C15 Krugman 11e

International Economics: Theory and
Policy
Eleventh Edition, Global Edition
Chapter 15
Money, Interest
Rates, and
Exchange Rates
Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Learning Objectives
15.1 Describe and discuss the national money markets in which
interest rates are determined.
15.2 Show how monetary policy and interest rates feed into the
foreign exchange market.
15.3 Distinguish between the economy’s long-run position and
the short run, in which money prices and wages are sticky.
15.4 Explain how price levels and exchange rates respond to
monetary factors in the long run.
15.5 Outline the relationship between the short-run and the long-
run effects of monetary policy, and explain the concept of
short-run exchange rate overshooting.

Preview
• What is money?
• Control of the supply of money
• The willingness to hold monetary assets
• A model of real monetary assets and
interest rates
• A model of real monetary assets, interest rates, and
exchange rates
• Long-run effects of changes in money on prices, interest
rates, and exchange rates

What Is Money? (1 of 3)
• Money is an asset that is widely used as a means of
payment.
– Different groups of assets may be classified as money.
 Money can be defined narrowly or broadly.
 Currency in circulation, checking deposits, and debit
card accounts form a narrow definition of money.
 Deposits of currency are excluded from this narrow
definition, although they may act as a substitute for
money in a broader definition.

• Money is a liquid asset: it can be easily used to pay for
goods and services or to repay debt without substantial
transaction costs.
– But monetary or liquid assets earn little or no interest.
• Illiquid assets require substantial transaction costs in terms
of time, effort, or fees to convert them to funds for
payment.
– But they generally earn a higher interest rate or rate of
return than monetary assets.

• Let’s group assets into monetary assets (or liquid assets)
and nonmonetary assets (or illiquid assets).
• The demarcation between the two is arbitrary,
– but currency in circulation, checking deposits, debit
card accounts, savings deposits, and time deposits are
generally more liquid than bonds, loans, deposits of
currency in the foreign exchange markets, stocks, real
estate, and other assets.

Money Supply
• The central bank substantially controls the quantity of
money that circulates in an economy, the money supply.
– In the U.S., the central banking system is the Federal
Reserve System.
 The Federal Reserve System directly regulates the
amount of currency in circulation.
 It indirectly influences the amount of checking
deposits, debit card accounts, and other monetary
assets.

Money Demand
• Money demand represents the amount of monetary
assets that people are willing to hold (instead of illiquid
assets).
– What influences willingness to hold monetary assets?
– We consider individual demand of money and
aggregate demand of money.

What Influences Demand of Money for
Individuals and Institutions?
1. Interest rates/expected rates of return on monetary
assets relative to the expected rates of returns on non-
monetary assets.
2. Risk: the risk of holding monetary assets principally
comes from unexpected inflation, which reduces the
purchasing power of money.
– But many other assets have this risk too, so this risk is
not very important in defining the demand of monetary
assets versus nonmonetary assets.
3. Liquidity: A need for greater liquidity occurs when the
price of transactions increases or the quantity of goods
bought in transactions increases.
What Influences Aggregate Demand
of Money? (1 of 2)
1. Interest rates/expected rates of return: monetary
assets pay little or no interest, so the interest rate on non-
monetary assets like bonds, loans, and deposits is the
opportunity cost of holding monetary assets.
– A higher interest rate means a higher opportunity cost
of holding monetary assets  lower demand of money.
2. Prices: the prices of goods and services bought in
transactions will influence the willingness to hold money
to conduct those transactions.
– A higher level of average prices means a greater need
for liquidity to buy the same amount of goods and
services  higher demand of money.
What Influences Aggregate Demand
of Money? (2 of 2)
3. Income: greater income implies more goods and
services can be bought, so that more money is needed to
conduct transactions.
– A higher real national income (GNP) means more
goods and services are being produced and bought in
transactions, increasing the need for liquidity  higher
demand of money.

A Model of Aggregate Money Demand
The aggregate demand of money can be expressed
as:
M d  P  L  R,Y  or
where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand of real monetary assets
• Aggregate demand of real monetary assets is a function of
national income and interest rates.
Md
 L  R,Y 
P
Figure 15.1 Aggregate Real Money
Demand and the Interest Rate
The downward-sloping real money demand schedule shows that for a

given real income level Y, real money demand rises as the interest rate
falls.
Figure 15.2 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 whole
demand schedule to shift upward.
A Model of the Money Market (1 of 4)
• The money market is where monetary or liquid assets,
which are loosely called “money,” are lent and borrowed.
– Monetary assets in the money market generally
have low interest rates compared to interest rates on
bonds, loans, and deposits of currency in the foreign
exchange markets.
– Domestic interest rates directly affect rates of return
on domestic currency deposits in the foreign
exchange markets.

• When no shortages (excess demand) or surpluses (excess
supply) of monetary assets exist, the model achieves an
equilibrium:
Ms  Md
• Alternatively, when the quantity of real monetary assets

supplied matches the quantity of real monetary assets
demanded, the model achieves an equilibrium:
Ms
 L  R,Y 
P

• When there is an excess supply of monetary assets, there
is an excess demand for interest- bearing assets like
bonds, loans, and deposits.
– People with an excess supply of monetary assets are
willing to offer or accept interest-bearing assets (by
giving up their money) at lower interest rates.
– Others are more willing to hold additional monetary
assets as interest rates (the opportunity cost of holding
monetary assets) fall.

• When there is an excess demand of monetary assets,
there is an excess supply of interest- bearing assets like
bonds, loans, and deposits.
– People who desire monetary assets but do not have
access to them are willing to sell nonmonetary assets
in return for the monetary assets that they desire.
– Those with monetary assets are more willing to give
them up in return for interest-bearing assets as interest
rates (the opportunity cost of holding money) rise.

Figure 15.3 Determination of the
Equilibrium Interest Rate
Ms
With P and Y given and a real money supply of , money market equilibrium is
P
at point 1. At this point, aggregate real money demand and the real money
supply are equal and the equilibrium interest rate is R1.
Figure 15.4 Effect of an Increase in the
Money Supply on the Interest Rate
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 (point 1)
to R2 (point 2).
Figure 15.5 Effect on the Interest Rate
of a Rise in Real Income
MS
Given the real money supply,
P

 Q1 ,  a rise in real income from Y1 to Y2
raises the interest rate from R1 (point 1) to R2 (point 2).
Figure 15.6 Simultaneous Equilibrium in the U.S.
Money Market and the Foreign Exchange Market
Both asset markets are in equilibrium at the interest rate R1 and

exchange rate E1; at these values, money supply equals money demand
(point 1) and the interest parity condition holds (point 1’).
Figure 15.7 Money Market/Exchange
Rate Linkages
Monetary policy actions by
the Fed affect the U.S.
interest rate, changing the
dollar/euro exchange rate
that clears the foreign
exchange market. The
ECB can affect the
exchange rate by changing
the European money
supply and interest rate.

Figure 15.8 Effect on the Dollar/Euro Exchange Rate
and Dollar Interest Rate of an Increase in the U.S.
Money Supply
Given PUS and YUS when the money supply rises from M1 to M2 the dollar interest rate
declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates
against the euro (as foreign exchange market equilibrium is reestablished at point 2’).
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.

Changes in the Foreign Money Supply (1 of 2)
• How would a change in the supply of euros affect the U.S.
money market and foreign exchange markets?
• An increase in the supply of euros causes a depreciation
of the euro (an appreciation of
the dollar).
• A decrease in the supply of euros causes an appreciation
of the euro (a depreciation of the dollar).

Figure 15.9 Effect of an Increase in the European
Money Supply on the Dollar/Euro Exchange Rate
By lowering the dollar return on euro deposits (shown as a leftward shift in the
expected euro return curve), an increase in Europe’s money supply causes the dollar
to appreciate against the euro. Equilibrium in the foreign exchange market shifts from
point 1’ to point 2’ but equilibrium in the U.S. money market remains at point 1.
Changes in the Foreign Money Supply (2 of 2)
• The 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.

Long Run and Short Run (1 of 3)
• In the short run, prices do not have sufficient time to adjust to
market conditions.
– The analysis heretofore has been a short-run analysis.
• In the long run, 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 of saved funds.

• In the long run, the quantity of money supplied is predicted
not to influence the amount of output, (real) interest rates,
and the aggregate demand of real monetary assets L(R,Y).
• However, the quantity of money supplied is predicted to
make the level of average prices adjust proportionally in
the long run.
MS
– The equilibrium condition  L  R,Y  shows that P
P
is predicted to adjust proportionally when Ms adjusts,
because L(R,Y) does not change.

• In the long run, there is a direct relationship between the
inflation rate and changes in the money supply.
M S  P  L  R,Y 
MS
P 
L  R,Y 
P M S L
 S

P M L
– The inflation rate is predicted to equal the growth rate
in money supply minus the growth rate in money
demand.
Figure 15.10 Average Money Growth and Inflation in
Western Hemisphere Developing Countries, by Year,
1987–2014
Even year by year, there is a strong positive relation between average Latin American
money supply growth and inflation. (Both axes have logarithmic scales.)
Source: World Bank development indicators database and own calculations. Regional
aggregates are weighted by shares of dollar GDP in total regional dollar GDP.
Money and Prices in the Long Run (1 of 2)
• How does a change in the money supply cause prices of
output and inputs to change?
1. Excess demand of goods and services: 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,
creating a strong demand of labor services, 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 costs.
Money and Prices in the Long Run (2 of 2)
– Alternatively, for a fixed amount of output and inputs,
producers can charge higher prices and still sell all of their
output due to the high demand.
2. Inflationary expectations:
– 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 costs if they expect
to raise prices.
– Result: expectations about inflation caused by an expected
increase in the money supply causes actual inflation.

Figure 15.11 Month-to-Month Variability of the
Dollar/Yen Exchange Rate and of the U.S./Japan
Price Level Ratio, 1980–2016
The much greater month-to-month variability of the exchange rate suggests that
price levels are relatively sticky in the short run.
Source: Price levels from International Monetary Fund, International Financial
Statistics. Exchange rate from Global Financial Data.
Money, Prices, Exchange Rates, and
Expectations
• When we consider price changes in the long run,
inflationary expectations will have an effect in foreign
exchange markets.
• Suppose that expectations about inflation change as
people change their minds, but actual adjustment of
prices occurs afterwards.

Figure 15.12 Short-Run and Long-Run Effects of
an Increase in the U.S. Money Supply (Given Real
Output, Y)
(a) Short-run adjustment of the asset markets. (b) How the interest rate, price
level, and exchange rate move over time as the economy approaches its long-
run equilibrium.
Money, Prices, and Exchange Rates in the
Long Run
• A permanent increase in a 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 country’s money supply causes
a proportional long-run appreciation of its currency.
– However, the dynamics of the model predict a large
appreciation first and a smaller subsequent
depreciation.

Figure 15.13 Time Paths of U.S. Economic Variables
after a Permanent Increase in the U.S. Money Supply
After the money supply increases at t0 in panel (a), the interest rate [in panel (b)],
price level [in panel (c)], and exchange rate [in panel (d)] move as shown toward
their long-run levels. As indicated in panel
(d) by the initial jump from E1 to E2 , the exchange rate overshoots in the short
run before settling down to its long-run level, E3.
Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long-
run 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.

Summary (1 of 4)
1. Money demand for individuals and institutions is primarily
determined by interest rates and the need for liquidity, the
latter of which is influenced by prices and income.
2. Aggregate money demand is primarily determined by
interest rates, the level of average prices, and national
income.
• Aggregate demand of real monetary assets depends
negatively on the interest rate and positively on real
national income.

Summary (2 of 4)
3. When the money market is in equilibrium, there are no
surpluses or shortages of monetary assets: the quantity
of real monetary assets supplied matches the quantity of
real monetary assets demanded.
4. Short-run scenario: changes in the money supply affect
domestic interest rates, as well as the exchange rate. An
increase in the domestic money supply
1. lowers domestic interest rates,
2. thus lowering the rate of return on deposits of
domestic currency,
3. thus causing the domestic currency to depreciate.

Summary (3 of 4)
5. Long-run scenario: changes in the quantity of money supplied
are matched by a proportional change in prices, and do not
affect real income and real interest rates. An increase in the
money supply
1. causes expectations about inflation to adjust,
2. thus causing the domestic currency to depreciate further,
3. and causes prices to adjust proportionally in the long run,
4. thus causing interest rates to return to their long-run values,
5. and causes a proportional long-run depreciation in the
domestic currency.

Summary (4 of 4)
6. Interest rates adjust immediately to changes in monetary
policy, but prices and (expected) inflation may adjust only
in the long run, which results in overshooting of the
exchange rate.
• 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.

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International Economics: Theory and

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

The downward-sloping real money demand schedule shows that for a

An increase in real income from Y1 to Y2 raises the demand for real

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

• Alternatively, when the quantity of real monetary assets

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Both asset markets are in equilibrium at the interest rate R1 and

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

Copyright © 2018 Pearson Education, Ltd. All rights reserved.

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