Chapter 4 Money, Interest Rates, and

Exchange Rates
Learning Objectives
1 Describe and discuss the national money markets in which
interest rates are determined.
2 Show how monetary policy and interest rates feed into the
foreign exchange market.
3 Distinguish between the economy’s long-run position and the
short run, in which money prices and wages are sticky.
4 Explain how price levels and exchange rates respond to
monetary factors in the long run.
5 Outline the relationship between the short-run and the long-run
effects of monetary policy, and explain the concept of short-
run exchange rate overshooting.
Preview
• 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
What Is Money?
• Money is characterized by 3 key features
1. Medium of exchange
2. Unit of account
3. Store of value
Narrow and Broad Definition of Money
• Money can be defined narrowly or broadly
– Narrow:
 currency in circulation, checking deposits, savings deposits
 called M1 by the Federal Reserve
 bank deposits in foreign currency are excluded from this
definition
 this will be the definition we use for money supply
– Broad:
 also includes money market securities, mutual funds, CD’s and
other time deposits
 called M2 by Federal Reserve
US Money Supply

● On April 24, 2020, the Federal Reserve Board announced

they would loosen regulations on savings deposits,
effectively shifting them into the M1 money supply
Vietnam Money Supply
Liquid and Illiquid Assets
• 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.
• Trade-off: convenience of liquid asset vs. higher return
Grouping Assets
• Let’s group assets into two groups:
1. Money or monetary assets
 liquid
 no return (or very little)
 currency in circulation, checking deposits
2. Nonmonetary assets
 illiquid
 earn a return
 bonds, loans, deposits of currency in the foreign
exchange markets, stocks, real estate, and other
assets
Money Supply

• Central banks control the quantity of money that circulates

in an economy, the money supply.
– In the U.S., the central banking system is the Federal
Reserve (the Fed).
 The Fed directly regulates the amount of currency in
circulation.
 It indirectly influences the amount of checking
deposits (through monetary policy – more on this in
Chapter 7)
• For now, we will assume the central bank simply picks the
money supply
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:
1. Interest rates / expected returns
2. Liquidity
– Prices
– Income
3. Risk
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 like bonds,
loans, and savings 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.
What Influences Aggregate Demand
of Money?
2. Liquidity
– Prices: 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: 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.
What Influences Aggregate Demand
of Money?
3. 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 it is not
very important in defining the demand of monetary
assets versus nonmonetary assets (we will ignore for
now)
• In sum:
– ↑ Interest rate → Money demand ↓
– ↑ Price level → Money demand ↑
– ↑ National income → Money demand ↑
Money Market Model
A Model of Aggregate Money Demand
The aggregate demand of money can be expressed
as:
𝑀𝑀𝑑𝑑 = 𝑃𝑃 × 𝐿𝐿 𝑅𝑅, 𝑌𝑌
where:
P = the aggregate price level
Y = real national income
R = a measure of interest rates on nonmonetary assets
L(R,Y) = the aggregate demand for (real) liquidity or the
real money demand
• Alternatively, aggregate real money demand is a function
of national income and interest rates.
𝑀𝑀𝑑𝑑
= 𝐿𝐿 𝑅𝑅, 𝑌𝑌
𝑃𝑃
Aggregate Real Money Demand and the
Interest Rate

𝑅𝑅 ↓
Effect on the Aggregate Real Money Demand
Schedule of a Rise in Real Income
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 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.
A Model of the Money Market
• 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
= L ( R,Y )
P
A Model of the Money Market
• When there is an excess supply of monetary assets, there
is an excess demand for interest-bearing assets like
bonds, loans, and savings deposits.
– People with an excess supply of monetary assets are
willing to 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.
• Opposite result if there is an excess demand of monetary
assets and an excess supply of interest- bearing assets
like bonds, loans, and savings deposits.
Determination of the Equilibrium Interest
Rate

Excess supply of money

Excess demand of money

Effect of an Increase in the Money Supply
on the Interest Rate
Effect on the Interest Rate of a Rise in
Real Income
Linking the Money Market to the
Foreign Exchange Market
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.
Simultaneous Equilibrium in the U.S. Money
Market and the Foreign Exchange Market
Effect on the Dollar/Euro Exchange Rate and Dollar
Interest Rate of an Increase in the U.S. Money Supply
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
– 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
– 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
Expected dollar return on
euro deposits: 𝑅𝑅 + 𝐸𝐸𝑒𝑒 $/€ - 1
€ 𝐸𝐸$/€
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.
Prices in the Long Run
Month-to-Month Variability of the Dollar/Yen
Exchange Rate and of the U.S./Japan Price Level
Ratio, 1980–2016
Short Run and Long Run
• In the short run, prices do not have sufficient time to
adjust to market conditions (sticky prices).
– The analysis so far 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.
Effect of Money Supply in Long Run
• In the long run, the money supply (𝑀𝑀𝑆𝑆 ) is predicted not to
influence the real output (Y), interest rates (R), and hence
the real money demand L(R,Y).

– 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.

– Interest rates depend on the supply of saved funds and

the demand of saved funds.

• “Long-run neutrality of money”

Effect of Money Supply in Long Run
• However, the money supply is predicted to make the level
of average prices adjust proportionally in the long run.

MS
– The equilibrium condition: = L ( R,Y ) shows that P
P
is predicted to adjust proportionally when Ms adjusts,
because L(R,Y) does not change.
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, driving up wages and prices.
2. Inflationary expectations: if workers expect future prices to
rise due to an expected money supply increase, they will want
to be compensated.
– Result: expectations about inflation caused by an expected
increase in the money supply causes actual inflation.
3. Raw material prices: can change even in short-run (less
sticky), raising production costs and general prices.
Money Supply and Inflation in Long Run
• In the long run, there is a direct relationship between the
inflation rate and changes in the money supply.

M S= P × L ( R,Y )
MS
P =
L ( R,Y )
∆P ∆M S ∆L
= S
−
P M L
– The inflation rate is predicted to equal the growth rate
in money supply minus the growth rate in real money
demand.
Average Money Growth and Inflation in Western
Hemisphere Developing Countries, by Year, 1987–2014
Hyperinflation
• A period where inflation rates are at least 50% per month
• Hyperinflation occurs when there is a continuing (and
often accelerating) rapid increase in money supply that is
not supported by a corresponding growth in the output of
goods and services.
• Most hyperinflations have been caused by
government budget deficits financed by money creation
(printing money), often due to wars or other
socioeconomic upheavals.
Hyperinflation: Historical examples
There have been 57 documented episodes, including
Venezuela's current crisis
Hyperinflation in Venezuela

More than
100,000%
Hyperinflation in Venezuela
Hyperinflation in Venezuela
Hyperinflation in Venezuela
Exchange Rates
in the Long Run
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.
Short-Run and Long-Run Effects of an Increase in
the U.S. Money Supply (Given Real Output, Y)
𝐸𝐸 𝑒𝑒 $/€
𝑅𝑅$ = 𝑅𝑅€ + -1
𝐸𝐸$/€
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.
Time Paths of U.S. Economic Variables after a
Permanent Increase in the U.S. Money Supply
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 and expected
inflation, but not on prices.
• Overshooting helps explain why exchange rates are so
volatile.
Summary
1. Aggregate money demand is primarily determined by
interest rates, the level of average prices, and national
income.
• Aggregate money demand depends negatively on the
interest rate and positively on real national income.
2. 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.
Summary
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 to depreciate.
Summary
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.
Summary
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.