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

2024
Views:

165

Pages:

27
Author:

Joselyn Lindsey

Topic 8 Money, Interest Rates, and Exchange Rates Changes in the Domestic Money Supply • An increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate. • A decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate. 14-27 Changes in the Foreign Money Supply • How would an increase in the supply of euros affect the U.S. money market and foreign exchange markets? • An increase in the supply of euros reduces interest rates in the EU, reducing the expected rate of return on euro deposits. • This reduction in the expected rate of return on euro deposits causes the euro to depreciate. • We predict no change in the U.S. money market due to the change in the supply of euros. 14-28 Fig 9: Effect of an Increase in the European Money Supply on the $/€ Exchange Rate At point 1 and 1’ the U.S. money market and foreign exchange market are in equilibrium. An increase in the European money supply reduces the euro interest rate, which shifts the “expected euro return” schedule inward. Given the lower euro interest rate and the current exchange rate (E1), the expected return on dollar deposits is greater than that on euro deposits. The euro depreciates (to E2) as holders of euro deposits bid for dollar deposits. The foreign exchange market reaches a new equilibrium at point 2’. The change in the European money supply does not affect the U.S. money market. Long Run and Short Run • Our SR analysis of the link between countries’ money markets and foreign exchange markets assumes that price levels and exchange rate expectations were given. • We must now consider how monetary changes work themselves out over the LR –when prices are perfectly flexible and adjust to preserve full employment. 14-30 Long Run and Short Run (cont.) • In the SR, prices do not have sufficient time to adjust to market conditions. ♦ Our previous analysis has been a SR analysis. • In the LR, prices of factors of production and of output have sufficient time to adjust to market conditions. ♦ Wages adjust to the demand and supply of labor. ♦ Real output and income are determined by the amount of workers and other factors of production—by the economy’s productive capacity—not by the quantity of money supplied. ♦ (Real) interest rates depend on the supply of saved funds and the demand for saved funds. 14-31 Long Run and Short Run (cont.) • In the LR, the quantity of money supplied does not influence the amount of output, (real) interest rates, and therefore the aggregate real money demand, L(R,Y). • However, the quantity of money supplied is predicted to make the level of average prices adjust proportionally in the LR. ♦ The equilibrium condition Ms/P = L(R,Y) shows that P adjusts proportionally when Ms changes because L(R,Y) does not change. 14-32 Long Run and Short Run (cont.) • E.g., a doubling of the money supply has the same LR effect as a currency reform in which each unit of “old currency” is replaced by two units of “new currency.” • If the economy is initially fully employed, every money price eventually doubles, but real GNP, the (real) interest rate, and all relative prices return to their LR levels. Why? • Full-employment GNP is determined by the economy’s endowments of factors, so LR real output does not depend on the money supply. 14-33 Long Run and Short Run (cont.) • The (real) interest rate is independent of the money supply in the LR. • If the money supply and all prices double permanently, there is no reason why people previously willing to borrow or lend at 10% would not be willing to do so afterward. • Relative prices also remain the same if all money prices double. • Thus, money supply changes do not change the LR allocation of resources! Only the absolute value of money prices change. 14-34 Long Run and Short Run (cont.) • A doubling of the U.S. money supply would cause the $/€ exchange rate to double. So the U.S. dollar would depreciate by 50% against the euro. • A permanent increase in a country’s money supply causes a proportional LR depreciation of its currency against foreign currencies. 14-35 Short-run Price Rigidity • Our SR analysis has assumed that prices (unlike exchange rates) do not change immediately. Why? • Many prices (like wages) are written into long-term contracts and cannot be changed immediately when the money supply changes. • Wages comprise 70% of production costs and therefore strongly influence output prices. • Output prices are “sticky” in the SR because wages are “sticky” in the SR. 14-36 Fig 10: Monthly Variability of the Exchange Rate and of U.S./Japan Price Level Ratio, 1974–2007 The SR “stickiness” of price levels is shown here. Price levels (influenced by sluggish wages) are much less volatile than exchange rates. Exchange rates are influenced by interest rates and expectations which may change rapidly. Source: International Monetary Fund, International Financial Statistics Money and Prices in the Long Run • Although price levels are sticky in the SR, an increase in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. • These pressures come from three main sources. 14-38 Money and Prices in the LR (cont.) 1. Excess demand for output and labor: a higher quantity of money supplied implies that people have more funds available to pay for goods and services. ♦ To meet high demand, producers hire more workers 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 labor costs. 14-39 Money and Prices in the LR (cont.) 2. Inflationary expectations: ♦ If workers expect future prices to rise due to an increase in the money supply, they will insist on higher wages. ♦ And if producers expect the same, they are more willing to raise wages. ♦ Producers will be able to match higher wage costs if they expect to raise output prices. ♦ Result: if everyone expects the price level to rise in the future, their expectations will increase the pace of inflation today. 14-40 Money and Prices in the LR (cont.) 3. Raw materials prices: • Many raw materials (like oil and metals) used in the production of goods are sold in markets where prices adjust rapidly, even in the SR. • By causing the prices of such materials to jump upward, a money supply increase raises production costs. • Eventually producers will raise output prices to cover their higher materials costs. 14-41 Money, Prices, Exchange Rates, and Expectations • We now apply our analysis of inflation to study the adjustment of the $/€ exchange rate following a permanent increase in the U.S. money supply. • We begin our analysis by assuming that the economy starts with all variables at their long-run levels and that output remains constant as the economy adjusts to the money supply increase. 14-42 Money, Prices, and Exchange Rates in the Long Run (cont.) • Fig. 11 shows the SR and LR effects of an increase in the U.S. money supply on the interest rate, price level, and exchange rate. • The LR interest rate is R1 (point 1). • An increase in the MS at fixed prices (P1) leads to a higher real MS and thereby a lower SR interest rate, R2 (at point 2). • The lower interest rate reduces the return on dollar deposits which causes the exchange rate to appreciate (i.e., the dollar depreciates) from E1 to E3 (point 1’ to point 3’). 14-43 Money, Prices, and Exchange Rates in the Long Run (cont.) • So far we have repeated our earlier SR analysis which held prices and exchange rate expectations fixed. • But people will now expect a LR increase in all dollar prices (including the $/€ exchange rate). • Recall that a rise in the expected future $/€ exchange rate (i.e., a future euro appreciation) raises the expected dollar return on euro deposits which shifts the “expected euro return” schedule outward. 14-44 Money, Prices, and Exchange Rates in the Long Run (cont.) • Notice that the dollar depreciation is greater (E1 to E2) than it would be if the expected future exchange rate stayed fixed (E1 to E3). • If the expected exchange rate did not change, the new SR equilibrium would be at point 3’ rather than point 2’. • Panel (b): the price level begins to rise from P1 to its new LR level of P2. • The real money supply has not changed in the LR because the price level has risen in proportion to the increase in the nominal money supply. 14-45 Money, Prices, and Exchange Rates in the Long Run (cont.) • Since the real money supply has fallen to its initial level, the equilibrium interest rate must increase to R1 in the LR (point 4). • The dollar appreciates against the euro (from E2 to E3) in this adjustment because the U.S. interest rate has increased from R2 to R1. • The LR equilibrium exchange rate is E3 at point 4’. 14-46 Fig 11: SR and LR Effects of an Increase in the U.S. Money Supply (Given Real Output, Y) LR interest rate E3$/€ LR interest rate Money, Prices, and Exchange Rates in the Long Run (cont.) • A permanent increase in a country’s money supply causes a proportional LR 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 LR appreciation of its currency. ♦ However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation. 14-48 Money, Prices, and Exchange Rates in the Long Run (cont.) • Fig. 12 shows the time paths of U.S. economic variables after a permanent increase in the U.S. money supply. • After the MS increases at t0 in panel (a), the interest rate falls immediately to R2 but begins rising back to its LR level (R1) as prices eventually rise from P1 to P2 which reduces the real MS. • Panel (d) shows the initial jump in the exchange rate from E1 to E2. The exchange rate overshoots in the SR before settling at its LR level of E3. 14-49 Fig 12: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. MS Exchange Rate Overshooting • The exchange rate is said to overshoot when its immediate response to a change is greater than its LR response. • Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation. • Overshooting helps explain why exchange rates are so volatile. • Overshooting is a direct consequence of the SR rigidity of prices. 14-51 Exchange Rate Overshooting (cont.) • In a pretend world where the price level could adjust immediately to its new LR level after a money supply increase, the dollar interest rate would not fall because prices would adjust immediately to stop the real money supply from rising. • There would be no need for overshooting to maintain equilibrium in the foreign exchange market. • The exchange rate would jump to its new LR equilibrium immediately. 14-52

Money, Interest Rates, and Exchange Rates, Part 2

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