Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Advanced International Economics

ECON 758 Professor Yamin Ahmad Lecture 9: Money Interest Rates Exchange Rates

I This In Thi Lecture L t

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

Note: These lecture notes are incomplete without having attended lectures.

9-2

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Wh t is What i M Money: D Definitions fi iti

1.

Wh t is What i M Money(cont.) ( t)
It is important to distinguish between money, wealth and income: Money

Money is the stock of assets that can be readily used to make transactions. Money is anything that is generally accepted in payment for goods and services
Note: These lecture notes are incomplete without having attended lectures.

Flow

Stock

Stock

2.

Wealth: Money + Assets

Stock

Income: earnings at a point in time

Flow
9-4

9-3

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Cl Classifications ifi ti of fM Money

In the United States:

M Money supply l measures, April 2006

symbol assets included C Currency C + demand deposits, travelers checks, other checkable deposits M1 + small time deposits, p savings deposits, money market mutual funds, money market deposit accounts amount ($ billions) $739 $1391

M1 = Currency + Traveler's Checks + Demand Deposits +

Other Checkable Deposits

M2 = M1 + Small denomination time deposits & repurchase

agreements + Savings Deposits and money market deposit accounts + Money Market mutual fund shares (noninstitutional)

M1

M3 = M2 + Large denomination time deposits and

repurchase p agreements g + Money y Market mutual fund shares (institutional) + Repurchase Agreements + Eurodollars [Note: As of March 2006, the Fed has discontinued M3]

M2

$6799

See: http://www.federalreserve.gov/releases/h6/hist/
Note: These lecture notes are incomplete without having attended lectures.

9-5

Note: These lecture notes are incomplete without having attended lectures.

9-6

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Money: F Functions ti
Medium of Exchange we use it to buy stuff Store of Value transfers purchasing power from the present to the future Unit of Account the common unit by which everyone measures prices and values Money helps to:

S So What Wh t Is I Money? M ?
Money is an asset that is widely used and accepted as a means of payment.

Different groups of assets may be classified as money. Currency and checking accounts form a useful definition of money, but bank deposits in the foreign exchange market are excluded from this definition.

Lower transaction costs Increase Liquidity in an economy

9-7
Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

9-8

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Di Discussion i Q Question ti
Which of these are money?
a. b. c. d. e.

Wh t Is What I Money? M ? (cont.) ( t)

Money is very liquid: it can be easily and quickly i kl used dt to pay f for goods d and d services. i Money, however, pays little or no rate of return. Suppose we can group assets into money (liquid assets) and all other assets (illiquid assets).

Currency Checks Deposits in checking accounts (demand deposits) Credit cards Certificates of deposit (ti (time d deposits) it )

All other assets are less liquid but pay a higher return.
9-10

Note: These lecture notes are incomplete without having attended lectures.

9-9

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Money Supply S l
The money supply is the quantity of money available in the economy. Monetary policy is the control over the money supply. supply Who controls the quantity of money that circulates in an economy, the money supply?
Note: These lecture notes are incomplete without having attended lectures.

Th central The t lb bank k

Monetary y policy p y is conducted by y a countrys y central bank. In the U.S., US the central bank is called the Federal Reserve (the Fed).
The Federal Reserve Building Washington, DC
Note: These lecture notes are incomplete without having attended lectures.

9-11

9-12

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Money Supply S l
Central banks determine the money supply supply.

M Money Demand D d
Money demand is the amount of assets that people are willing to hold as money (instead of illiquid assets).

The Federal Reserve directly regulates the amount of currency in circulation. circulation It indirectly controls the amount of checking deposits issued by private banks.

We will consider individual money demand and aggregate money demand. What influences willingness to hold money?

Note: These lecture notes are incomplete without having attended lectures.

9-13

Note: These lecture notes are incomplete without having attended lectures.

9-14

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Wh t Influences What I fl Individual I di id l D Demand df for M Money? ?

1. Expected returns/interest rate on money relative to the expected returns on other assets.

Wh t Influences What I fl Aggregate A t Demand D d for f Money? M ?

1. Interest rates: money pays little or no interest, so the interest rate is the opportunity cost of holding money instead of other assets, like bonds, which have a higher expected return/interest rate.

2.

Risk: the risk of holding money principally comes from unexpected inflation, thereby unexpectedly reducing the purchasing power of money.

A higher interest rate means a higher opportunity cost of holding money lower money demand.

but many other assets have this risk too, so this risk is not very important in money demand

2. Prices: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.

3.

Liquidity: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought i t in transactions ti i increases.
9-15

A higher price level means a greater need for liquidity to buy the same amount of goods and services higher money demand. d d
9-16

Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

What Influences Aggregate Demand for Money? (cont.)

3 3. Income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions.

A Model M d l of f Aggregate A t Money M Demand D d

The aggregate demand for money can be expressed by: Md = 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

A higher real national income means more goods and services are being produced and bought in transactions, increasing the need for liquidity higher money demand.

Alternatively: Md/P = L(R,Y)

Aggregate real money demand is a function of national income and interest rates.
Note: These lecture notes are incomplete without having attended lectures.

9-17

Note: These lecture notes are incomplete without having attended lectures.

9-18

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

A Model of Aggregate Money Demand (cont.)

A Model of Aggregate Money Demand (cont.)

For a g given level of income, real money demand decreases as the interest rate increases.

When income increases, real money demand increases at every interest rate.
9-19
Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

9-20

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Money The M Market M k t

The money market uses the (aggregate) money demand and (aggregate) ( gg g ) money y supply. y The condition for equilibrium in the money market is: Ms = Md

Th Money The M Market M k t (cont.) ( t)

When there is an excess supply of money money, there is an excess demand for interest bearing assets.

People with an excess supply of money are willing to acquire interest bearing assets (by giving up their supply of money) at a lower interest rate. Potential money holders are more willing to hold additional quantities of money as the interest rate (the opportunity cost of holding money) falls.

Alternatively, we can define equilibrium using the supply of real Alternatively money and the demand for real money (by dividing both sides by the price level): Ms/P = L(R,Y R Y)

q condition will y yield an equilibrium q interest rate. This equilibrium

9-21
Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

9-22

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Th Money The M Market M k t (cont.) ( t)

When there is an excess demand for money money, there is an excess supply of interest bearing assets.

M Money Market M k t Equilibrium E ilib i

People who desire money but do not have access to it are willing illi t to sell ll assets t with ith a hi higher h i interest t t rate t i in return t f for the money balances that they desire. Those with money balances are more willing to give them up i return in t for f interest i t t bearing b i assets t as the th interest i t t rate t on these assets rises and as the opportunity cost of holding money (the interest rate) rises.

Note: These lecture notes are incomplete without having attended lectures.

9-23

Note: These lecture notes are incomplete without having attended lectures.

9-24

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ch Changes i in th the M Money S Supply l

A decrease in the y supply pp y raises money the interest rate for a given price level.

Ch Changes i in N National ti lI Income

An increase in the money supply lowers the interest rate for a given price level level.

An increase in national income increases equilibrium interest rates for a given price level.
9-25
Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

9-26

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Linking the Money Market to the Foreign Exchange Market Linking the Money y Market to the Foreign Exchange M k t Market

Note: These lecture notes are incomplete without having attended lectures.

9-27

Note: These lecture notes are incomplete without having attended lectures.

9-28

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ch Changes i in th the M Money S Supply l

An increase in a countrys country s money supply causes its currency to depreciate.

Changes in the Domestic Money Supply

A decrease in a countrys money supply causes its currency to appreciate.

Note: These lecture notes are incomplete without having attended lectures.

9-29

Note: These lecture notes are incomplete without having attended lectures.

9-30

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ch Changes i in th the F Foreign i M Money S Supply l

How would a change in the euro money supply affect the US money market and foreign exchange market?

Changes in the Foreign Money Supply (cont.)

An increase in the EU money supply causes a depreciation of the euro (appreciation of the dollar). dollar) A decrease in the EU money supply causes an appreciation of the euro (a depreciation of the dollar).

Note: These lecture notes are incomplete without having attended lectures.

9-31

Note: These lecture notes are incomplete without having attended lectures.

9-32

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ch Changes i in th the F Foreign i M Money S Supply l ( (cont.) t)

The increase in the EU money supply reduces interest rates in the EU, reducing the expected return on euro deposits.

L Long R Run and d Sh Short tR Run

The difference between the short run and long run lies in the idea that prices, wages and certain factors of production may be constrained in the short run, but not in the long run Here we assume that in the short run, the price level is fixed at some level.

This reduction in the expected p return on euro deposits p leads to a depreciation of the euro.

the analysis heretofore has been a short run analysis.

The change in the EU money supply does not change the US money market equilibrium.

Note: These lecture notes are incomplete without having attended lectures.

9-33

Note: These lecture notes are incomplete without having attended lectures.

9-34

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

L Long R Run and d Sh Short tR Run ( (cont.) t)

In the long run, prices of factors of production and of output are allowed to adjust to demand and supply in their respective markets.

L Long R Run and d Sh Short tR Run ( (cont.) t)

In the long run, the level of the money supply does not t influence i fl the th amount t of f real l output t t nor the th interest rate.

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 economys economy s productive capacitynot by the supply of money. The interest rate depends on the supply of saving and the demand for saving in the economy and the inflation rate and thus is also independent of the money supply level.

Long run monetary neutrality. neutrality

But in the long run run, prices of output and inputs adjust proportionally to changes in the money supply:

Long run equilibrium: Ms/P = L(R,Y) Ms = P x L(R,Y) increases in the money y supply y are matched by y proportional increases in the price level.
9-36

Note: These lecture notes are incomplete without having attended lectures.

9-35

Note: These lecture notes are incomplete without having attended lectures.

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

L Long R Run and d Sh Short tR Run ( (cont.) t)

In the long run run, there is a direct relationship between the inflation rate and changes in the money y supply. pp y

Ms = P x L(R,Y) P = Ms/L(R,Y R Y)

P/P = Ms/Ms - L/L

The inflation rate equals growth rate in money supply minus the growth rate for money demand.

Note: These lecture notes are incomplete without having attended lectures.

9-37

Note: These lecture notes are incomplete without having attended lectures.

9-38

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Money and dP Prices i i in th the L Long R Run

M Money and dP Prices i i in th the L Long R Run ( (cont.) t)

1. Excess demand: an increase in the money supply implies that people have more funds available to pay for goods and services.

How does a change in the money supply cause prices of output and inputs to change?

To meet strong demand, producers hire more workers, creating ti a strong t demand d df for l labor, b or make k existing i ti employees work harder. Wages rise to attract more workers or to compensate workers k for f overtime. ti Prices of output will eventually rise to compensate for higher costs. Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the strong demand.

Note: These lecture notes are incomplete without having attended lectures.

9-39

Note: These lecture notes are incomplete without having attended lectures.

9-40

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Money and dP Prices i i in th the L Long R Run ( (cont.) t)

2 Inflationary expectations: 2.

Money, Prices and the Exchange Rates and Expectations When we consider price changes in the long run, inflationary expectations will have an effect in the foreign g exchange g market.

If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. And if producers expect the same, they are more willing to raise wages. Producers will be able to match higher g costs if they y expect p to raise prices. Result: expectations about inflation caused by an expected y supply pp y increase leads to actual inflation. money

Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterwards.

Note: These lecture notes are incomplete without having attended lectures.

9-41

Note: These lecture notes are incomplete without having attended lectures.

9-42

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Money, Prices and the Exchange Rates and Expectations (cont.)

Change in expected return on euro deposits

Money, y Prices and the Exchange Rates in the Long Run

Original (long run) return on dollar deposits

The expected Th t d return t on euro deposits rises because of inflationary expectations: The Th dollar d ll i is expected t dt to b be less valuable when buying goods and services and less valuable when buying euros. The dollar is expected to depreciate, increasing the return on deposits in euros.

As prices increases, the real money supply decreases and the domestic interest rate returns to its long run rate.

Note: These lecture notes are incomplete without having attended lectures.

9-43

Note: These lecture notes are incomplete without having attended lectures.

9-44

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Money, Prices and the Exchange Rates in the Long Run (cont.)
A permanent increase in a countrys country s money supply causes a proportional long run 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 countrys money supply causes a proportional long run appreciation of its currency. y

However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.

Note: These lecture notes are incomplete without having attended lectures.

9-45

Note: These lecture notes are incomplete without having attended lectures.

9-46

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

E h Exchange R Rate t O Overshooting h ti

The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response.

E h Exchange R Rate t V Volatility l tilit

C a ges in p Changes price ce levels are less volatile, suggesting that price levels change g slowly. y

We assume that changes in the money supply have immediate effects on interest rates and exchange rates rates. We assume that people change their expectations about inflation immediately after a change in the money supply.

Overshooting helps explain why exchange rates are so volatile. Overshooting g occurs in the model because p prices do not adjust quickly, but expectations about prices do.
Note: These lecture notes are incomplete without having attended lectures.

Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.

9-47

Note: These lecture notes are incomplete without having attended lectures.

9-48

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Summary
1 Money demand on an individual level is determined 1. by interest rates and liquidity, the latter of which is influenced by prices and income. 2. Money demand on an aggregate level is determined by interest rates, the price level and national income.

S Summary (cont.) ( t)
4 Short run scenario: changes in the money supply 4. affect the domestic interest rate, as well as the exchange rate.
1. 2. 3.

An increase in the domestic money supply lowers the domestic interest rate, lowering the rate of return on domestic deposits, causing the domestic currency to depreciate.

Aggregate real money demand depends negatively on the interest rate and positively on real national income.

3. Money supply equals money demandor real money supply l equals l real l money d demandat d t the th equilibrium interest rate in the money market.

Note: These lecture notes are incomplete without having attended lectures.

9-49

Note: These lecture notes are incomplete without having attended lectures.

9-50

Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

S Summary (cont.) ( t)
5 Long run scenario: changes in the level of the 5. money supply are matched by a proportional change in prices, and do not affect real income and i t interest t rates. t
1. 2. 3. 4. 5.

S Summary (cont.) ( t)
6 Expectations about inflation adjust quickly 6. quickly, but prices adjust only in the long run, which results in overshooting g of exchange g rate.

An increase in the money supply causes expectations t ti about b t inflation i fl ti t to adjust, dj t causing the domestic currency to depreciate further, and causes p prices to adjust j p proportionally p y in the long g run, causing interest rates return to their long run rate, and causes a proportional long run depreciation in the exchange rate. rate
9-51

Overshooting occurs when the immediate response of the exchange rate due to a change is greater than its long run response. Overshooting helps explain why exchange rates are so volatile. volatile

Note: These lecture notes are incomplete without having attended lectures.

Note: These lecture notes are incomplete without having attended lectures.

9-52