Ch. 15: Money, Interest Rates,and Exchange Rates

Udayan RoyECO41 International Economics

What is Money?

• Money is any asset that is widely used and accepted as a means of payment.

• So, a country’s quantity of money (Ms) includes– All currency with the public and

– The value of all checking accounts• bank deposits in a foreign currency are excluded from this

definition.

• M1 and M2 are two well-known periodically published measures of the quantity of money

Properties of Money: No Return

• We can classify all assets into:– Money, which earns no return• Currency with the public, checking accounts

– Assets that earn a return• Stocks, bonds, real estate, etc.

Properties of Money: Liquid

• Money is very liquid: – that is, it can easily and quickly be used to purchase goods

and services.

• Assets that earn a return are less liquid

Money Supply

• The quantity of money is also called the money supply

• Who controls the money supply?

• Central banks determine the money supply.– In the US, the central bank is the Federal Reserve.

– The Federal Reserve directly regulates the amount of currency in circulation.

– It indirectly controls the amount of checking deposits issued by private banks.

Money Demand

• Money demand is the amount of their wealth that people are willing to hold in the form of money …– (… instead of other assets that are less liquid but earn a

higher return).

Money Demand: Individual

1. Interest rate (on interest-earning assets): this is the cost (or, downside) of holding money.

2. Risk: the risk of holding money principally comes from unexpected inflation, thereby unexpectedly reducing the purchasing power of money.– but many other assets have this risk too, so this risk is not very

important in money demand

3. Liquidity: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought in transactions increases.

Money Demand: Aggregate

• Interest rate• Average level of prices• Income

Money Demand: Aggregate

• Money pays little or no interest. • So, the interest rate on interest-earning assets

(such as bonds) is the opportunity cost of holding money (instead of non-money assets).

• A higher interest rate means a higher opportunity cost of holding money lower money demand

• Therefore, aggregate money demand (Md) is inversely related to the interest rate (R)

Money Demand: Aggregate

• The overall level of prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.

• A higher overall price level means a greater need for liquidity to buy the same amount of goods and services higher money demand

• Therefore, aggregate money demand (Md) is directly related to the overall level of prices (P)

Money Demand: Aggregate

• Higher income implies more goods and services are being produced and bought

• So, more money would be 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 money demand

• Therefore, aggregate money demand (Md) is directly related to GNP (Y)

Money Demand: Aggregate

• , where blue indicates a direct effect and red indicates an inverse effect

Money Demand: Aggregate

• Let’s be specific about the L in money demand• Let , where L0 represents all the other factors

that affect people’s willingness to hold their wealth in the form of money other than P, R, and Y.

• Then,

Equilibrium

• For an economy to be in equilibrium, money supply must equal money demand

• A central bank may determine the money supply

• But it cannot force people to hold exactly that much of their wealth in the form of money

• Therefore, is necessary for equilibrium

Equilibrium

• Therefore, is essential for equilibrium• With our specific version of money demand,

the equilibrium condition becomes • This equation has two parameters—Ms and L0

—with values that are assumed known, and three variables—P, Y, and R—of unknown value

THE AA CURVEThis topic is actually in Chapter 17. But let’s do it now anyway.

Two Markets: Foreign Exchange and Money

• So far, we have seen the equilibrium conditions for the two asset markets– The foreign exchange market (Ch. 14), and– The money market (this chapter)

),( YRLP

M s

1* E

ERR

e

Equilibrium in Asset Markets

• Let us simplify the money market equilibrium equation to or equivalently to

• The interest parity equation then yields • Note that this equation must be true if there

is equilibrium in the foreign exchange and money markets

Equilibrium in Asset Markets

• If all parameters and variables are constant, except Y and E, then we get an inverse link between Y and E.

• Why? If E increases, the right-hand-side of the equation decreases. Therefore, Y must decrease.

Equilibrium in Asset Markets

• If all parameters and variables are constant, except Y and E, then we get an inverse link between Y and E.

• Why? If E increases, the right-hand-side of the equation decreases. Therefore, Y must decrease.

This gives us the AA Schedule (or the AA Curve) of Chapter 17.

Fig. 17-7: The AA Schedule

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ERR

e

),( YRLP

M s

Shifting the AA Curve

– Suppose the economy is initially at Point 2

– Suppose there is a decrease in Ms or R* or Ee, or an increase in L0 or P

– If E stays unchanged at E2, then Y must decrease

– The economy must go from Point 2 to, perhaps, Point 3

– In other words, a decrease in Ms or R* or Ee, or an increase in L0 or P shifts the AA curve left

AA2

3

Shifting the AA Curve

• The AA curve shifts right if:– Ms increases– P decreases– Ee rises– R* rises– L decreases for some unknown reason

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),( YRLP

M s

Y

E

E0

Y0 Y1

E1