Ch. 15: Money , Interest Rates, and Exchange Rates. Udayan Roy ECO41 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 ( M s ) includes All currency with the public and
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 Interest rate (on interest-earning assets): this is the cost (or, downside) of holding money. 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 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
This topic is actually in Chapter 17. But let’s do it now anyway. The aa curve
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)
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 betweenY and E. Why? If Eincreases, 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 betweenY and E. Why? If Eincreases, 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
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 3 AA2
Shifting the AA Curve The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason E E0 E1 Y Y0 Y1