Chapter 14
Money,Interest Rates,and Exchange rates
Slide 14-2Copyright? 2003 Pearson Education,Inc.
Introduction
Money Defined,A Brief Review
The Demand for Money by Individuals
Aggregate Money Demand
The Equilibrium Interest Rate,The Interaction of
Money Supply and Demand
Chapter Organization
Slide 14-3Copyright? 2003 Pearson Education,Inc.
The Money Supply and the Exchange Rate in the
Short Run
Money,the Price Level,and the Exchange Rate in the
Long Run
Inflation and Exchange Rate Dynamics
Summary
Chapter Organization
Slide 14-4Copyright? 2003 Pearson Education,Inc.
Introduction
Factors that affect a country’s money supply or
demand are among the most powerful determinants of
its currency’s exchange rate against foreign
currencies.
This chapter combines the foreign-exchange market
with the money market to determine the exchange
rate in the short run.
It analyzes the long-term effects of monetary changes
on output prices and expected future exchange rates.
Slide 14-5Copyright? 2003 Pearson Education,Inc.
Money Defined,A Brief Review
Money as a Medium of Exchange
A generally accepted means of payment
Money as a Unit of Account
A widely recognized measure of value
Money as a Store of Value
A transfer of purchasing power from the present into
the future
Slide 14-6Copyright? 2003 Pearson Education,Inc.
What Is Money?
Assets widely used and accepted as a means of
payment.
Money is very liquid,but pays little or no return.
– All other assets are less liquid but pay higher return.
Money Supply (Ms)
Ms = Currency + Checkable Deposits
Money Defined,A Brief Review
Slide 14-7Copyright? 2003 Pearson Education,Inc.
How the Money Supply Is Determined
An economy’s money supply is controlled by its
central bank.
– The central bank:
– Directly regulates the amount of currency in existence
– Indirectly controls the amount of checking deposits issued by
private banks
Money Defined,A Brief Review
Slide 14-8Copyright? 2003 Pearson Education,Inc.
Three factors influence money demand:
Expected return
Risk
Liquidity
Expected Return
The interest rate measures the opportunity cost of
holding money rather than interest-bearing bonds.
– A rise in the interest rate raises the cost of holding
money and causes money demand to fall.
The Demand for
Money by Individuals
Slide 14-9Copyright? 2003 Pearson Education,Inc.
Risk
Holding money is risky,
– An unexpected increase in the prices of goods and
services could reduce the value of money in terms of the
commodities consumed.
Changes in the risk of holding money need not cause
individuals to reduce their demand for money.
– Any change in the riskiness of money causes an equal
change in the riskiness of bonds.
The Demand for
Money by Individuals
Slide 14-10Copyright? 2003 Pearson Education,Inc.
Liquidity
The main benefit of holding money comes from its
liquidity.
– Households and firms hold money because it is the
easiest way of financing their everyday purchases.
A rise in the average value of transactions carried out
by a household or firm causes its demand for money to
rise.
The Demand for
Money by Individuals
Slide 14-11Copyright? 2003 Pearson Education,Inc.
Aggregate Money Demand
Aggregate money demand
The total demand for money by all households and
firms in the economy.
It is determined by three main factors:
– Interest rate
– It reduces the demand for money.
– Price level
– It raises the demand for money.
– Real national income
– It raises the demand for money.
Slide 14-12Copyright? 2003 Pearson Education,Inc.
The aggregate demand for money can be expressed by:
Md = P x L(R,Y) (14-1)
where:
P is the price level
Y is real national income
L(R,Y) is the aggregate real money demand
Equation (14-1) can also be written as:
Md/P = L(R,Y) (14-2)
Aggregate Money Demand
Slide 14-13Copyright? 2003 Pearson Education,Inc.
Figure 14-1,Aggregate Real Money Demand and the Interest Rate
L(R,Y)
Interest
rate,R
Aggregate real
money demand
Aggregate Money Demand
Slide 14-14Copyright? 2003 Pearson Education,Inc.
Figure 14-2,Effect on the Aggregate Real Money Demand Schedule of
a Rise in Real Income
L(R,Y2)
Increase in
real income
L(R,Y1)
Interest
rate,R
Aggregate real
money demand
Aggregate Money Demand
Slide 14-15Copyright? 2003 Pearson Education,Inc.
Equilibrium in the Money Market
The condition for equilibrium in the money market is:
Ms = Md (14-3)
The money market equilibrium condition can be
expressed in terms of aggregate real money demand as:
Ms/P = L(R,Y) (14-4)
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-16Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-3,Determination of the Equilibrium Interest Rate
Aggregate real
money demand,
L(R,Y)
Interest
rate,R
Real money
holdings
Real money supply
MS
P ( = Q
1)
R2
Q2
2
R1 1
R3
Q3
3
Slide 14-17Copyright? 2003 Pearson Education,Inc.
Interest Rates and the Money Supply
An increase (fall) in the money supply lowers (raises)
the interest rate,given the price level and output.
– The effect of increasing the money supply at a given
price level is illustrated in Figure 14-4.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-18Copyright? 2003 Pearson Education,Inc.
M2
P
R2 2
M1
P
Real money
supply Real money
supply increase
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-4,Effect of an Increase in the Money Supply on the Interest
Rate
L(R,Y1)
R1 1
Interest
rate,R
Real money
holdings
Slide 14-19Copyright? 2003 Pearson Education,Inc.
Output and the Interest Rate
An increase (fall) in real output raises (lowers) the
interest rate,given the price level and the money
supply.
– Figure 14-5 shows the effect on the interest rate of a rise
in the level of output,given the money supply and the
price level.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-20Copyright? 2003 Pearson Education,Inc.
Q2
1'
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-5,Effect on the Interest Rate of a Rise in Real Income
L(R,Y1)
L(R,Y2)
Increase in
real income
Real money supply
MS
P ( = Q
1)
R2 2
R1 1
Interest
rate,R
Real money
holdings
Slide 14-21Copyright? 2003 Pearson Education,Inc.
The Money Supply and the
Exchange Rate in the Short Run
Short run analysis
The price level and the real output are given.
Long run analysis
The price level is perfectly flexible and always
adjusted immediately to preserve full employment.
Slide 14-22Copyright? 2003 Pearson Education,Inc.
Linking Money,the Interest Rate,and the Exchange
Rate
The U.S,money market determines the dollar interest
rate,which in turn affects the exchange rate that
maintains the interest parity.
– Figure 14-6 links the U.S,money market (bottom) and
the foreign exchange market (top).
The Money Supply and the
Exchange Rate in the Short Run
Slide 14-23Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-6,Simultaneous Equilibrium in the U.S,Money Market
and the Foreign-Exchange Market
Return on
dollar deposits
Expected
return on
euro deposits
L(R$,YUS)
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
(increasing)
Foreign
exchange
market
Money
market
E1$/� 1'
R1$
1
U.S,real
money
supply
MSUS
PUS
Slide 14-24Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-7,Money-Market/Exchange Rate Linkages
European
money market
United States
money market
Europe
European System
of Central Banks
United States
Federal Reserve System
(United States
money supply)M
SUS MSE (European
money supply)
R$
(Dollar interest rate)
R�
(Euro interest rate)
Foreign
exchange
market
E$/�
(Dollar/Euro exchange rate)
Slide 14-25Copyright? 2003 Pearson Education,Inc.
U.S,Money Supply and the Dollar/Euro Exchange
Rate
What happens when the Federal Reserve changes the
U.S,money supply?
– An increase (decrease) in a country’s money supply
causes its currency to depreciate (appreciate) in the
foreign exchange market.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-26Copyright? 2003 Pearson Education,Inc.
Increase in U.S.
real money supply
Expected
return on
euro deposits
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-8,Effect on the Dollar/Euro Exchange Rate and Dollar
Interest Rate of an Increase in the U.S,Money Supply
E2$/� 2'
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
Return on
dollar deposits
L(R$,YUS)
E1$/� 1'
R1$
1
M1US
PUS
R2$
2
M2US
PUS
Slide 14-27Copyright? 2003 Pearson Education,Inc.
Europe’s Money Supply and the Dollar/Euro
Exchange Rate
An increase in Europe’s money supply causes a
depreciation of the euro (i.e.,appreciation of the
dollar).
A reduction in Europe’s money supply causes an
appreciation of the euro (i.e.,a depreciation of the
dollar).
The change in the European money supply does not
disturb the U.S,money market equilibrium.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-28Copyright? 2003 Pearson Education,Inc.
Figure 14-9,Effect of an Increase in the European Money Supply
on the Dollar/Euro Exchange Rate
Increase in European
money supply
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
Expected
euro return
L(R$,YUS)
U.S,real
money
supply
MSUS
PUS
R1$
1
E1$/� 1'
Dollar return
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
E2$/� 2'
Slide 14-29Copyright? 2003 Pearson Education,Inc.
Money,the Price Level,and the
Exchange Rate in the Long Run
Long-run equilibrium
Prices are perfectly flexible and always adjusted
immediately to preserve full employment.
Money and Money Prices
The money market equilibrium (Equation 14-4) can be
rearranged to give the long-run equilibrium price level:
P = Ms/L(R,Y) (14-5)
An increase in a country’s money supply causes a
proportional increase in its price level.
Slide 14-30Copyright? 2003 Pearson Education,Inc.
The Long-Run Effects of Money Supply Changes
A change in the supply of money has no effect on the
long-run values of the interest rate or real output.
A permanent increase in the money supply causes a
proportional increase in the price level’s long-run
value,
– This prediction is based on the money market
equilibrium condition,Ms/P = L or P = Ms/L.
– This condition implies that?P/P =?Ms/Ms -?L/L.
– The inflation rate equals the monetary growth rate less the
growth rate for money demand.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-31Copyright? 2003 Pearson Education,Inc.
Empirical Evidence on Money Supplies and Price
Levels
In a cross-section of countries,long-term changes in
money supplies and price levels show a clear positive
correlation.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-32Copyright? 2003 Pearson Education,Inc.
Figure 14-10,Monetary Growth and Price-Level Change in the Seven
Main Industrial Countries,1973-1997
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-33Copyright? 2003 Pearson Education,Inc.
Money and the Exchange Rate in the Long Run
A permanent increase (decrease) in a country’s money
supply causes a proportional long-run depreciation
(appreciation) of its currency against foreign
currencies.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-34Copyright? 2003 Pearson Education,Inc.
Inflation and
Exchange Rate Dynamics
Inflation
A situation where an economy’s price level rises.
Deflation
A situation where an economy’s price level falls.
Short-Run Price Rigidity versus Long-Run Price
Flexibility
The short-run,stickiness” of price levels is illustrated
in Figure 14-11.
Slide 14-35Copyright? 2003 Pearson Education,Inc.
Figure 14-11,Month-to-Month Variability of the Dollar/DM Exchange
Rate and of the U.S./German Price-Level Ratio,1974-2001
Inflation and
Exchange Rate Dynamics
Slide 14-36Copyright? 2003 Pearson Education,Inc.
A change in the money supply creates demand and
cost pressures that lead to future increases in the price
level from three main sources:
– Excess demand for output and labor
– Inflationary expectations
– Raw materials prices
Inflation and
Exchange Rate Dynamics
Slide 14-37Copyright? 2003 Pearson Education,Inc.
Permanent Money Supply Changes and the Exchange
Rate
How does the dollar/euro exchange rate adjust to a
permanent increase in the U.S,money supply?
– Figure 14-12 shows both the short-run and long-run
effects of the increase in the U.S,money supply.
Inflation and
Exchange Rate Dynamics
Slide 14-38Copyright? 2003 Pearson Education,Inc.
Figure 14-12,Effects of an Increase in the U.S.Money Supply
Dollar return Dollar return
M1US
P1US
M2US
P1US
U.S,real money supply
M2US
P2US
M2US
P1US
Dollar/euro exchange
Rate,E$/�
Rates of return
(in dollar
terms)
U.S,real
money holdings
0
(a) Short-run effects
0
(b) Adjustment to long-
run equilibrium
Dollar/euro exchange
Rate,E$/�
U.S,real
money holdings
E2$/� 2'
E3$/� 4'
R1$
4
R2$
2
R1$
1
Inflation and
Exchange Rate Dynamics
3'
2'E2
$/� Expected
euro return Expectedeuro return
L(R$,YUS)R
2$
2
L(R$,YUS)
E1$/� 1'
Slide 14-39Copyright? 2003 Pearson Education,Inc.
Figure 14-13,Time Paths of U.S,Economic Variables After a Permanent
Increase in the U.S,Money Supply
Inflation and
Exchange Rate Dynamics
P2US E3$/�
E1$/�
t0
(a) U.S,money supply,MUS
Time
(c) U.S,price level,PUS
Time
(b) Dollar interest rate,R$
Time
M1US
t0t0
R1$M2US
P1US
t0
R2$
E2$/�
(d) Dollar/euro exchange rate,E$/�
Time
Slide 14-40Copyright? 2003 Pearson Education,Inc.
Exchange Rate Overshooting
The exchange rate is said to overshoot when its
immediate response to a disturbance is greater than its
long-run response.
It helps explain why exchange rates move so sharply
form day to day.
It is a direct result of sluggish short-run price level
adjustment and the interest parity condition.
Inflation and
Exchange Rate Dynamics
Slide 14-41Copyright? 2003 Pearson Education,Inc.
Summary
Money is held because of its liquidity.
Aggregate real money demand depends negatively on
the opportunity cost of holding money and positively
on the volume of transactions in the economy.
The money market is in equilibrium when the real
money supply equals aggregate real money demand.
By lowering the domestic interest rate,an increase in
the money supply causes the domestic currency to
depreciate in the foreign exchange market.
Slide 14-42Copyright? 2003 Pearson Education,Inc.
Permanent changes in the money supply push the
long-run equilibrium price level proportionally in the
same direction.
These changes do not influence the long-run values of
output,the interest rate,or any relative prices.
An increase in the money supply can cause the
exchange rate to overshoot its long-run level in the
short run.
Summary
Money,Interest Rates,and Exchange rates
Slide 14-2Copyright? 2003 Pearson Education,Inc.
Introduction
Money Defined,A Brief Review
The Demand for Money by Individuals
Aggregate Money Demand
The Equilibrium Interest Rate,The Interaction of
Money Supply and Demand
Chapter Organization
Slide 14-3Copyright? 2003 Pearson Education,Inc.
The Money Supply and the Exchange Rate in the
Short Run
Money,the Price Level,and the Exchange Rate in the
Long Run
Inflation and Exchange Rate Dynamics
Summary
Chapter Organization
Slide 14-4Copyright? 2003 Pearson Education,Inc.
Introduction
Factors that affect a country’s money supply or
demand are among the most powerful determinants of
its currency’s exchange rate against foreign
currencies.
This chapter combines the foreign-exchange market
with the money market to determine the exchange
rate in the short run.
It analyzes the long-term effects of monetary changes
on output prices and expected future exchange rates.
Slide 14-5Copyright? 2003 Pearson Education,Inc.
Money Defined,A Brief Review
Money as a Medium of Exchange
A generally accepted means of payment
Money as a Unit of Account
A widely recognized measure of value
Money as a Store of Value
A transfer of purchasing power from the present into
the future
Slide 14-6Copyright? 2003 Pearson Education,Inc.
What Is Money?
Assets widely used and accepted as a means of
payment.
Money is very liquid,but pays little or no return.
– All other assets are less liquid but pay higher return.
Money Supply (Ms)
Ms = Currency + Checkable Deposits
Money Defined,A Brief Review
Slide 14-7Copyright? 2003 Pearson Education,Inc.
How the Money Supply Is Determined
An economy’s money supply is controlled by its
central bank.
– The central bank:
– Directly regulates the amount of currency in existence
– Indirectly controls the amount of checking deposits issued by
private banks
Money Defined,A Brief Review
Slide 14-8Copyright? 2003 Pearson Education,Inc.
Three factors influence money demand:
Expected return
Risk
Liquidity
Expected Return
The interest rate measures the opportunity cost of
holding money rather than interest-bearing bonds.
– A rise in the interest rate raises the cost of holding
money and causes money demand to fall.
The Demand for
Money by Individuals
Slide 14-9Copyright? 2003 Pearson Education,Inc.
Risk
Holding money is risky,
– An unexpected increase in the prices of goods and
services could reduce the value of money in terms of the
commodities consumed.
Changes in the risk of holding money need not cause
individuals to reduce their demand for money.
– Any change in the riskiness of money causes an equal
change in the riskiness of bonds.
The Demand for
Money by Individuals
Slide 14-10Copyright? 2003 Pearson Education,Inc.
Liquidity
The main benefit of holding money comes from its
liquidity.
– Households and firms hold money because it is the
easiest way of financing their everyday purchases.
A rise in the average value of transactions carried out
by a household or firm causes its demand for money to
rise.
The Demand for
Money by Individuals
Slide 14-11Copyright? 2003 Pearson Education,Inc.
Aggregate Money Demand
Aggregate money demand
The total demand for money by all households and
firms in the economy.
It is determined by three main factors:
– Interest rate
– It reduces the demand for money.
– Price level
– It raises the demand for money.
– Real national income
– It raises the demand for money.
Slide 14-12Copyright? 2003 Pearson Education,Inc.
The aggregate demand for money can be expressed by:
Md = P x L(R,Y) (14-1)
where:
P is the price level
Y is real national income
L(R,Y) is the aggregate real money demand
Equation (14-1) can also be written as:
Md/P = L(R,Y) (14-2)
Aggregate Money Demand
Slide 14-13Copyright? 2003 Pearson Education,Inc.
Figure 14-1,Aggregate Real Money Demand and the Interest Rate
L(R,Y)
Interest
rate,R
Aggregate real
money demand
Aggregate Money Demand
Slide 14-14Copyright? 2003 Pearson Education,Inc.
Figure 14-2,Effect on the Aggregate Real Money Demand Schedule of
a Rise in Real Income
L(R,Y2)
Increase in
real income
L(R,Y1)
Interest
rate,R
Aggregate real
money demand
Aggregate Money Demand
Slide 14-15Copyright? 2003 Pearson Education,Inc.
Equilibrium in the Money Market
The condition for equilibrium in the money market is:
Ms = Md (14-3)
The money market equilibrium condition can be
expressed in terms of aggregate real money demand as:
Ms/P = L(R,Y) (14-4)
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-16Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-3,Determination of the Equilibrium Interest Rate
Aggregate real
money demand,
L(R,Y)
Interest
rate,R
Real money
holdings
Real money supply
MS
P ( = Q
1)
R2
Q2
2
R1 1
R3
Q3
3
Slide 14-17Copyright? 2003 Pearson Education,Inc.
Interest Rates and the Money Supply
An increase (fall) in the money supply lowers (raises)
the interest rate,given the price level and output.
– The effect of increasing the money supply at a given
price level is illustrated in Figure 14-4.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-18Copyright? 2003 Pearson Education,Inc.
M2
P
R2 2
M1
P
Real money
supply Real money
supply increase
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-4,Effect of an Increase in the Money Supply on the Interest
Rate
L(R,Y1)
R1 1
Interest
rate,R
Real money
holdings
Slide 14-19Copyright? 2003 Pearson Education,Inc.
Output and the Interest Rate
An increase (fall) in real output raises (lowers) the
interest rate,given the price level and the money
supply.
– Figure 14-5 shows the effect on the interest rate of a rise
in the level of output,given the money supply and the
price level.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-20Copyright? 2003 Pearson Education,Inc.
Q2
1'
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-5,Effect on the Interest Rate of a Rise in Real Income
L(R,Y1)
L(R,Y2)
Increase in
real income
Real money supply
MS
P ( = Q
1)
R2 2
R1 1
Interest
rate,R
Real money
holdings
Slide 14-21Copyright? 2003 Pearson Education,Inc.
The Money Supply and the
Exchange Rate in the Short Run
Short run analysis
The price level and the real output are given.
Long run analysis
The price level is perfectly flexible and always
adjusted immediately to preserve full employment.
Slide 14-22Copyright? 2003 Pearson Education,Inc.
Linking Money,the Interest Rate,and the Exchange
Rate
The U.S,money market determines the dollar interest
rate,which in turn affects the exchange rate that
maintains the interest parity.
– Figure 14-6 links the U.S,money market (bottom) and
the foreign exchange market (top).
The Money Supply and the
Exchange Rate in the Short Run
Slide 14-23Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-6,Simultaneous Equilibrium in the U.S,Money Market
and the Foreign-Exchange Market
Return on
dollar deposits
Expected
return on
euro deposits
L(R$,YUS)
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
(increasing)
Foreign
exchange
market
Money
market
E1$/� 1'
R1$
1
U.S,real
money
supply
MSUS
PUS
Slide 14-24Copyright? 2003 Pearson Education,Inc.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-7,Money-Market/Exchange Rate Linkages
European
money market
United States
money market
Europe
European System
of Central Banks
United States
Federal Reserve System
(United States
money supply)M
SUS MSE (European
money supply)
R$
(Dollar interest rate)
R�
(Euro interest rate)
Foreign
exchange
market
E$/�
(Dollar/Euro exchange rate)
Slide 14-25Copyright? 2003 Pearson Education,Inc.
U.S,Money Supply and the Dollar/Euro Exchange
Rate
What happens when the Federal Reserve changes the
U.S,money supply?
– An increase (decrease) in a country’s money supply
causes its currency to depreciate (appreciate) in the
foreign exchange market.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-26Copyright? 2003 Pearson Education,Inc.
Increase in U.S.
real money supply
Expected
return on
euro deposits
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Figure 14-8,Effect on the Dollar/Euro Exchange Rate and Dollar
Interest Rate of an Increase in the U.S,Money Supply
E2$/� 2'
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
Return on
dollar deposits
L(R$,YUS)
E1$/� 1'
R1$
1
M1US
PUS
R2$
2
M2US
PUS
Slide 14-27Copyright? 2003 Pearson Education,Inc.
Europe’s Money Supply and the Dollar/Euro
Exchange Rate
An increase in Europe’s money supply causes a
depreciation of the euro (i.e.,appreciation of the
dollar).
A reduction in Europe’s money supply causes an
appreciation of the euro (i.e.,a depreciation of the
dollar).
The change in the European money supply does not
disturb the U.S,money market equilibrium.
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
Slide 14-28Copyright? 2003 Pearson Education,Inc.
Figure 14-9,Effect of an Increase in the European Money Supply
on the Dollar/Euro Exchange Rate
Increase in European
money supply
U.S,real money holdings
Rates of
return
(in dollar
terms)
Dollar/euro
exchange Rate,E$/�
0
Expected
euro return
L(R$,YUS)
U.S,real
money
supply
MSUS
PUS
R1$
1
E1$/� 1'
Dollar return
The Equilibrium Interest Rate,The
Interaction of Money Supply and Demand
E2$/� 2'
Slide 14-29Copyright? 2003 Pearson Education,Inc.
Money,the Price Level,and the
Exchange Rate in the Long Run
Long-run equilibrium
Prices are perfectly flexible and always adjusted
immediately to preserve full employment.
Money and Money Prices
The money market equilibrium (Equation 14-4) can be
rearranged to give the long-run equilibrium price level:
P = Ms/L(R,Y) (14-5)
An increase in a country’s money supply causes a
proportional increase in its price level.
Slide 14-30Copyright? 2003 Pearson Education,Inc.
The Long-Run Effects of Money Supply Changes
A change in the supply of money has no effect on the
long-run values of the interest rate or real output.
A permanent increase in the money supply causes a
proportional increase in the price level’s long-run
value,
– This prediction is based on the money market
equilibrium condition,Ms/P = L or P = Ms/L.
– This condition implies that?P/P =?Ms/Ms -?L/L.
– The inflation rate equals the monetary growth rate less the
growth rate for money demand.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-31Copyright? 2003 Pearson Education,Inc.
Empirical Evidence on Money Supplies and Price
Levels
In a cross-section of countries,long-term changes in
money supplies and price levels show a clear positive
correlation.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-32Copyright? 2003 Pearson Education,Inc.
Figure 14-10,Monetary Growth and Price-Level Change in the Seven
Main Industrial Countries,1973-1997
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-33Copyright? 2003 Pearson Education,Inc.
Money and the Exchange Rate in the Long Run
A permanent increase (decrease) in a country’s money
supply causes a proportional long-run depreciation
(appreciation) of its currency against foreign
currencies.
Money,the Price Level,and the
Exchange Rate in the Long Run
Slide 14-34Copyright? 2003 Pearson Education,Inc.
Inflation and
Exchange Rate Dynamics
Inflation
A situation where an economy’s price level rises.
Deflation
A situation where an economy’s price level falls.
Short-Run Price Rigidity versus Long-Run Price
Flexibility
The short-run,stickiness” of price levels is illustrated
in Figure 14-11.
Slide 14-35Copyright? 2003 Pearson Education,Inc.
Figure 14-11,Month-to-Month Variability of the Dollar/DM Exchange
Rate and of the U.S./German Price-Level Ratio,1974-2001
Inflation and
Exchange Rate Dynamics
Slide 14-36Copyright? 2003 Pearson Education,Inc.
A change in the money supply creates demand and
cost pressures that lead to future increases in the price
level from three main sources:
– Excess demand for output and labor
– Inflationary expectations
– Raw materials prices
Inflation and
Exchange Rate Dynamics
Slide 14-37Copyright? 2003 Pearson Education,Inc.
Permanent Money Supply Changes and the Exchange
Rate
How does the dollar/euro exchange rate adjust to a
permanent increase in the U.S,money supply?
– Figure 14-12 shows both the short-run and long-run
effects of the increase in the U.S,money supply.
Inflation and
Exchange Rate Dynamics
Slide 14-38Copyright? 2003 Pearson Education,Inc.
Figure 14-12,Effects of an Increase in the U.S.Money Supply
Dollar return Dollar return
M1US
P1US
M2US
P1US
U.S,real money supply
M2US
P2US
M2US
P1US
Dollar/euro exchange
Rate,E$/�
Rates of return
(in dollar
terms)
U.S,real
money holdings
0
(a) Short-run effects
0
(b) Adjustment to long-
run equilibrium
Dollar/euro exchange
Rate,E$/�
U.S,real
money holdings
E2$/� 2'
E3$/� 4'
R1$
4
R2$
2
R1$
1
Inflation and
Exchange Rate Dynamics
3'
2'E2
$/� Expected
euro return Expectedeuro return
L(R$,YUS)R
2$
2
L(R$,YUS)
E1$/� 1'
Slide 14-39Copyright? 2003 Pearson Education,Inc.
Figure 14-13,Time Paths of U.S,Economic Variables After a Permanent
Increase in the U.S,Money Supply
Inflation and
Exchange Rate Dynamics
P2US E3$/�
E1$/�
t0
(a) U.S,money supply,MUS
Time
(c) U.S,price level,PUS
Time
(b) Dollar interest rate,R$
Time
M1US
t0t0
R1$M2US
P1US
t0
R2$
E2$/�
(d) Dollar/euro exchange rate,E$/�
Time
Slide 14-40Copyright? 2003 Pearson Education,Inc.
Exchange Rate Overshooting
The exchange rate is said to overshoot when its
immediate response to a disturbance is greater than its
long-run response.
It helps explain why exchange rates move so sharply
form day to day.
It is a direct result of sluggish short-run price level
adjustment and the interest parity condition.
Inflation and
Exchange Rate Dynamics
Slide 14-41Copyright? 2003 Pearson Education,Inc.
Summary
Money is held because of its liquidity.
Aggregate real money demand depends negatively on
the opportunity cost of holding money and positively
on the volume of transactions in the economy.
The money market is in equilibrium when the real
money supply equals aggregate real money demand.
By lowering the domestic interest rate,an increase in
the money supply causes the domestic currency to
depreciate in the foreign exchange market.
Slide 14-42Copyright? 2003 Pearson Education,Inc.
Permanent changes in the money supply push the
long-run equilibrium price level proportionally in the
same direction.
These changes do not influence the long-run values of
output,the interest rate,or any relative prices.
An increase in the money supply can cause the
exchange rate to overshoot its long-run level in the
short run.
Summary
