University:
California State University, Northridge
Course:
ECON 405 | International Trade
Academic year:

2024
Views:

146

Pages:

26
Author:

Anahi Baldwin

Topic 8 Money, Interest Rates, and Exchange Rates Preview • What is money? • Control of the supply of money • The willingness to hold money • A model of money and interest rates • A model of money, interest rates, and exchange rates • Long run effects of changes in money supply on prices, interest rates, and exchange rates 14-2 Introduction • In the next three lectures, we will build a macroeconomic model that links exchange rates, interest rates, inflation rates, and output. • Begin by examining how the supply and demand for money affects interest rates and exchange rates. 14-3 What Is Money? • It is a medium of exchange: a generally accepted means of payment. ♦ Money eliminates the enormous search costs connected with a barter system. • Money is a unit of account: a widely recognized measure of value. • It is an asset or a store of value. ♦ Money is the most liquid of all assets because it can be transformed into goods and services rapidly without high transactions costs. 14-4 What Is Money? (cont.) • Money is currency and bank deposits on which checks can be written. • Money supply in this class will be M1: the total amount of currency and checking deposits held by households and firms. ♦ In 2006, the U.S. total money supply was $1.39 trillion (or 10.5% of GNP). 14-5 Money Supply • An economy’s money supply is controlled by its central bank. • In the US, the central banking system is the Federal Reserve System. ♦ It directly regulates the amount of currency in circulation. And it indirectly controls the amount of checking deposits issued by private banks. • For now, we assume that the central bank simply sets the size of the money supply at the level it desires. 14-6 Money Demand • Money demand represents the amount of money (currency and checking deposits) that people are willing to hold (instead of less liquid assets like government bonds, a large time deposit, or real estate). ♦ What influences willingness to hold money? ♦ We consider individual demand for money and aggregate demand for money. 14-7 What Influences Demand for Money by Individuals and Institutions? • Individuals base their demand for any asset (including money) on three characteristics: 1. Expected return (or interest rates): the difference in rates of return between money and less liquid assets is reflected by the market interest rate. • A rise in the interest rate raises the cost of holding money (rather than interest-paying assets) and causes money demand to fall. 14-8 What Influences Demand for Money by Individuals and Institutions? (cont.) 2. Risk: the risk of holding money comes from unexpected inflation, which reduces the purchasing power of money. ♦ 3. But many other assets also have this risk, so this risk is not very important in defining the demand for money vs. nonmoney assets. Liquidity: the main benefit of holding money comes from its liquidity. • Households and firms hold money because it is the easiest way to finance everyday purchases. • A rise in the average value of transactions carried out by a household or firm causes its need for liquidity to rise and thereby its demand for money to rise. 14-9 What Influences Aggregate Demand for Money? • Aggregate money demand is just the sum of all the economy’s individual money demands. • Three main factors determine it: 1. The interest rate: money pays little or no interest, so the interest rate on non-money assets like bonds, loans, and time deposits is the opportunity cost of holding money. ♦ A higher interest rate means a higher opportunity cost of holding money → lower demand for money. 14-10 What Influences Aggregate Demand for Money? (cont.) 2. The price level: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. ♦ 3. A higher level of average prices means a greater need for liquidity to buy the same amount of goods and services → higher demand for money. Real national income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions. ♦ A higher GNP means more goods and services are being produced and bought in transactions, increasing the need for liquidity → higher demand for money. 14-11 Aggregate Money Demand The aggregate demand for money can be expressed as: Md = P x L(R,Y) where: P is the price level; Y is real national income R is a measure of interest rates on non-money assets L(R,Y) is the aggregate real money demand Alternatively: Md/P = L(R,Y) Aggregate real money demand is a function of interest rates and national income. 14-12 Fig. 1: Aggregate Real Money Demand and the Interest Rate The downward sloping real money demand schedule, L(R,Y), shows that for a given real income level, Y, real money demand rises as the interest rate falls. Fig. 2: Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income An increase in real income from Y1 to Y2 raises the demand for real money balances at every level of the interest rate and causes the demand schedule to shift outward. A Model of the Money Market • The money market is in equilibrium when the money supply set by the central bank equals aggregate money demand. • We examine how the interest rate is determined by money market equilibrium, given the price level and output, both of which are temporarily assumed to be unaffected by monetary changes. 14-15 A Model of the Money Market (cont.) • Equilibrium occurs when no shortages (excess demand) or surpluses (excess supply) of money exist: Ms = Md • Alternatively, equilibrium occurs when the quantity of real money supplied equals the quantity of real money demanded: Ms/P = L(R,Y) 14-16 A Model of the Money Market (cont.) • Point 1 in Fig. 3 shows the equilibrium interest rate is R1. • Point 2 shows an interest rate R2 that is above R1. • There is an excess supply of money and therefore an excess demand for interest-paying assets like bonds. • Individuals will attempt to reduce their liquidity by using some money to buy interest-paying assets. ♦ E.g., Individuals buy bonds with cash or they lend out their excess cash balances. • The increased demand for interest-paying assets puts pressure on the interest rate to fall. 14-17 A Model of the Money Market (cont.) • Alternatively, Point 3 shows an interest rate R3 that is below R1. • There is an excess demand for money and therefore an excess supply of interest-paying assets like bonds. • Individuals will attempt to increase their liquidity by selling some interest-paying assets to acquire money. ♦ E.g., Individuals sell bonds for cash or they borrow to increase their money holdings. • The reduced demand for interest-paying assets puts pressure on the interest rate to rise. 14-18 Fig 3: Determination of the Equilibrium Interest Rate Point 1: equilibrium Point 2: excess supply of money puts pressure on interest rates to fall. Point 3: excess demand for money puts pressure on interest rates to rise. A Model of the Money Market (cont.) • In Fig. 4, the real money supply is increased because the price level is given. • Initially the money market is in equilibrium at point 1. • The increased money supply temporarily creates an excess supply of money (at point 1’) which causes people to buy interest-paying assets. • Interest rates are driven down to point 2 as individuals buy bonds or lend money. • An increase in the money supply lowers the interest rate, while a fall in the money supply raises the interest rate, given the price level and output. 14-20 Fig 4: Effect of an Increase in the Money Supply on the Interest Rate 1’ For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2 reduces the interest rate from R1 to R2. A Model of the Money Market (cont.) • In Fig. 5, an increase in output (holding MS and P fixed) leads to an increase in aggregate real money demand. • Initially the money market is in equilibrium at point 1. • The increased money demand temporarily creates an excess demand for money (at point 1’) which causes interest rates to rise (to point 2). • An increase in real output raises the interest rate, while a fall in real output lowers the interest rate, given the price level and the money supply. 14-22 Fig 5: Effect on the Interest Rate of a Rise in Real Income Given the real money supply, a rise in real income from Y1 to Y2 raises the equilibrium interest rate from R1 to R2. Fig 6: Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market The top diagram shows equilibrium in the foreign exchange market. The “return on dollar deposits” schedule is the dollar interest rate, R1$, which is determined in the money market (shown in the bottom diagram). The “expected return on euro deposits” schedule has a negative slope because a stronger dollar (↓ $/€ exchange rate), given its unchanged expected future level, makes euro deposits cheaper to purchase today. Point 1’ gives the equilibrium exchange rate where interest parity holds. Point 1 gives the equilibrium U.S. interest rate. Fig 7: Money Market/Exchange Rate Linkages The Fed and ECB determine the U.S. and EU money supplies. Given the P levels and GNP of the two countries, equilibrium in national money markets leads to the dollar and euro interest rates. These interest rates feed into the foreign exchange market where the current exchange rate is determined by interest parity. Fig 8: Effect on the $/€ Exchange Rate and Dollar Interest Rate of an Increase in the U.S. MS At point 1 and 1’ the U.S. money market and foreign exchange market are in equilibrium. An increase in the U.S. money supply creates an excess supply of money which forces the dollar interest rate down to a new equilibrium (point 2). Given the lower U.S. interest rate and the current exchange rate (E1), the expected return on euro deposits is greater than that on dollar deposits. The dollar depreciates (to E2) as holders of dollar deposits bid for euro deposits. The foreign exchange market reaches a new equilibrium at point 2’.

Money, Interest Rates, and Exchange Rates, Part 1

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