Money, Interest Rates and

Exchange Rates
Nguyễn Tiến Dũng, PhD
Faculty of International Economics,
College of Economics, VNU
Objective
This lesson discusses link between money, interest
rates, and the exchange rate, focussing on the impact
of the changes in money demand and supply on the
exchange rate, both in the short-run and the long-run
Content
A Brief Review of Money
The Demand for Money
Money market and the 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
1. A Brief Review 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 are 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.
1. A Brief Review 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.
1. A Brief Review 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.
2. The Demand for Money
The demand for money
The demand for money is the amount of money that
individuals and organizations wish to hold.
Questions: What are the factors that affecting the
demand for money?
2. The Demand for Money
The demand for money
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
2. The Demand for Money
The 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.
2. The Demand for Money
The 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.
2. The 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.
2. The 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.
2. The 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
2. The 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
2. The Demand for Money
Aggregate money demand (IV)
2. The Demand for Money
Aggregate money demand (IV)
3. Money market and the interest rate
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.
3. Money market and the interest rate
Equilibrium in the money market
The money market is in equilibrium when the supply
of money is equal to the demand for money
MS = Md or MS/P = L(Y,R)
Here MS is the supply of money
Md is the demand for money
3. Money market and the interest rate
Equilibrium in the money market
3. Money market and the interest rate
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, and it falls if there is excess supply
of money.
3. Money market and the interest rate
Increase in the money supply
3. Money market and the interest rate
Increase in the real income
3. Money market and the 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 un upward pressure on the
interest rate
4. Money supply and exchange rate in the short-run
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 or
rise above 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.
4. Money supply and exchange rate in the short-run
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.
4. Money supply and exchange rate in the short-run
Money and the exchange rate linkage
4. Money supply and exchange rate in the short-run
Simultanous equilibrium in the money and FX market
4. Money supply and exchange rate in the short-run
Increase in the US money supply
4. Money supply and exchange rate in the short-run
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 for 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
shift toward euro-denominated assets. The higher
demand for euro in turn causes a depreciation of the US
dollar.
4. Money supply and exchange rate in the short-run
Increase in the European money supply
4. Money supply and exchange rate in the short-run
Increase in the European 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.
5. Money, Prices and the exchange rate in the long-run
Permanent and Temporary (one-time) 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.
5. Money, Prices and the exchange rate in the long-run
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 opportunity
costs of holding money and the consumers’preferences
between current consumption and future consumption.
The one-time 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.
5. Money, Prices and the exchange rate in the long-run
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.
5. Money, Prices and the exchange rate in the long-run
Empirical evidence on the money supply and price level
(Western Hemisphere developing countries)
5. Money, Prices and the exchange rate in the long-run
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.
5. Money, Prices and the exchange rate in the long-run
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: Other things equal, a change in a
country’s money supply will cause a proportional
change in the price level and exchange rate.
5. Money, Prices and the exchange rate in the long-run
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.
6. 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.
6. Inflation and the dynamics of the exchange rate
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.
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
Short-run Effects of a Permanent Increase in US money Supply
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
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.
6. Inflation and the dynamics of the exchange rate
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.
6. Inflation and the dynamics of the exchange rate
Exchange rate overshooting