Money, Interest Rates, and Exchange Rates

Lecture (7)
Chapter 15
1. Characteristics of Money
 Medium of Exchange:
 Generally accepted mean of payment in exchange for goods and services.
 Unit of Account:
 Generally accepted measure of value.
 Gives us the ability to compare between items.
 The convention of quoting prices in money terms simplifies economic calculations by
making it easy to compare the prices of different commodities (Relative Price).
 Store of Value
 Generally accepted mean to transfer purchasing power from the present into the future.
 This attribute is essential cause no one will accept it if its value evaporates immediately.

2. What is Money?
 Money is the most liquid of all assets.
 An asset is said to be liquid when it can be transformed into goods and services rapidly
and without high transaction costs.
 Since money is acceptable as a mean of payment, money sets the standard against which
the liquidity of other assets is judged.
 Money = Currency in circulation + bank deposit.
 Money circulates in the economy is controlled by central banks either directly through
Money supply or indirectly through market operations.
 Money supply: the monetary aggregate the Federal Reserve calls M1, that is, the total
amount of currency and checking deposits held by households and firms.
 M1 represents liquid assets like currency and demand deposits.
 M2 includes less liquid assets such as savings accounts.
 M3 comprises larger time deposits and institutional funds, reflecting the spectrum of money's
liquidity.
 M1 = M0 + demand deposits
 M2 = M1 + marketable securities + other less liquid bank deposits
 M3 = M2 + money market funds
 M4 = M3 + least liquid assets
3. The Demand for Money

The Theory of Asset Demand states that other things equal, people prefer assets offering higher
expected returns. Because an increase in the interest rate is a rise in the rate of return on less
liquid assets relative to the rate of return on money, individuals will want to hold more of their
wealth in nonmoney assets that pay the market interest rate and less of their wealth in the form of
money if the interest rate rises. We conclude that, all else equal, a rise in the interest rate causes
the demand for money to fall.

Individual demand for an asset is based on 3 characteristics:

1. The expected return the asset offers compared with the returns offered by other assets.
2. The riskiness of the asset’s expected return.
3. The asset’s liquidity.
 Expected Return

 Currency pays no interest/has no returns.

 When you hold money, you therefore sacrifice the higher interest rate you could earn by
holding your wealth in any asset that could bring you returns/has interest rate.
 When interest rate ↑, demand for liquid money ↓ (Ceters Paribus)
 The interest rate measures the opportunity cost of holding money rather than interest-bearing
assets.
 A rise in the interest rate therefore raises the cost of holding money and causes money
demand to fall.

Risk

• It is risky to hold money because an unexpected increase in the prices of goods and services
could reduce the value of your money in terms of the commodities you consume (Purchasing
Power).

• Because any change in the riskiness of money causes an equal change in the riskiness of
assets, changes in the risk of holding money need not cause individuals to reduce their
demand for money and increase their demand for interest-paying assets.

Liquidity

• The main benefit of holding money comes from its liquidity (the ease of doing daily
transactions).

• An individual’s need for liquidity rises when the average daily value of his/her transactions
rises.

• A student who takes the bus every day, for example, does not need to hold as much cash as a
business executive who takes taxis during rush hour.

• We conclude that a rise in the average value of transactions carried out by a household or
firm causes its demand for money to rise.
 4. Aggregate Money Demand
 The total demand for money by all households and firms in the economy.
 Aggregate money demand is just the sum of all the economy’s individual money demands.

3 main factors that determine Aggregate Money Demand (AMD):

1. Interest rate: i↑, AMD↓.

2. Price level: p↑, AMD↑.
3. Real national income: GNP↑, AMD↑.

d
M
Captured by =L ( R , Y )
P
d
M
Real purchasing power people would like to hold in liquid form.
P

L ( R ,Y ) Demand to hold a certain amount of real purchasing power in liquid form.

4. Equilibrium in Money Market

1. The market always moves toward an interest rate at

which the real money supply equals aggregate real
 money demand. If there is initially an excess supply of money, the interest rate falls, and
if there is initially an excess demand, it rises (movement).

2. 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 (shift).

3. 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 (shift).

5. Money Supply and Exchange Rate in Short Run

 When Egyptian pound supply (Ms) ↑, i↓, households don’t want Egyptian pound cause it
gives lower rate of return, depreciation of Egyptian pound compared to other currencies,
households start to demand other currencies.
 When Egyptian pound supply (Ms) ↓, i ↑, households want Egyptian pound cause it gives
higher rate of return, appreciation of Egyptian pound compared to other currencies,
households start to demand Egyptian pound.
 Assuming everything else constant in the economy and more specifically domestic price
level.
6. Money Supply and Exchange Rate in Long Run
 Money supply and exchange rate in the long run depends on the economy.
 If the economy is at full utilization of resources, an increase in money supply/currency
reform will cause an increase in the inflation, depreciating the currency. In the long run,
changes in production are not affected by money supply but rather the endowments of labor
and capital, capital formation, investments, etc.
 However, if the economy is not in full utilization of recourses, changes in money supply will
cause inflation and consequently the economy with all of its aspects will be affected.

7. Inflation and Exchange Rate Dynamics

Short run price rigidity/stickiness:

 Excess demand for output and labor: when Ms↑, i↓, yet inflation↑, expansionary effect on
the economy.
 Inflationary expectations: when we expect inflation, we create inflation.
 Raw materials prices: there are some raw materials prices adjusted on daily bases and react
sharply to inflation as petroleum.

Long run price flexibility:

 Many prices in the economy are written into long-term contracts and cannot be changed
immediately when changes in the money supply occur as wages.
 Permanent money supply changes:
 On the short run, the effect of rising Ms is expected to be high compared to the net effect on
the long run after all adjustments take place.

Exchange Rate Overshooting:

 The exchange rate is said to overshoot when its immediate response to a disturbance is
greater than its long-run response.
 An important phenomenon because it helps explain why exchange rates move so sharply
from day to day.

Overshooting is a direct consequence of the short-run rigidity of the price level. In a hypothetical
world where the price level could adjust immediately to its new, long-run level after a money
supply increase, the dollar interest rate would not fall because prices would adjust immediately
and prevent the real money supply from rising. Thus, there would be no need for overshooting to
maintain equilibrium in the foreign exchange market. The exchange rate would maintain
equilibrium simply by jumping to its new, long-run level right away.
Questions:

1. Identify the characteristics of money.

 Medium of Exchange
 Unit of Account
 Store of Value
2. Based on the theory of asset demand, what are the 3 main characteristics based on
which individuals demand a new asset.
 Expected Return.
 Risk.
 Liquidity.
3. What are the 3 main factors that determine aggregate demand of money?

Interest rate: Interest ↑ AMD ↓

Price level: Price ↑ AMD ↑

Real national income: GNP ↑ AMD ↑

4. What is the relationship between money supply and interest rate?

The market always moves toward an interest rate at which the real money supply = aggregate
real money demand. If there is initially an excess supply of money, the interest rate falls, if there
is initially an excess demand, it rises (movement).

Money Supply↑ Interest Rate↓

Money Supply↓ Interest Rate↑

Given the price level and output (shift).

Real Output↑ Interest Rate↑

Real Output↓ Interest Rate↓

Given the price level and the money supply (shift).

5. Explain the dynamic relationship between money, interest rate, and exchange rate?

Money Supply and Exchange Rate in Short Run

When Egyptian pound supply (Ms) ↑, i↓, households don’t want Egyptian pound cause it gives
lower rate of return, depreciation of Egyptian pound compared to other currencies, households
start to demand other currencies.

When Egyptian pound supply (Ms) ↓, i ↑, households want Egyptian pound cause it gives higher
rate of return, appreciation of Egyptian pound compared to other currencies, households start to
demand Egyptian pound.

Assuming everything else constant in the economy and Money Supply and Exchange Rate in
Short Run more specifically domestic price level.

Money Supply and Exchange Rate in Long Run

If the economy is at full utilization of resources, so increase in money supply/currency reform

will cause an increase in the inflation, depreciating the currency and that’s it. simply because on
the long run, changes in production does not affected by money supply but rather the
endowments of labor and capital, capital formation, investments, etc.

However, if the economy is not in full utilization of recourses; so changes in money supply will
cause inflation and consequently the economy with all of its aspects will be affected.