Money, Interest Rates, and Exchange Rates: A University Presentation

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:

  . 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 as a Liquid Asset

• 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 (non-monetary-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.

  . 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 Demand and Supply

• The central bank substantially controls the quantity of money that circulates in an economy, the money supply.
• 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.

Influences on Demand of Money for Individuals and Institutions

• Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets.
• 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.

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

Influences on Aggregate Demand of Money

• 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 means a higher opportunity cost of holding monetary assets -> lower demand of money.

• 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 -> higher demand of money.
• 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 means more goods and services are being produced and bought in transactions, increasing the need for liquidity -> higher demand of money.

A Model of Aggregate Money Demand

The aggregate demand of money can be expressed as: Md = P x 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 demand of real monetary assets is a function of national income and interest rates. Nº =L(R,Y) Mª

Aggregate Real Money Demand and the Interest Rate

Interest rate, R L(R, Y) Aggregate real money demand 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 of a Rise in Real Income on Aggregate Real Money Demand

Interest rate, R Increase in real income L(R, Y2) L(R, Y1) Aggregate real money demand 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.

The Money Market

• 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.

Money Market Equilibrium

• 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: P Ms = L(R,Y)

Money Market Dynamics

• When there is an excess supply of monetary assets, there is an excess demand for interest-bearing assets such as bonds, loans, and deposits.
• 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

Interest rate, R Real money supply 2 R2 Aggregate real money demand, L(R, Y)/ 1 R1 I 1 1 I I R3- 1 1 I I 3 | Q2 MS p (= Q1) Q3 Real money holdings 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 interest rate is R1.

Effect of an Increase in Money Supply on Interest Rate

Interest rate, R Real money supply Real money supply increases R1 1 2 R2 L(R, Y) M1 P M2 P Real money holdings 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 of a Rise in Real Income on the Interest Rate

Interest rate, R Real money supply Increase in real income 2 1 1 1 1' R1 1 1 L(R, Y2) L(R, Y1) MS p (= Q1) Q2 Real money holdings Given the real money supply, a rise in real income from Y1 to Y2 increases the interest rate from R1 (point 1) to R2 (point 2). R2 I

Simultaneous Equilibrium in Money and Foreign Exchange Markets

Dollar/euro exchange rate, Ese Return on dollar deposits Foreign exchange market 1º Expected return on euro deposits Rates of return (in dollar terms) 0 L(Rs. Yus) Money market MS Mus Pus U.S. real money supply 1 (increasing) > U.S. real money holdings . Both asset markets are in equilibrium at the interest rate R3 and exchange rate E1 · at these values, money supply equals money demand (point 1) and the interest parity condition holds (point 1').

Money Market and Exchange Rate Linkages

United States Federal Reserve System Europe European Central Bank MS WUs (United States money supply) M (European money supply) U.S. money market European money market Rs (Dollar interest rate) Foreign exchange market RE (Euro interest rate) > Es/€ (Dollar/euro exchange rate) . 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 of an Increase in U.S. Money Supply on Dollar/Euro Exchange Rate and Dollar Interest Rate

Dollar/euro exchange rate, Ese Dollar return 4 2' Ege 1' Eye Expected euro return 0 Rates of return (in dollar terms) L(Rs. Yus) 1 I Mus Pus 1 1 1 Increase in U.S. real money supply Mus Pus 2 U.S. real money holdings · 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').

Changes in 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.
• An increase in the supply of foreign currency causes a depreciation of the foreign currency (an appreciation of the domestic currency).
• A decrease in the supply of foreign currency causes an appreciation of the foreign currency (a depreciation of the domestic currency).

Effect of an Increase in European Money Supply on Dollar/Euro Exchange Rate

Dollar/euro exchange rate, Exe Dollar return 1 Ege Increase in European money supply (fall in euro interest rate) 2' Eye Expected euro return Rates of return (in dollar terms) 0 L(Rs, Yus) Mus Pus U.S. real money supply 1 U.S. real money holdings 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.

Short Run and Long Run

• In the short run, prices do not have sufficient time to adjust to market conditions.
• The analysis carried out so far
• 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 number 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.