Central Role of the Interest
Rate
• It plays a central role in the goods market
as the price (a determinant) of capital
• It is the price of money in the money
market
• It is an important factor in determining the
exchange rate, especially in the short run
The link
Given the price level and the exchange rate:
Y = C + I + G + (X – IMP)
I = I (i)
Md = M (i)
i
i
DM
IS
M
Q
0
0
Money
• The story of money: From the commodity money
to the modern fiat money
• Stock of money
• Types of money
– Notes and coins
– Checkable deposits
– Near moneys
• Money as an instrument of liquidity (medium of
exchange)
• Other functions of money
• Money as a form of asset
• Real money versus nominal money
• Money and the banking system
• How money is created
• The central banking system
How does the Fed create money?
Day One
Assets
Liabilities
-------------------------------------------------------FX
100
Currency 200
Govt. bonds 100
Money stock = 200
Day Two
A commercial bank opens: Com Bank
Com Bank
Fed
Assets Liabilities
Assets Liabilities
----------------------------------------------FX
Reserve 50
Net worth 50
Money stock = 150
100
Com B. Res. Dep. 50
Govt. Bonds 100 Currency
150
Day Three: Com. Bank receives
deposits.
Com Bank
Assts
Lib
-------------------------------Reserve
150
Deposits 100
Net worth 50
The Fed
Assts
Lib
------------------------------FX
100
Govt bonds 100
Com B Res Dep 150
Currency
*Note the ratio between the com. bank’s reserve and its demand deposit.
Total money stock = 150
50
Day Four: Com. Bnk makes a loan.
Com Bank
Assts
Lib
------------------------------Reserves
150
Deposits
200
The Fed
Assts
Lib
-----------------------------------FX
100
Govt bonds 100
Loan papers 100
Net worth 50
Money stock: 250
Reserve/Deposit ratio: ¾ or 75%
Com B Res Dep 150
Currency
50
Day Five: Com. Bnk makes more loans
Com Bank
Assts
Lib
------------------------------Reserves
150
Loan papers 100
Loan papers 100
Deposits
300
The Fed
Assts
Lib
-----------------------------------FX
100
Govt bonds 100
Net worth 50
Money stock: 350
Reserve/Deposit ratio: 1/2 or 50%
Com B Res Dep 150
Currency
50
Day Six: Com. Bnk makes more loans
Com Bank
Assts
Lib
------------------------------Reserves
150
Deposits
750
The Fed
Assts
Lib
-----------------------------------FX
100
Govt bonds 100
Loan papers 100
Loan papers 100
Loan papers 450
Net worth 50
800
800
Com B Res Dep 150
Currency
Money stock: 800
Reserve/Deposit ratio: 1/5 or 20%
*Note that a total reserve of $150 lead to the creation of $750’s worth of checkable
Deposits.
50
Reserve Requirements and Money
Multiplier
• The reserve requirement ratio: The required ratio
between the deposits held by a commercial bank
and the sum of its cash reserve and its reserve
deposit with the Fed.
• Money multiplier mm= 1/rrr
M = mm(Bank Reserves) + Currency in cir.
The potential increase in the money stock
(checkable deposits) resulting from one dollar
increase in the com. banks’ reserves.
How does the Fed change the money
stock?
• Open Market Operation
• Buying or selling bonds
• FX Market Intervention
• Buying or selling FX
• Other methods
Given the currency in circulation,
Δ M = mm (Δ GB + Δ FXR)
The Money Market
• Real money versus nominal money
Real Money = L = M/P
• Demand for real money
• Transaction demand
• Asset demand
LD = L ( Q, i)
• Money stock (supply)
The stock money is (exogenously) determined
by monetary authorities.
Money Market Equilibrium
For any given level of output, Q,
the money market is in equilibrium
if the interest rate is at a level at
which the quantity of real money,
L, people want to hold is equal to
the stock of real money provided
by the monetary authorities (the
Fed).
Money Market
r
Mo/Po
Shifts in LD :
Changes in Q
Other exogenous changes
Shifts in real money stock:
Changes in M
Changes in P
r2
r1
LD =L( Q1 , i)
ro
LD =L( Qo , i)
0
L
Money Market Equilibrium and
the Output Level: The LM Curve
As the out put level changes the demand
for real money will change, given the
money stock, resulting in changes in the
interest rate:
Q  LD  (Given M/P) i
 A positive relationship between Q and
equilibrium i: The LM curve
The LM Curve
i
M/Po
i
LM
LD =L( Q1 , i)
LD =L( Qo , i)
0
0
Qo
Q1
Q
Shifts in the LM Curve
i
Mo/Po
M1/Po
i
LMo
LM1
LD =L( Q1 , i)
LD =L( Qo , i)
0
0
Qo
Q1
Q
Factors Causing Shifts in the LM Curve
• Changes in the real money stock
– Changes in the nominal money stock
• Monetary and FX policies affecting
banks reserves: Buying and selling
bonds and/or FX
– Changes in the price level
• The price level could be affected by
both internal (domestic) and external
(foreign) factors.
i
IS and LM Curves
LM1
LMo
IS
IS’
0
Q’ Q
Q
Balance of Payment Equilibrium
Recall:
CAB = X (Q*, R) – Imp (Q, R)
CAB = CAB ( Q*, Q, R )
KAB = K inflow – K outflow
Also recall:
At parity i = i* + (ef-e)/e or I*+ (ee-e)/e
That means direction of the funds would
depend on i, i*, e, ef , ee
So we write:
KAB = KAB (i, i*, e, ef , ee)
+ - + - At equilibrium:
CAB ( Q*, Q, R ) = - KAB (i, i*, e, ef , ee)
+ - + - + - Given i*, e, ef , ee , Q*, R
CAB (Q) = - KAB ( i )
As Q increases CAB worsens, for the BOP to
be restored the interest rate must increase.
45o
BOP Equilibrium
CAB (Q)
BOP>o
KAB (i)
BOP<0
BOP Equilibrium
i
BOP
i*, e, ef , ee , Q*, R
- + - - + Q
0
Adjustments under Flexible X
i
Rate
(eo) > (e1)
LMo
BOP(e1)
BOP(eo)
E
E’
IS(eo)
IS(e1)
0
Q’ Q
Q
The adjustment process:
The case of a BOP surplus:
Appreciation of the home currency, e will fall
R will increase  Exports will decrease
 Imports will increase
IS curve will shift to the left
BOP curve will shift to the left
The case of a BOP Deficit:
Depreciation of the home currency, e will increase
R will decrease  Exports will increase
 Imports will decrease
IS curve will shift to the right
BOP curve will shift to the right
Adjustments Under A Fixed X
Rate Regime
The case of a BOP surplus:
To keep the X rate fixed the Fed would have to
buy FX.
 An increase in the money stock
 Shift of the LM curve to the right
The case of a BOP deficit:
To keep the X rate fixed the Fed would have to
sell FX.
 A reduction in the money stock
 Shift of the LM curve to the left
Adjustments under a Fixed X
i
Rate
LMo
LM1
BOP(e)
E
i
E’
i’
IS(e)
0
Q
Q’
Q