International Monetary Economics
Lecture 4: Money, Interest Rates and Exchange Rates
Master d’Affaires Publiques SciencesPo Spring 2013
Pierre-Olivier Gourinchas
Slide 4-2
§ Money and Interest Rates • 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 § Money, the Price Level, and the Exchange Rate in the
Long Run § Inflation and Exchange Rate Dynamics § Summary
Roadmap
Slide 4-3
The Interaction of Money Supply and Demand Figure 4-1: 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)
MSUS MS
E (European money supply)
i$ (Dollar interest rate)
i€ (Euro interest rate)
Foreign exchange
market
E$/€ (Dollar/Euro exchange rate)
Slide 4-4
Money Defined: A Brief Review
§ Money as a Medium of Exchange
§ Money as a Unit of Account
§ Money as a Store of Value
Slide 4-5
§ What Is Money? • Assets widely used and accepted as a means of payment. • Money is very liquid, but pays little or no return.
• Money Supply (Ms)
Ms = Currency + Checkable Deposits – This corresponds to the monetary aggregate “M1”. – Broader aggregates exist (M2, for instance, includes time
deposits). – In December 2012:
– ECB M1 stands at €5085 billion. – ECB M2 stands at €8970 billion. – ECB M3 stands at €9740 billion
Money Defined: A Brief Review
Slide 4-6
§ How the Money Supply Is Determined • An economy’s money supply is controlled by its central
bank, both directly and indirectly. – The central bank:
– Directly regulates the amount of currency;
– Indirectly controls the amount of checking deposits issued by private banks
Money Defined: A Brief Review
600#
1100#
1600#
2100#
2600#
3100#
2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012#M0# M1#
Slide 4-7
Figure 4-2: Monetary Aggregates, billions USD, 2004-2012
The explosion of the US Money Base
0.00#
0.20#
0.40#
0.60#
0.80#
1.00#
1.20#
1.40#
1.60#
1.80#
2.00#
2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012#M1/M0#
Slide 4-8
Figure 4-2b: The US money multiplier
The explosion of the US Money Base
0.00#
2.00#
4.00#
6.00#
8.00#
10.00#
12.00#
2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012#M3/M0#
Slide 4-9
Figure 4-2c: M3/M0, Euro area, 2004-2012
The Euro Money Multiplier
Slide 4-10
§ Three factors influence money demand: • Expected Return
• Risk
• Liquidity
The Demand for Money by Individuals
Slide 4-13
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
– Price level
– Real national income
Slide 4-14
§ The aggregate demand for money can be expressed by: Md = P L(i,Y) where: P is the price level Y is real national income L(i,Y) is the aggregate real money demand
§ Can also be written as: Md/P = L(i,Y)
Aggregate Money Demand
Slide 4-15
Figure 4-3: Aggregate Real Money Demand and the Interest Rate
L(i,Y)
Interest rate, i
Aggregate real money demand
Aggregate Money Demand
Slide 4-17
§ Equilibrium in the Money Market • The condition for equilibrium in the money market is:
Ms = Md
• The money market equilibrium condition can be expressed
in terms of aggregate real money demand as: Ms/P = L(i,Y)
§ The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-18
Figure 4-4: Determination of the Equilibrium Interest Rate
L(i,Y)
Interest rate, i
Aggregate real money demand
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-20
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Figure 4-5: Effect of an Increase in the Money Supply on the Interest Rate
Aggregate real money demand, L(i,Y)
Interest rate, i
Real money holdings
Real money supply
MS P
( = Q1)
i1 1
Slide 4-22
§ Interest Rates and the Money Supply • An increase in the money supply lowers the interest rate,
given the price level and output.
• A fall in the money supply raises the interest rate, given the price level and output.
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-23
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Figure 4-6: Effect on the Interest Rate of a Rise in Real Income
Aggregate real money demand, L(i,Y)
Interest rate, i
Real money holdings
Real money supply
MS P
( = Q1)
i1 1
Slide 4-25
§ Output and the Interest Rate • An increase in real output raises the interest rate, given the
price level and the money supply.
• An fall in real output lowers the interest rate, given the price level and the money supply.
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-26
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 4-27
§ Linking Money, the Interest Rate, and the Exchange Rate • The U.S. money market determines the dollar interest rate, • The Japanese money market determines the yen interest
rate, • The dollar and yen interest rates determine the dollar/yen
exchange rate that maintains the interest parity.
The Money Supply and the Exchange Rate in the Short Run
Slide 4-28
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Figure 4-7: Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market
Return on dollar deposits
Expected return on yen deposits
L(i$, YUS)
U.S. real money holdings
Rates of return (in dollar terms)
Dollar/yen exchange Rate, E$/¥
§ 0
(increasing)
Foreign exchange market
Money market
E1$/¥
1'
i1$
1 U.S. real money supply
MSUS
PUS
Slide 4-29
§ U.S. Money Supply and the Dollar/Yen Exchange Rate • What happens when the Federal Reserve changes the U.S.
money supply?
§ The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-30
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Figure 4-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply
Return on dollar deposits
Expected return on yen deposits
L(i$, YUS)
U.S. real money holdings
Rates of return (in dollar terms)
Dollar/yen exchange Rate, E$/¥
§ 0
(increasing)
Foreign exchange market
Money market
E1$/¥
1'
i1$
1 U.S. real money supply
MSUS
PUS
Slide 4-32
§ Japan’s Money Supply and the Dollar/Yen Exchange Rate • What happens when the Bank of Japon changes the
Japanese money supply?
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Slide 4-33
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Figure 4-9: Effect an Increase in the Japanese Money Supply
Return on dollar deposits
Expected return on yen deposits
L(i$, YUS)
U.S. real money holdings
Rates of return (in dollar terms)
Dollar/yen exchange Rate, E$/¥
§ 0
(increasing)
Foreign exchange market
Money market
E1$/¥
1'
i1$
1 U.S. real money supply
MSUS
PUS
Slide 4-35
The Short Run vs. the Long Run
§ Short run analysis • The price level and real output are given.
§ Long run analysis • The price level is perfectly flexible and adjusts immediately
to maintain the economy at its potential output.
Slide 4-36
Money and the Price Level in the Long Run
§ Long-run equilibrium: position the economy would reach if no new shocks were to occur, and prices and wages have time to adjust. • In the long run, output (Ylr) is determined by the supply of factors of
production • The long run real interest rate (rlr) is determined by the return to capital • The long run nominal interest rate (ilr) is determined by the Fischer
relationship
Slide 4-37
Money and the Price Level in the Long Run
§ Money and Prices • In the long run, the money market equilibrium determines
the equilibrium price level:
• [In the short run, the money market equilibrium determines the nominal interest rate]
Slide 4-38
The Quantity Theory of Money
§ Special case: The Quantity Theory of Money (QTM) • The QTM assumes that the demand for real liquidity is proportional to real
activity. (k is a constant) Ms/ P = k Y
• Equivalently, there is a constant ‘velocity’ v: PY/ Ms = 1/k = v
• In the long run, with Y = Ylr, this implies that inflation is proportional to the
growth in money supply:
π = ΔP/P = ΔMs/Ms - ΔYlr/Ylr
§ Inflation is a monetary phenomenon!!
Slide 4-39
§ 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 (neutrality).
• A permanent increase in the money supply causes a proportional increase in the price level’s long-run value.
– Think of a currency reform…
• In general, changes in money demand affect long run inflation. – Consider the money market equilibrium condition: P = Ms/L(i,Y). – This condition implies that ΔP/P = ΔMs/Ms - ΔL/L.
Money and the Price Level in the Long Run
Slide 4-40
§ 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 and the Price Level in the Long Run
Slide 4-41
Figure 4-10: Monetary Growth and Price-Level Change in the OECD, 1970-1998
USA
DEU
SWEDNK
BELAUTJPN
NORCAN
CHENTL
FIN AUSIRLGBR
NZLESP
PRTGRE
ISL
510
1520
25
Infla
tion
(per
cent
per
yea
r), 1
970-
1998
5 10 15 20 25Money Growth (percent per year), 1970-1998
Money and the Price Level in the Long Run
Slide 4-43
§ 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.
– Why? Suppose the U.S. money supply doubles.
Money and the Price Level in the Long Run
Slide 4-47
Figure 4-11: The Swiss and the Saddam dinar
Money, the Price Level, and the Exchange Rate in the Long Run
§ The Swiss Dinar, used by the Kurds
§ The Saddam Dinar, used in Iraq
Slide 4-48
Figure 4-12: The Swiss and the Saddam dinar exchange rate
Money, the Price Level, and the Exchange Rate in the Long Run
Slide 4-51
Inflation and Exchange Rate Dynamics
§ From the Short Run to the Long Run: Inflation and Exchange Rate Dynamics • In the short run, prices and output are fixed and exchange
rates can move. – Changes in money supply affect interest rates and the
exchange rate • In the long run, price and exchange rate are flexible.
– Changes in money supply affect ‘nominal’ variables (prices and the nominal exchange rate).
– Full employment output • As we will see, this explains why exchange rates are very
volatile in the short run.
Slide 4-52
Figure 4-13: Month-to-Month Variability of the USD/JPY Exchange Rate and of the U.S./Japan Price-Level Ratio, 1974-2007
Inflation and Exchange Rate Dynamics
Slide 4-53
§ 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?
Inflation and Exchange Rate Dynamics
Slide 4-54
Figure 4-14: Effects of an Increase in the U.S.Money Supply
0
(b) Adjustment to long- run equilibrium
Dollar/euro exchange Rate, E$/€
U.S. real money holdings
Expected euro return
L(i$, YUS)
Dollar return
M1US
P1US
Dollar/euro exchange Rate, E$/€
Rates of return (in dollar terms)
U.S. real money holdings
0
(a) Short-run effects
i1$
1 L(i$, YUS)
E1$/€ 1'
Inflation and Exchange Rate Dynamics
Slide 4-56
Figure 4-15: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply
P2US E3
$/€ E1
$/€
t0
(a) U.S. money supply, MUS
Time (c) U.S. price level, PUS
Time
(b) Dollar interest rate, i$
Time t0
i1$
M1US
t0
M2US
P1US
t0
i2$
E2$/€
(d) Dollar/euro exchange rate, E$/€
Time
Inflation and Exchange Rate Dynamics
Slide 4-57
§ Exchange Rate Overshooting (Dornbusch, 1976) • 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 4-58
• In the overshooting model, a permanent increase in money supply leads to a depreciation of the domestic currency (immediate) and an increase in inflation (gradual).
• Yet in many situations, we see a currency appreciate when inflation rises. How should we interpret this?
Inflation and Exchange Rate Dynamics
Slide 4-59
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 4-60
§ 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. § The response of the monetary authorities to inflationary
shocks can lead to a negative correlation between the exchange rate and the inflation rate.
Summary