ECO2008 International Economics Week 12b PDF

ECO2008 International Economics Money, Interest Rates, and Exchange Rates Week 12b Brian Varian Money 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 o...

ECO2008 International Economics Money, Interest Rates, and Exchange Rates Week 12b Brian Varian Money 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Money Supply The central bank substantially controls the quantity of money that circulates in an economy, the money supply. It directly regulates the amount of currency in circulation. It indirectly influences the amount of checking deposits, debit card accounts, and other monetary assets. Copyright © 2018 Pearson Education, Ltd. All rights reserved. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. What Influences Demand of Money for Individuals and Institutions? 1. Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets. 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. 3. Liquidity: A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions Copyright © 2018 Pearson Education, Ltd. All rights reserved. What Influences Aggregate Demand of Money? (1 of 2) 1. Interest rates/expected rates of return: monetary assets pay little or no interest, so the interest rate on non-monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets. – A higher interest rate means a higher opportunity cost of holding monetary assets lower demand of money. 2. Prices: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. – A higher level of average prices means a greater need for liquidity to buy the same amount of Copyright © 2018 Pearson Education, Ltd. All rights reserved. What Influences Aggregate Demand of Money? (2 of 2) 3. Income: greater income implies more goods and services can be bought, so that more money is 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 demand of money. Copyright © 2018 Pearson Education, Ltd. All rights reserved. A Model of Aggregate Money Demand The aggregate demand of money can be expressed as: M d  P L R,Y  or 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 Aggregate demand M d of real monetary assets is a function of national  L R,Y  and interest rates. income P Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.1 Aggregate Real Money Demand and the Interest Rate The downward-sloping real money demand schedule shows that for a given real income level Y, real money demand rises as the interest rate falls. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.2 Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income An increase in real income from Y1 to Y2 raises the demand for real money balances at every level of the interest rate and causes the whole demand schedule to shift upward. Copyright © 2018 Pearson Education, Ltd. All rights reserved. A Model of the Money Market (1 of 2) The money market is where monetary or liquid assets, which are loosely called “money,” are lent and borrowed. – 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. A Model of the Money Market (2 of 2) When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium: M s M d Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium: Ms  L R,Y  P Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.3 Determination of the Equilibrium Interest Rate Ms , With P and Y given and a real money money market P supply of at point 1. At this point, aggregateequilibriumreal moneyis R. 1 demand and the real money supply are equal and Copyright © 2018 Pearson Education, Ltd. All rights reserved. the equilibrium interest rate is Figure 15.4 Effect of an Increase in the Money Supply on the Interest Rate For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2 reduces the interest rate from R1 (point 1) to R2 (point 2). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.5 Effect on the Interest Rate of a Rise in Real Income MS Given the real money   a rise in real income from Y1 to P Q 1 , supply, raises the interest rate from R1 (point Y2 1) to R2 (point 2). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.6 Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market Both asset markets are in equilibrium at the interest rate R1 and exchange rate E1; at these values, money supply equals money demand (point 1) and the interest parity condition holds (point 1’). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.7 Money Market/Exchange Rate Linkages Monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The ECB can affect the exchange rate by changing the European money supply and interest rate. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.8 Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply Given PUS and YUS when the money supply rises from M1 to M2 the dollar interest rate declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates against the euro (as foreign exchange market equilibrium is reestablished at point 2’). Copyright © 2018 Pearson Education, Ltd. All rights reserved. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Changes in the Foreign Money Supply (1 of 2) How would a change in the supply of euros affect the U.S. money market and foreign exchange markets? An increase in the supply of euros causes a depreciation of the euro (an appreciation of the dollar). A decrease in the supply of euros causes an appreciation of the euro (a depreciation of the dollar). Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.9 Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate By lowering the dollar return on euro deposits (shown as a leftward shift in the expected euro return curve), an increase in Europe’s money supply causes the dollar to appreciate against the euro. Equilibrium in the foreign exchange market shifts from point 1’ to point 2’ but equilibrium in the U.S. money market remains at point 1. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Changes in the Foreign Money Supply (2 of 2) 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. We predict no change in the U.S. money market due to the change in the supply of euros. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Long Run and Short Run (1 of 2) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Long Run and Short Run (2 of 2) 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 – The equilibrium in M S the long run.  L R,Y  shows that P condition P is predicted to adjust proportionally when Ms adjusts, because L(R,Y) does not change. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Money and Prices in the Long Run (1 of 2) 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 Copyright © 2018 Pearsonrise toLtd. All rights reserved. Education, Money and Prices in the Long Run (2 of 2) – 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Money, Prices, Exchange Rates, and Expectations When we consider price changes in the long run, inflationary expectations will have an effect in foreign exchange markets. Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterwards. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.12 Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y) (a) Short-run adjustment of the asset markets. (b) How the interest rate, price level, and exchange rate move over time as the economy approaches its long-run equilibrium. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Money, Prices, and Exchange Rates in the Long Run 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Figure 15.13 Time Paths of U.S. Economic Variables after a Permanent Increase in the U.S. Money Supply After the money supply increases at t0 in panel (a), the interest rate [in panel (b)], price level [in panel (c)], and exchange rate [in panel (d)] move as shown toward their long-run levels. As indicated in panel (d) by the initial jump from E1 to E2 , the exchange rate overshoots in the short run before settling down to its long-run level, E3. Copyright © 2018 Pearson Education, Ltd. All rights reserved. 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (1 of 4) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (2 of 4) 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 Copyright © 2018 Pearson Education,to Ltd. All rights reserved. Summary (3 of 4) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved. Summary (4 of 4) 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. Copyright © 2018 Pearson Education, Ltd. All rights reserved.