Session 4 - Money, Interest Rates, and Exchange Rates PDF

Money, Interest Rates, and Exchange Rates 07/10/2024 18:54 YOU WILL LEARN THIS WEEK What is money? Control of the supply of money The willingness to hold monetary assets A model of real monetary assets and interest rates A model of real monetary assets, interest rates,...

Money, Interest Rates, and Exchange Rates 07/10/2024 18:54 YOU WILL LEARN THIS WEEK What is money? Control of the supply of money The willingness to hold monetary assets 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 PART - MONEY What Is Money? Money is an asset that is widely used as a means of payment. Different groups of assets may be classified as money. Money can be defined narrowly or broadly. (depending on convention) - Currency in circulation, checking deposits, and debit card accounts form a narrow definition of money. - Deposits of currency are excluded from this narrow definition, although they may act as a substitute for money in a broader definition. 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. (house, shares, shop etc) - But they generally earn a higher interest rate or rate of return than monetary assets. Let's group assets into monetary (liquid) assets) and non-monetary (illiquid) assets. The demarcation between the two is arbitrary, but: - currency in circulation, checking deposits, debit card accounts, savings deposits, and time deposits are generally more liquid - than bonds, loans, deposits of currency in the foreign exchange markets, stocks, real estate, and other assets. Money Supply The central bank substantially controls the quantity of money that circulates in an economy, the money supply. Central banks: - The United States: the Federal Reserve System (FED) The United Kingdom: the Bank of England The European Union: the Bank of England the European Central Bank (ECB) (every country has their own) Central banks directly regulate the amount of currency in circulation. Central banks indirectly influence the amount of checking deposits, debit card accounts, and other monetary assets. 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. 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 non-monetary assets. 3. Liquidity: A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases. What Influences Aggregate Demand of Money? 1. Interest rates/expected rates of return: monetary assets pay little or no interest, so the interest rate on non-monetary assets such as bonds, loans, and deposits is the opportunity cost of holding monetary assets. A higher interest rate on non-monetary assets means a higher opportunity cost of holding monetary assets, i.e. 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 goods and services, i.e. higher demand of money. 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, i.e. higher demand of money. PART A MODEL OF AGGREGATE MONEY DEMAND AND A MODEL OF THE MONEY MARKET A Model of Aggregate Money Demand Aggregate demand of real monetary assets is a function of national income and interest rates. The aggregate demand of money can be expressed as: Md = P x L(R,Y) or. Md/P = L(R, Y) where: P is the price level Y is real national income R is a measure of interest rates on non-monetary assets L (R,Y) is the aggregate demand of real monetary assets 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. 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. (Higher) GNP = Higher demand for real (liquid) money (real money is the purchasing power that money has) A Model of the Money Market The money market is where monetary or liquid assets, which are loosely called "money," are lent and borrowed. - Monetary assets(liquid) 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. When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium: Ms = 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) When there is an excess supply of monetary assets, there is an excess demand for interest-bearing assets such as bonds, loans, and deposits. (if there is supply surplus for liquid assets it means that there is demand surplus for illiquid asset ) People with an excess supply of monetary assets are willing to offer or accept interest-bearing assets (by giving up their money) at lower interest rates. Others are more willing to hold additional monetary assets as interest rates (the opportunity cost of holding monetary assets) fall. When there is an excess demand of monetary assets, there is an excess supply of interest-bearing assets such as bonds, loans, and deposits. People who desire monetary assets but do not have access to them are willing to sell non-monetary assets in return for the monetary assets that they desire. Those with monetary assets are more willing to give them up in return for interest-bearing assets as interest rates (the opportunity cost of holding money) rise. Determination of the Equilibrium Interest Rate With P and Y given and a real money supply of Ms/ P money market equilibrium is at point 1. At this point, aggregate real money demand and the real money supply are equal and the equilibrium rate is R1 P is the price level Y is real national income R is a measure of interest rates on non-monetary assets L (R,Y) is the aggregate demand of real monetary assets (the slope) MS/P = real money supply (line) 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). Effect on the Interest Rate of a Rise in Real Income Given the real money supply, MS/p (=Q1), a rise in real income from Y1 to Y2 raises the interest rate from R1 (point 1) to R2 (point 2). P is the price level Y is real national income R is a measure of interest rates on non-monetary assets L (R,Y) is the aggregate demand of real monetary assets PART MONEY MARKET - EXCHANGE MARKET LINKAGE The assumption of ignoring risk is not ok ; we cannot ignore it despite this assumption Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market Both asset markets are in equilibrium at the interest rate R1$ (the graphs are inverted only for comparison ; as we previously saw the L(R,Y) was downord sloping and what is on the x axis here was on the y axis and vice versa and exchange rate E1$/euro ; at these values, money supply equals money demand (point 1) and the interest parity condition holds (point 1'). 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. 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). - Higher Ms U.S -> lower interest rates --> $ depreciates -> euro appreciates - Lower Ms U.S. -> higher interest rates -> $ appreciates > euro depreciates 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. 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? 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). 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. Changes in the Foreign Money Supply 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. PART LONG RUN AND SHORT RUN Long Run and Short Run 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. 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. Long Run and Short Run In the long run, there is a direct relationship between the inflation rate and changes in the money supply. P is the price level Y is real national income R is a measure of interest rates on non-monetary assets L (R,Y) is the aggregate demand of real monetary assets The inflation rate is predicted to equal the growth rate in money supply minus the growth rate in money demand. (Empirically) Expect a positive association between money supplies and price levels in the data, although the relation will not be exact. MS growth = higher inflation 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. 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. - Excess demand (GOODS SERVICES) -> higher emplyment, higher wages, higher prices for production, higher prices 2. Inflationary expectations: If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. (lower purchasing power) 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. 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 afterward. 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. 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. (initial fast reaction and then adjusting)