Chapter 3: Money, Interest
Rates and Exchange Rates
Nguyễn Tiến Dũng, PhD
Faculty of International Economics,
College of Economics, VNU
Objective
This lesson discusses link between money,
interest rates, and the exchange rate,
focussing on the impact of the changes in
money demand and supply on the exchange
rate, both in the short-run and the long-run
Content
A Brief Review of Money
The Demand for Money
Money market and the interest rate
Money supply and exchange rate in the
short-run
Money, Prices and the exchange rate in
the long-run
Inflation and the dynamics of the
exchange rate
1. A Brief Review of Money
Money as a medium of exchange
Money is a medium of exchange, and is generally
accepted as a means of payments
In a barter economy, goods are directly traded. It would
take time and high cost to search for consumers or
producers who need the goods
In a modern economy, money is widely used as a medium
of exchange, thus reducing the transaction cost and
stimulating trade.
1. A Brief Review of Money
Money as a unit of account
Money is widely recognized as a measure of value
In modern economy, all prices are expressed in terms of
money.
Quoting prices in terms of money makes it easy to
compare prices between commodities and countries.
Money prices denominated in different currencies can be
translated into comparable terms using the exchange rate.
1. A Brief Review of Money
Money as a store of value
Since money is a widely recognized medium of exchange,
it has a purchasing power and can be used as a store of
value.
Money is the most liquid asset since it can be transformed
into other goods and assets without transaction costs and
fees.
Money sets a standard against which the liquidity of other
assets is judged.
2. The Demand for Money
The demand for money
The demand for money is the amount of
money that individuals and organizations
wish to hold.
Questions: What are the factors that affecting
the demand for money?
2. The Demand for Money
The demand for money
The demand for money depends on three
factors:
i) the expected return to money (relative to
other assets);
ii) the degree of risk;
iii) the liquidity
2. The Demand for Money
The expected return to money
Currency and checking deposits pay no
interest rates or only low interest rates. Other
assets with less liquidity offer higher rates of
return
The opportunity cost of holding money is the
rate of return on other less liquid assets.
When the interest rate rises, the opportunity
cost of holding money rises and reduces the
demand for money.
2. The Demand for Money
The degree of risk
The increase in the prices of goods and
services reduces the purchasing power of
money, and poses a risk to the holding of
money.
The inflation does not only reduce the value
of money, but also the value of assets
denominated in the same currency.
2. The Demand for Money
Liquidity
Since money is high liquid assets, it is held
mainly for daily transaction.
The demand for liquidity depends on the
amount of daily transaction.
When the demand for everyday transaction
rises, people want to keep more money and the
demand for money increases.
2. The Demand for Money
Aggregate money demand
The aggregate demand for money is the sum
of individual demand for money by all
households and firms in an economy.
The aggregate demand for money depends on
three factors:
The interest rate
The price level
Income.
2. The Demand for Money
Aggregate money demand
The interest rate: a higher interest rate
reduces the individual demand for money and
the aggregate demand for money
The price level: when inflation rises, people
need more money to purchase the same
amount of goods and services, thus raising
the demand for money.
Income: the increase in income raises the
demand for goods and services, thus raising
the demand for money
2. The Demand for Money
Aggregate money demand
The aggregate demand for money can be
expressed as follows:
Md = P*L(Y,R)
here P denotes for the pricelevel
Y is the real income
R is the interest rate
The real aggregate demand for money can be
written as
Md/P = L(Y,R)
here, L(Y,R) is the real aggregate demand for money
2. The Demand for Money
Aggregate money demand
2. The Demand for Money
Aggregate money demand
3. Money market and the interest rate
Money supply
The money supply can be defined in broad terms or
narrow terms
In a narrow term (M1), the money supply consists of high
liquid assets widely used in daily transaction, that is cash
and checking deposit.
In a broader term (M2), the money supply consists of M1
components and some less liquid assets such as term
deposits.
The supply of money is controlled by the central bank.
3. Money market and the interest rate
Equilibrium in the money market
The money market is in equilibrium when the
supply of money is equal to the demand for
money
M S = Md or MS/P = L(R,
Y)
Here MS is the supply of money
Md is the demand for money
3. Money market and the interest rate
Equilibrium in the money market
3. Money market and the interest rate
Equilibrium interest rate
The interest rate that brings the demand for
money into the equality with the supply of
money is called as the equilibrium interest
rate
The interest rate tends to settle at the
equilibrium level. The interest rate rises if
there is an excess demand for money, and it
falls if there is excess supply of money.
3. Money market and the interest rate
Increase in the money supply
3. Money market and the interest rate
Increase in the real income
3. Money market and the interest rate
Interest rate, the supply of money and income
The equilibrium interest rate is affected by
the changes in the supply of money and
income
Supply of money: an increase in the supply of
money creates an excess supply and put a
downward pressure on the interest rate
Income: An increase in income or output
raises the demand for money and put un
upward pressure on the interest rate
4. Money supply and exchange rate in the short-run
The short-run and the long-run
In the short-run, prices and wage rates are
sticky, and output may fall below the full-
employment level or rise above the full
employment level.
Long-run equilibrium is the position in which
prices and wages have enough time to adjust
to their market-clearing levels.
In the long-run, prices adjust in line with the
money supply and output is assumed at the
full-employment level.
4. Money supply and exchange rate in the short-run
Money, the interest rate and the exchange rate
The change in money supply can affect the
short-run exchange rate through its effect on
the interest rate.
The change in the money supply affects the
equilibrium interest rate in the money market
(assume prices and output remain unchanged)
Given an expected exchange rate, the change
in the interest rate affects the exchange rate
through the interest parity condition.
4. Money supply and exchange rate in the short-run
Money and the exchange rate linkage
4. Money supply and exchange rate in the short-run
Simultanous equilibrium in the money and FX market
4. Money supply and exchange rate in the short-run
Increase in the US money supply
4. Money supply and exchange rate in the short-run
Increase in the US money supply
The US money supply and the exchange rate
The expansion in the US money supply creates
an excess supply for money and reduces the
US interest rate.
The expected return on dollar-denominated
assets falls due to the lower US interest rate
and causes a portfolio shift toward euro-
denominated assets. The higher demand for
euro in turn causes a depreciation of the US
dollar.
4. Money supply and exchange rate in the short-run
Increase in the European money supply
4. Money supply and exchange rate in the short-run
Increase in the European money supply
The European money supply and the
exchange rate
The expansion in the European money supply
creates an excess supply of money in Europe
and reduces the European interest rate
The lower European interest rate reduces the
expected return on euro-denominated assets,
thus lowering the demand for euro and causing
a depreciation of euro against US dollar.
In summary, monetary expansion in a foreign
country will lead to an appreciation of domestic
currency.
5. Money, Prices and the exchange rate in the long-run
Permanent and Temporary (one-time) Policy Changes
The permanent and temporary changes in the
money supply have different short-run effects:
A temporary change in the money supply is not
maintained in the future, thus it has no effect
on the long-run equilibrium.
A permanent change in the money supply can
affect the long-run equilibrium and the
expected exchange rate.
5. Money, Prices and the exchange rate in the long-run
Long-run impacts the money supply
Given the full-employment assumption, the long-run
real output depends only on the endowment of
production factors and technology.
In the long-run, the interest rate reflect the
opportunity costs of holding money and the
consumers’preferences between current consumption
and future consumption.
The one-time change in the supply of money has no
impacts on the interest rate and the real ouput over
the long-run.
Given other things equal, the change in the money
supply cause a proportional change in the price level.
5. Money, Prices and the exchange rate in the long-run
Long-run equilibrium price level
In the long-run, the price level depends on
the the interest rate, real output and the
supply of money.
The long-run equilibrium condition in the
money market can be written as:
P = Ms/L(R,Y)
In the long-run equilibrium, an increase in
the supply of money causes a proportional
increase in the prices level given all other
things equal.
5. Money, Prices and the exchange rate in the long-run
Empirical evidence on the money supply and price level
(Western Hemisphere developing countries)
5. Money, Prices and the exchange rate in the long-run
Empirical evidence on the money supply and price level
The empirical evidence show a strong positive correlation between
the supply of money and the prices level in different countries,
justifying in part the predictions by the monetary theory.
However, empirical evidence fails to show an exact proportional
relationship between the money supply and the price level since
there are various factors that affect real output and the interest rate
in the long run.
Real output can be affected by the changes in the supply of labor and
capital and technological progress.
The demographic change or financial inovation can affect the
demand for money and the interest rate.
5. Money, Prices and the exchange rate in the long-run
Money and the exchange rate in the long-run
Since the exchange rate is the price of foreign
currency meassured in terms of domestic curency,
the change in the price level has an impact on the
exchange rate.
In the long-run, an increase in the domestic price
level causes a proportional increase in the exchange
rate or a proportional depreciation of domestic
currency
Conclusion: Other things equal, a change in a
country’s money supply will cause a proportional
change in the price level and exchange rate.
5. Money, Prices and the exchange rate in the long-run
Money and the exchange rate in the long-run
A permanent increase in a country’s money supply causes a
proportional increase in the price level and a proportional long
run depreciation of its currency.
A permanent decrease in a country’s money supply causes a
proportional decrease in the price level and a proportional long
run appreciation of its currency.
6. Inflation and the dynamics of the exchange rate
Short-run price rigidity
The assumption of short-run price rigidity says
that prices will not change immediately in
response to the changing economic conditions
The short-run price stickiness stems from the
slugish movement of wage rates, the long-term
contracts and the regulation and intervention
by the government.
The stickiness (or the flexibility of prices) in
the short-run varies between commodities and
countries and remain debated in economics.
6. Inflation and the dynamics of the exchange rate
Long-run price flexibility
The change in the supply of money causes prices to
the change in the long-run.
An increase in the money supply raises the demand for
goods and services. The resulting increase in demand
for labor and wage rates eventually cause the
production costs and prices to rise.
The increase in the money supply causes an expectation
on inflation, which in turn creates an upward pressure
on the wage rate and prices.
The prices of raw material and fuel tend to adjust
quickly in the short-run, thus raising the production
cost and putting an upward pressure on the price of
final goods.
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
Short-run Effects of a Permanent Increase in US money Supply
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
6. Inflation and the dynamics of the exchange rate
Adjustment toward long-run equilibrium
In the short-run, a permanent increase in the supply of
money reduces the domestic interest rate, which, in
combination with the expected depreciation of domestic
currency, raises the expected return on foreign assets.
Over time, domestic prices rise, raising the demand for
money. The interest rate is back to the initial level,
causing the appreciation of domestic currency during the
adjustment toward long-run equilibrium.
At the new equilibrium, the interest rate settles at the
initial level. The domestic currency still depreciates but
to a lesser extent as compared to the short-run level.
6. Inflation and the dynamics of the exchange rate
Exchange rate overshooting
In the sort-run, the exchange rate rises above
the long-run level, showing a greater
depreciation of domestic currency in the short-
run as compared to the long-run level. This
phenomenon is called the exchange rate
overshooting.
The exchange rate overshooting can be
explained by the interest parity condition so that
the higher domestic interest rate must be offset
by the appreciation of the domestic currency
during the adjust ment.
6. Inflation and the dynamics of the exchange rate
Exchange rate overshooting