CHAPTER 15

Money, Interest Rates, and

Exchange Rates
MONEY MARKET/EXCHANGE RATE LINKAGES
15-2
15-3
PREVIEW

• What is money?
• The supply and demand for money
• 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? DEFINITION

Money is the stock

of assets that can be
readily used to make
transactions.
 THE ROLE OF MONEY IN ECONOMY

• Medium of exchange
• A generally accepted means of payment

• A unit of account (numeraire)

• A widely recognized measure of value

• A store of value
• A transfer purchasing power from the present into the future
15-6
WHAT IS MONEY? (CONT.)

• 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.
15-7
WHAT IS MONEY? (CONT.)

• Different groups of assets may be classified as money.

• Money can be defined narrowly or broadly.

• M1 = Currency in circulation + demand deposits (checking

deposits), form a narrow definition of money.

• M2 = M1 + time deposits + saving deposits, form a broader

definition of money.

• Liquidity: M2<M1

• In this chapter, when we speak of the money, we are referring

M1.
15-8
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.

• In China, the central bank is the People’s Bank of China (PBC).

To expand the money supply:
The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.

To reduce the money supply:

The Federal Reserve sells U.S. Treasury Bonds
and receives the existing dollars.
15-10
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.
15-11
WHAT INFLUENCES DEMAND OF MONEY
FOR INDIVIDUALS AND INSTITUTIONS?

1. Interest rates/expected rates of return on non-monetary

assets relative to the expected rates of returns on monetary
assets.
 Non-monetary assets pay higher interest rates
 A higher interest rate means a higher opportunity cost of holding
monetary assets  lower demand of money

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.
15-12
WHAT INFLUENCES DEMAND OF
MONEY FOR INDIVIDUALS? (CONT.)
• Liquidity: A need for greater liquidity occurs when the
price of transactions increases or the quantity of goods
bought in transactions increases.
 When the price level increases, nominal transaction volume increases,
and demand of money increases
 When income rises, transaction volume increases and demand of
money rises
A MATHEMATICAL MODEL
15-13

max log c1   log c2

c1 ,c2 , M , s

 P  c1  s   M  PY

s.t.   2 
 Pc2  M  1  r  Ps  P  s 
 2 

where P   scaptures
2 transaction cost for illiquidity asset s.
 
2 
 15-14
WHAT INFLUENCES AGGREGATE
DEMAND OF MONEY?
Aggregate demand of money is just the sum of
individual demand, therefore aggregate demand of
money is still affected by:

 Interest rates/expected rates of return: R

 Prices: P

 Income: Y
15-15
A MODEL OF AGGREGATE MONEY
DEMAND
The aggregate demand of money can be expressed as:
Md = P x L(R,Y)
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
Alternatively:
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of
national income and interest rates.
15-16
FIG. 15-1: AGGREGATE REAL MONEY
DEMAND AND THE INTEREST RATE
For a given level of
income , real money
demand decreases as the
interest rate increases
15-17 FIG. 15-2: EFFECT ON THE AGGREGATE REAL
MONEY DEMAND SCHEDULE OF A RISE IN REAL
INCOME
When income increases,
real money demand
increases at every interest
rate.
MONEY MARKET EQUILIBRIUM
15-18

• The money market is for the monetary or liquid assets, which are loosely
called “money”.
• 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.
15-19
MONEY MARKET EQUILIBRIUM
(CONT.)
• When no shortages (excess demand) or surpluses
(excess supply) of monetary assets exist, the model
achieves an equilibrium:
M s = Md
• Alternatively, when the quantity of real monetary
assets supplied matches the quantity of real monetary
assets demanded, the model achieves an equilibrium:
Ms/P = L(R,Y)
15-20
FIG. 15-3: DETERMINATION OF THE
EQUILIBRIUM INTEREST RATE

Excess demand
MONEY MARKET EQUILIBRIUM(CONT.)
15-21

• When there is an excess supply of monetary

assets, people are more willing to purchase
interest-bearing assets like bonds, loans, and
deposits. This will bid up the price of non-
monetary asset, or push down the interest rate,
until there is no excess supply of money.
15-22
FIG. 15-4: EFFECT OF AN INCREASE IN THE
MONEY SUPPLY ON THE INTEREST RATE
An increase in the money
supply lowers the interest
rate for a given price level.

A decrease in the money

supply raises the interest
rate for a given price level.
15-23
FIG. 15-5: EFFECT ON THE INTEREST
RATE OF A RISE IN REAL INCOME
An increase in real national
income increases interest rate
for a given price level.
FIG. 15-7: MONEY MARKET/EXCHANGE RATE
LINKAGES
15-24
FIG. 15-6:
SIMULTANEOUS
15-25

EQUILIBRIUM IN THE
U.S. MONEY MARKET
AND THE FOREIGN
EXCHANGE MARKET
FIG. 15-8: EFFECT ON THE DOLLAR/EURO EXCHANGE RATE AND
DOLLAR INTEREST RATE OF AN INCREASE IN THE U.S. MONEY
15-26
SUPPLY
15-27
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.
15-28
EXERCISE

• How does the increase in the real national income affect

the exchange rate?
15-29
CHANGES IN THE FOREIGN MONEY
SUPPLY

• How would a change in the supply of euros affect the U.S.

money market and foreign exchange markets?
FIG. 15-9: EFFECT OF AN INCREASE IN THE EUROPEAN MONEY
SUPPLY
15-30
ON THE DOLLAR/EURO EXCHANGE RATE

US money market equilibrium

does not change
15-31
CHANGES IN THE FOREIGN MONEY
SUPPLY (CONT.)

• 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.

• There is no change in the U.S. money market due to the

change in the supply of euros.
LONG RUN AND SHORT RUN
15-32

• 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.
15-33
LONG RUN AND SHORT RUN
(CONT.)
• Neutrality of money: 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.
• The equilibrium condition Ms/P = L(R,Y) shows that P is predicted to
adjust proportionally when Ms adjusts, because L(R,Y) does not
change.
15-34
LONG RUN AND SHORT RUN
(CONT.)
• In the long run, there is a direct relationship between the
inflation rate and changes in the money supply.

Ms = P x L(R,Y)

P = Ms/L(R,Y)

P/P = Ms/Ms – L/L

• The inflation rate is predicted to equal the growth rate in money
supply minus the growth rate in money demand.
FIG. 15-10: AVERAGE MONEY GROWTH
AND INFLATION IN WESTERN HEMISPHERE DEVELOPING
15-35
COUNTRIES, BY YEAR, 1987–2007

Source: IMF, World Economic Outlook, various issues. Regional aggregates are weighted by shares of dollar GDP in total
regional dollar GDP.
15-36
MONEY AND PRICES IN THE LONG
RUN
• 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.
 15-37
MONEY AND PRICES IN THE LONG RUN
(CONT.)
• 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.
15-38
MONEY, PRICES, EXCHANGE RATES,
AND EXPECTATIONS

• Temporary change in the level of money supply

• There is one-time change of money supply, and money supply
will come back to its initial level

• There is no change of exchange rate expectation

• Permanent change in the level of money supply

• Once money supply changes, it stays at the new level forever

• There is a change of exchange rate expectation

15-39
MONEY, PRICES, EXCHANGE RATES,
AND EXPECTATIONS (CONT.)
• Money supply increase affects exchange rate expectations
• Permanent increase in money supply -> expected increase in all
dollar prices, including the exchange rate, which is the dollar price of
euros -> a rise in the expected future dollar/euro exchange rate
 FIGURE: SHORT-RUN AND LONG-RUN EFFECTS OF A TEMPORARY
INCREASE IN THE U.S. MONEY SUPPLY (GIVEN REAL OUTPUT, Y)

S.R
L.R.

Temporary change in money supply does

not change the expectation of exchange
rate!

S.R.

L.R.
 MONEY, PRICES, AND EXCHANGE RATES IN THE LONG RUN

• A temporary increase in a country’s money supply causes its currency to

depreciate in the foreign exchange market in short run; in long run,
temporary increase in money supply has no impact on both exchange rate
and interest rate.

• A temporary decrease in a country’s money supply causes its currency to

appreciate in the foreign exchange market in short run; in long run,
temporary increase in money supply has no impact on both exchange rate
and interest rate.
FIG. 15-12: SHORT-RUN AND LONG-RUN EFFECTS OF AN
PERMANENT
15-42 INCREASE IN THE U.S. MONEY SUPPLY (GIVEN REAL
OUTPUT, Y)
FIG. 15-13: TIME PATHS OF U.S. ECONOMIC VARIABLES
15-43
AFTER A PERMANENT INCREASE IN THE U.S. MONEY
SUPPLY
15-44
MONEY, PRICES, AND EXCHANGE RATES
IN THE LONG RUN (CONT.)

• 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.
 15-45
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.

 15-46
SUMMARY
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.
15-47
SUMMARY (CONT.)

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.
15-48
SUMMARY (CONT.)

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.
15-49
SUMMARY (CONT.)

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.