INTERNATIONAL

FINANCE

INTERNATIONAL

FINANCE

CHAPTER 14

Money, Interest Rates, and Money, Interest Rates, and

Exchange RatesExchange Rates

Money Defined: a Brief Review

Money as a Medium of ExchangeMoney as a Medium of Exchange Money as a Unit of AccountMoney as a Unit of Account

Money as a Store of ValueMoney as a Store of Value What Is Money?What Is Money?

How the Money Supply Is Determined

33 03 5

Ms Ms

R

M s

An economy’s money supply is controlled by its central bank.

The Demand For Money by Individuals

Expected ReturnExpected Return

RiskRisk

LiquidityLiquidity

The expected return the asset offers compared with the returns offered by The expected return the asset offers compared with the returns offered by other assetsother assets

The riskiness of the asset’s expected returnThe riskiness of the asset’s expected return

The asset’s liquidityThe asset’s liquidity

Aggregate Money Demand (I)

The interest rate (The interest rate (RR ) )MMdd = = ((RR))

-

A rise in the interest rate cause each individual in the economy to reduce her demand for money. All else equal, aggregate money demand therefore falls when the interest rate rises.

Figure 14-1 Aggregate Real Money Demand and the Interest Rate

L( R ,Y)

L

R

Aggregate real money demand

Interest rate, R

R

Aggregate Money Demand (II)

The price level ( The price level ( PP ) )

MMdd = = ((PP))+

P is the price of a broad reference basket of goods and services in terms of currency.

If the price level rises, people would like to demand for more money in order to maintain the same level liquidity as before.Therefore Md and P are positively correlated.

Aggregate Money Demand (III)

Real national income (Real national income (YY ) ) MMdd = = ((YY))+

When real national (GNP) rises, more goods and services are being sold in the economy.

This increase in the real value of transactions raises the demand for money, given the price level.

Figure 14-2 Effect on the Aggregate Real Money Demand Schedule of aRise in Real Income

L(R, Y 2 )L(R, Y 1 )

R

L 1L 2

Aggregate real money demand

Interest rate, R

Y

Aggregate Money Demand (IV)

How is How is LL((RR, , YY) determined by the three main factors, ) determined by the three main factors, RR, , PP and and YY??

MMdd = = RR, , PP,,YY+ +-

or

MMdd = = PP x x LL((RR, , YY) (14-1)) (14-1)

The equivalent form of (14-1) is:

Md/P = L(R, Y) (14-2)

where L(R, Y) is aggregate money demand.

real

The Equilibrium Interest Rate: The Interaction of Money Supply And Demand

Equilibrium in the Money MarketEquilibrium in the Money Market

Interest Rates and the Money SupplyInterest Rates and the Money Supply

Output and the Interest RateOutput and the Interest Rate

Equilibrium in the Money Market

If Ms is the money supply, the condition for equilibrium in the money market is:

Ms = Md (14-3)

∵ Md = P x L(R, Y) ; Md/P = L(R,

Y) ∴ The money market equilibrium condition can also be express as

Ms/P = L(R, Y) (14-4)

Equilibrium in the Money Market

Given P, Y and Ms/P, money market equilibrium is at point 1.

Therefore the equilibrium interest rate is R1

Figure 14-3 Determination of the Equilibrium Interest Rate

Aggregate realmoney demand

L(R,Y)

2

Real moneysupply

M s/P ( = Q 1 )

R 11

R 2

Real money holdings

Interest rate, R

R

MMss/P = L/P = L((R, YR, Y))

Interest Rates & the Money Supply

Given P and Y, an increase in the money supply reduces interest rate, and vice versus.

Figure 14-4 Effect of a Change in the Money Supply on the Interest Rate

Aggregate realmoney demand

L(R,Y)

2

M 2 /P

Real moneysupply

M 1 /P

R 11

R 2

0 . 0 %

0 . 4 %

0 . 8 %

1 . 2 %

1 . 6 %

3 E + 1 3 7 E + 1 3 1 . 1 E + 1 4 1 . 5 E + 1 4 1 . 9 E + 1 4 2 . 3 E + 1 4

Real money holdings

Interest rate, R

M s /P

Output and the Interest RateFigure 14-5 Effect on the Interest Rate of a Change in Real Income

L(R,Y 2)L(R,Y 1)

M s/P ( =Q 1 )

1R 1

1'2R 2

Q 2

Real money holdings

Interest rate, R

Y

Given Ms/P(=Q1), a rise in Y raises R, while a fall in Y lowers R.

The Money Supply And the Exchange Rate In the Shout Run

Linking Money, the Interest Rate, and the Exchange RateLinking Money, the Interest Rate, and the Exchange Rate

U.S. Money Supply and the Dollar/Euro Exchange RateU.S. Money Supply and the Dollar/Euro Exchange Rate

Europe’s Money Supply and the Dollar/Euro Exchange Europe’s Money Supply and the Dollar/Euro Exchange RateRate

Linking Money, the Interest Rate, and the Exchange RateFigure14-6 Simultaneous Equilibrium in the U.S. Money Market and the

Foreign-Exchange Market

R $1

Expected return on

euro deposits

Return on dollar

deposits

1'E $/€1

Rates of return (in dollar terms)

Dollar/euroexchangerate,E $/€

L(R$,Yus)

U.S. real money supply

Mus

/Pus

1R$

1

Rates ofreturn

(in dollarterms)

Figure14-6 Simultaneous Equilibrium in the U.S. MoneyMarket and the Foreign-Exchange Market

L(R$,Yus)

M us/P us

U.S. real moneysupply

1

R $1

Expected return on

eurodeposits

Return on dollar

deposits

1'E $/€

1

Rates of return (in dollar terms)

E $/€

Foreign exchange market

Money market

Money-Market/Exchange Rate LinkagesFederal Reserve System (the Fed)

European System of Central Banks (ESCB)

USD money market EUR money market

FX market

Msus Ms

E

R$ R€

E$/€

U.S. Money Supply and the Dollar/Euro Exchange Rate

U.S. realmoney

holdings

Figure14-8 Effect on the Dollar/Euro Exchange Rate andDollar Interest Rate of an Increase in the U.S. Money

Supply

L(R$,Yus)

M us1/Pus 1

R $1

Expected euro return

1'E $/€

1

M us2/Pus 2

Dollar return

E $/€2

2'

R $2

Rates of return (in dollar terms)

Dollar/euroexchange

rate,E $/€

M us /P us

Given Pus and Yus, when the money supply rises from M1

us to M2us, the dollar

interest rate decline( 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’)

Europe’s Money Supply and the Dollar/Euro Exchange RateFigure14-12 (a) Short-run effects

L(R $ ,Y u

s )M us

s/P

us 1

R $1

Expected euro return

Dollarreturn

2'E 2$/€

1'E 1$/€

Dollar/euroexchange

rate,E $/€

U.S. realmoney

holdings

M s€

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.

Money, the Price Level, and the Exchange Rate in the Long Run

Money and Money PriceMoney and Money Price The Long-Run Effects of Money Supply ChangesThe Long-Run Effects of Money Supply Changes

Money and the Exchange Rate in the Long RunMoney and the Exchange Rate in the Long Run

Money and Money PriceIf the price level and output are fixed in the short run, the condition ( 14 - 4 ) of money market equilibrium,

Ms/P = L(R,Y) (14-4)(14-4)(14-5)+

All else equal, an increase in a country’s money supply causes a proportional increase in its price level.

The Long-Run Effects of Money Supply Changes

P = Ms /L(R,Y)

Permanent increase

(14-5)

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. In particular, if the economy is initially at full employment, a permanent increase in the money supply eventually will be followed by a proportional increase in the price level.

Money and the Exchange Rate in the Long Run

A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency against foreign currencies. Similarly, a permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency against foreign currencies.

Inflation and Exchange Rate Dynamics

Short-Run Price Rigidity versus Long-Run Price Short-Run Price Rigidity versus Long-Run Price FlexibilityFlexibility

Permanent Money Supply Changes and the Permanent Money Supply Changes and the Exchange RateExchange Rate

Exchange Rate OvershootingExchange Rate Overshooting

Short-Run Price Rigidity versus Long-Run Price Flexibility (I)Since output prices depend heavily on

production costs, the behavior of the overall price level is influenced by the sluggishness of wage movements. In extremely inflationary conditions, such as those seen in the 1980s in some Latin American countries, long-term contracts specifying domestic money payments may go out of use.

Short-Run Price Rigidity versus Long-Run Price Flexibility (II)

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. These pressures come from three main sources:• Excess demand for output and labor.

• Inflationary expectations.

• Raw materials prices.

Permanent Money Supply Changes and the Exchange Rate (I)Figure14-12 (b) Adjustment to long-run equilibrium

L(R $,Y us )

M us1/Pus

1

R $1

M us2/Pus 2

Dollarreturn

R $2

E $/€3

E $/€2

Rates of return (in dollar terms)

E $/€

Figure14-12 (a) Short-run effects

L(R $,Y us )

M us1/Pus

1

R $1

Expected euro return

1'E $/€

1

M us2/Pus 2

Dollarreturn

R $2

E $/€2

Dollar/euroexchange

rate,E $/€

U.S. realmoney

holdings

M us/P us

M us/ P us

(a) Short-run adjustment of the asset markets.

(b) How the R$, Pus, and E$/€

move over time as the economy approaches its long-run equilibrium

M/P = L(R$,Y)

R$=R€+(Ee/E-1)

E

/P = L(M R$,Y)

R$=R€+(Ee/ -1) In the Short Run

In the Long Run

R$=R€+(Ee/E-1)

M/P = L(R$,Y)M/ = L( ,Y

)P R$

ER$=R€+(Ee/ -1)

Rudi Dornbusch鲁迪 ·多恩布什

Hi! This part is about the theory of exchange rate over

shooting put forward by me.

Permanent Money Supply Changes and the Exchange Rate (II)

At t0, Ms increases

When Ms increases at t0, R falls down.

When Ms

increases and R falls down at t0, P remains unchanged.

As R falls down at t0, E jumps up.

As the time goes by, Ms remains unchanged at a higher level.

As the time goes by, P keeps rising until M2/P2=M1/P1

As P keeps rising R rises until its original level is reached.

As R rises, E keeps falling until its long-run level is reached.

(a) U. S. money suppl y, Mus

M us1

Mus

Ti me

(b) Dol l ar i nterest rate, R$

R$1

R$

Ti me

(c) U. S. pri ce l evel , Pus

Pus1

Ti me

Pus

(d) Dol l ar/ euro exchange rate, E$/ €

E$/ €1

Ti me

E$/ €

t

(a) U. S. money suppl y, Mus

M us1

Mus

Ti me

(b) Dol l ar i nterest rate, R$

R$1

R$

Ti me

(c) U. S. pri ce l evel , Pus

Pus1

Ti me

Pus

(d) Dol l ar/ euro exchange rate, E$/ €

E$/ €1

Ti me

E$/ €

t

(a) U. S. money suppl y, Mus

M us1

Mus

Ti me

(b) Dol l ar i nterest rate, R$

R$1

R$

Ti me

(c) U. S. pri ce l evel , Pus

Pus1

Ti me

Pus

(d) Dol l ar/ euro exchange rate, E$/ €

E$/ €1

Ti me

E$/ €

t

Exchange rate overshooting

is an important phenomenon

because it helps explain why

exchange rates move so sharply

from day to day.

Only if the dollar/euro exchange

rate overshoots E initially will

market participants expect a

subsequent appreciation of the

dollar against the euro.

超调(a) U. S. money suppl y, Mus

M us1

Mus

Ti me

(b) Dol l ar i nterest rate, R$

R$1

R$

Ti me

(c) U. S. pri ce l evel , Pus

Pus1

Ti me

Pus

(d) Dol l ar/ euro exchange rate, E$/ €

E$/ €1

Ti me

E$/ €

Question

Thanks