Money, Interest Rates and

Exchange Rates
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

Functions of Money

Money as a medium of exchange

 Money is a medium of exchange, and is generally
accepted as a means of payments
 In a barter economy, goods were directly traded. It would
take time and high cost to search for consumers or
producers who need the goods
 In a modern economy, money is widely used as a medium
of exchange, thus reducing the transaction cost and
stimulating trade.
Functions of Money

Money as a unit of account

 Money is widely recognized as a measure of value
 In modern economy, all prices are expressed in terms of
money.
 Quoting prices in terms of money makes it easy to
compare prices between commodities and countries.
 Money prices denominated in different currencies can be
translated into comparable terms using the exchange rate.
Functions of Money

Money as a store of value

 Since money is a widely recognized medium of
exchange, it has a purchasing power and can be used as a
store of value.
 Money is the most liquid asset since it can be transformed
into other goods and assets without transaction costs and
fees.
 Money sets a standard against which the liquidity of other
assets is judged.
Money supply
 The money supply can be defined in broad terms or
narrow terms
 In a narrow term (M1), the money supply consists of high
liquid assets widely used in daily transaction, that is cash
and checking deposit.
 In a broader term (M2), the money supply consists of M1
components and some less liquid assets such as term
deposits.
 The supply of money is controlled by the central bank.
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

Demand for Money

 The demand for money is the amount of money that

individuals and organizations wish to hold for daily
transactions
 The demand for money depends on three factors:
 i) the expected return to money (relative to other
assets);
 ii) the degree of risk;
 iii) the liquidity
Demand for Money

Expected return to money

 Currency and checking deposits pay no interest rates
or only low interest rates. Other assets with less
liquidity offer higher rates of return
 The opportunity cost of holding money is the rate of
return on other less liquid assets.
 When the interest rate rises, the opportunity cost of
holding money rises and reduces the demand for
money.
Demand for Money

Degree of risk
 The increase in the prices of goods and services
reduces the purchasing power of money and poses a
risk to the holding of money.
 The inflation does not only reduce the value of money,
but also the value of assets denominated in the same
currency.
Demand for Money

Liquidity
 Since money is high liquid assets, it is held mainly for
daily transaction.
 The demand for liquidity depends on the amount of
daily transaction.
 When the demand for everyday transaction rises, people
want to keep more money and the demand for money
increases.
Demand for Money

Aggregate money demand (I)

 The aggregate demand for money is the sum of
individual demand for money by all households and
firms in an economy.
 The aggregate demand for money depends on three
factors:
➢ The interest rate
➢ The price level
➢ Income.
Demand for Money

Aggregate money demand (II)

 The interest rate: a higher interest rate reduces the
individual demand for money and the aggregate
demand for money
 The price level: when inflation rises, people need more
money to purchase the same amount of goods and
services, thus raising the demand for money.
 Income: the increase in income raises the demand for
goods and services, thus raising the demand for money
Demand for Money

Aggregate money demand (III)

 The aggregate demand for money can be expressed as
follows:
Md = P*L(Y,R)
➢ here P denotes for the pricelevel
➢ Y is the real income
➢ R is the interest rate

 The real aggregate demand for money can be written as

Md/P = L(Y,R)
➢ here, L(Y,R) is the real aggregate demand for money
Aggregate money demand (IV)
Figure 14-1:Aggregate Real Money Demand and the Interest Rate
Interest
rate, R
The downward sloping real
money demand schedule
shows that for a given real
income level Y, real money
demand rise as interest rate
falls

L(R,Y)

Aggregate real
money demand
Aggregate money demand (V)
Figure 14-2: Effect on the Aggregate Real Money Demand Schedule
Rise in Real Income
Interest
rate, R
An increase in real
income from Y1 to Y2
raises the demand for
Increase in
real money balance at real income
every level of the
interest rates and cause
the whole demand
schedule to shift L(R,Y2)
upward.
L(R,Y1)

Aggregate real
money demand
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

Equilibrium in the money market

 Condition for equilibrium in the money market

➢MS = Md
➢MS/P = L(Y,R)
Equilibrium in the money market
Figure 14-3: Determination of the Equilibrium Interest Rate
Interest
rate, R
Real money supply

2
R2

1 Aggregate real
R1 money demand,
3 L(R,Y)
R3

Q2 MS ( = Q 1 ) Q3 Real money
P holdings
Equilibrium interest rate

 The interest rate that brings the demand for money

into the equality with the supply of money is called as
the equilibrium interest rate
 The interest rate tends to settle at the equilibrium
level.
 The interest rate rises if there is an excess demand
for money
 It falls if there is excess supply of money.
Increase in the money supply
Figure 14-4: Effect of an Increase in the Money Supply on the Interest
Rate
Interest - An increase in the
rate, R money supply
Real money cause the MS
supply Real money schedule to shift
supply increase right
At the initial interest
1 rate R1 there is an
R1 excess supply of
money, putting a
2 downward
R2
pressure on the
interest rate
L(R,Y1)
The new
equilibrium in the
money market is at
M1 M2 Real money point 2 with lower
P P holdings interest rate.
Increase in the real income
Figure 14-5: Effect on the Interest Rate of a Rise in Real Income
Interest
An increase in
rate, R income or output
Real money supply
raises the demand
for money (L(R,Y
schedule shifts
Increase in
upward)
real income
At the initial interest
2 rate R1 there is an
R2 excess demand for
1 1' money, putting an
R1 L(R,Y2) upward pressure on
the interest rate
L(R,Y1)
The new equilibrium
in the money market
MS ( = Q 1 ) 2
Q Real money is at point 2 with
P holdings higher interest rate
Interest rate, the supply of money and income

 The equilibrium interest rate is affected by the changes

in the supply of money and income
 Supply of money: an increase in the supply of
money creates an excess supply and put a downward
pressure on the interest rate
 Income: An increase in income or output raises the
demand for money and put an upward pressure on
the interest rate
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

The short-run and the long-run
 In the short-run, prices and wage rates are sticky,
and output may fall below the full-employment
level.
 Long-run equilibrium is the position in which prices
and wages have enough time to adjust to their market-
clearing levels.
 In the long-run, prices adjust in line with the
money supply and output is assumed at the full-
employment level.
Money, the interest rate and the exchange rate

 The change in money supply can affect the short-run

exchange rate through its effect on the interest rate.
 The change in the money supply affects the equilibrium
interest rate in the money market (assume prices and
output remain unchanged)
 Given an expected exchange rate, the change in the
interest rate affects the exchange rate through the
interest parity condition.
Money and the exchange rate linkage
Figure 14-7: Money-Market/Exchange Rate Linkages
United States Europe
Federal Reserve System European System
of Central Banks

MSUS (United States MS E (European

money supply) money supply)

United States European

money market money market

Foreign R€
R$
exchange (Euro interest rate)
(Dollar interest rate)
market

E$/€
(Dollar/Euro exchange rate)
 Simultaneous equilibrium in the money market and
foreign exchange market
Dollar/euro
exchange Rate, E$/€
Return on
dollar deposits
Foreign
exchange 1' Expected
E1$/€
market return on
euro deposits Rates of
return
0
R1$ L(R$, YUS) (in dollar
terms)
Money MSUS U.S. real
market PUS 1 money
(increasing) supply

U.S. real money holdings

Increase in the US money supply

Dollar/euro
exchange Rate, E$/€
Return on
dollar deposits
E2$/€ 2'
1' Expected
E1$/€
return on
euro deposits Rates of
return
0
R2$ R1$ L(R$, YUS) (in dollar
M1US terms)
PUS Increase in U.S.
1 real money supply
M2US
PUS 2

U.S. real money holdings

Increase in the US money supply

 The US money supply and the exchange rate

➢ The expansion in the US money supply creates an excess
supply of money and reduces the US interest rate.
➢ The expected return on dollar-denominated assets falls
due to the lower US interest rate and causes a portfolio
to shift toward euro-denominated assets.
➢ The higher demand for euro in turn causes a
depreciation of the US dollar.
 Increase in the EU money supply

Dollar/euro
exchange Rate, E$/€
Dollar return
1'
E1$/€ Increase in European
2' money supply
E2$/€
Expected Rates of
euro return return
0
R1$ (in dollar
L(R$, YUS)
terms)
MSUS U.S. real
PUS 1 money
supply

U.S. real money holdings

Increase in the EU money supply

 The European money supply and the exchange rate

➢ The expansion in the European money supply creates
an excess supply of money in Europe and reduces the
European interest rate
➢ The lower European interest rate reduces the expected
return on euro-denominated assets, thus lowering the
demand for euro and causing a depreciation of euro
against US dollar.
➢ In summary, monetary expansion in a foreign country
will lead to an appreciation of domestic currency.
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

Permanent and Temporary Policy Changes

 The permanent and temporary changes in the money

supply have different short-run effects:
 A temporary change in the money supply is not
maintained in the future, thus it has no effect on the
long-run equilibrium.
 A permanent change in the money supply can affect the
long-run equilibrium and the expected exchange rate.
Long-run impacts the money supply
 Given the full-employment assumption, the long-run real
output depends only on the endowment of production
factors and technology.
 In the long-run, the interest rate reflect the opportunities
cost of holding money and the consumers’preferences
between current consumption and future consumption.
 The change in the supply of money has no impacts on the
interest rate and the real ouput over the long-run.
 Given other things equal, the change in the money
supply cause a proportional change in the price level.
Long-run equilibrium price level

 In the long-run, the price level depends on the the

interest rate, real output and the supply of money.
 The long-run equilibrium condition in the money
market can be written as:
P = Ms/L(R,Y)
 In the long-run equilibrium, an increase in the supply
of money causes a proportional increase in the prices
level given all other things equal.
Empirical evidence on the money supply and price level
(Western Hemisphere developing countries)
Empirical evidence on the money supply and price level

 The empirical evidence show a strong positive correlation

between the supply of money and the prices level in different
countries, justifying in part the predictions by the monetary
theory.
 However, empirical evidence fails to show an exact
proportional relationship between the money supply and the
price level since there are various factors that affect real output
and the interest rate in the long run.
 Real output can be affected by the changes in the supply of labor
and capital and technological progress.
 The demographic change or financial inovation can affect the
demand for money and the interest rate.
Money and the exchange rate in the long-run

 Since the exchange rate is the price of foreign currency

meassured in terms of domestic curency, the change in the
price level has an impact on the exchange rate.
 In the long-run, an increase in the domestic price level
causes a proportional increase in the exchange rate or a
proportional depreciation of domestic currency
 Conclusion: a change in a country’s money supply will
cause a proportional change in the price level and
exchange rate.
Money and the exchange rate in the long-run

 A permanent increase in a country’s money supply causes a

proportional increase in the price level and a proportional
long run depreciation of its currency.

 A permanent decrease in a country’s money supply causes a

proportional decrease in the price level and a proportional
long run appreciation of its currency.
• Brief Review of Money

• Demand for Money

• Money Market and Interest Rate

• Money Supply and Exchange Rate in the short run

• Money, Prices and the exchange rate in the long-run

• Inflation and the dynamics of the exchange rate

Short-run price rigidity
 The assumption of short-run price rigidity says that
prices will not change immediately in response to the
changing economic conditions
 The short-run price stickiness stems from
 the slugish movement of wage rates,
 the long-term contracts and
 the regulation and intervention by the government.
 The stickiness (or the flexibility of prices) in the short-
run varies between commodities and countries and
remain debated in economics.
Long-run price flexibility
 The change in the supply of money causes prices to the
change in the long-run.
 An increase in the money supply raises the demand for
goods and services. The resulting increase in demand for
labor and wage rates eventually cause the production costs
and prices to rise.
 The increase in the money supply causes an expectation
on inflation, which in turn creates an upward pressure on
the wage rate and prices.
 The prices of raw material and fuel tend to adjust quickly in
the short-run, thus raising the production cost and
putting an upward pressure on the price of final goods.
 Adjustment toward long-run equilibrium
Figure 14-12: Effects of an Increase in the U.S.Money Supply
Dollar/euro exchange Dollar/euro exchange
Rate, E$/€ Rate, E$/€
Dollar return Dollar return
2'
E2$/€ E2$/€ 2'
Expected
euro return 4' Expected
3' E3$/€ euro return
E1$/€ 1'
Rates of return
0 (in dollar 0
R2$ R1$ L(R , Y ) terms) R2$ R1$
M1US $ US
2
M US L(R$, YUS)
P1US 1 P2US 4 U.S. real money supply
M2US M2US
2 P1US 2
P1US

(a) Short-run effects (b) Long-run effects

U.S. real U.S. real
money holdings money holdings
Adjustment toward long-run equilibrium
Figure 14-13: Time Paths of U.S. Economic Variables After a Permanent
Increase in the U.S. Money Supply
(a) U.S. money supply, MUS (b) Dollar interest rate, R$

M2US R1$

M1US R2$

t0 Time t0 Time
(c) U.S. price level, PUS (d) Dollar/euro exchange rate, E$/€
E2$/€

P2US E3$/€

P1US E1$/€

t0 Time t0 Time
Adjustment toward long-run equilibrium
 In the short-run, a permanent increase in the supply of
money reduces the domestic interest rate, which, in
combination with the expected depreciation of
domestic currency, raises the expected return on
foreign assets.
 Over time, domestic prices rise, raising the demand for
money. The interest rate is back to the initial level,
causing the appreciation of domestic currency during
the adjustment toward long-run equilibrium.
 At the new equilibrium, the interest rate settles at the
initial level. The domestic currency still depreciates
but to a lesser extent as compared to the short-run level.
Exchange rate overshooting
 In the sort-run, the exchange rate rises above the long-
run level, showing a greater depreciation of domestic
currency in the short-run as compared to the long-run
level. This phenomenon is called the exchange rate
overshooting.
 The exchange rate overshooting can be explained by
the interest parity condition so that the higher
domestic interest rate must be offset by the
appreciation of the domestic currency during the
adjust ment.
Exchange rate overshooting
Thank you!