international monetary economics - sciences po...

International Monetary Economics

Lecture 4: Money, Interest Rates and Exchange Rates

Master d’Affaires Publiques SciencesPo Spring 2013

Pierre-Olivier Gourinchas

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§ 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

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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)

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Money Defined: A Brief Review

§ Money as a Medium of Exchange

§ Money as a Unit of Account

§ Money as a Store of Value

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§ 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


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§ 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


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

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§  Three factors influence money demand: •  Expected Return

•  Risk

•  Liquidity

The Demand for Money by Individuals

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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

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§  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)


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Figure 4-3: Aggregate Real Money Demand and the Interest Rate

L(i,Y)

Interest rate, i

Aggregate real money demand


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§  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

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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

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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

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§  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.


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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

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§ 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.


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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.

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§  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

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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

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§ 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

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Figure 4-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply



L(i$, YUS)




§ 0

(increasing)


Money market

E1$/¥

1'

i1$


MSUS

PUS

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§  Japan’s Money Supply and the Dollar/Yen Exchange Rate •  What happens when the Bank of Japon changes the

Japanese money supply?


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Figure 4-9: Effect an Increase in the Japanese Money Supply



L(i$, YUS)




§ 0

(increasing)


Money market

E1$/¥

1'

i1$


MSUS

PUS

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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.

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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

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§ 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]

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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!!

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§  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.


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§  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.


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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


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§ 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.


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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

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Figure 4-12: The Swiss and the Saddam dinar exchange rate

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

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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.

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Figure 4-13: Month-to-Month Variability of the USD/JPY Exchange Rate and of the U.S./Japan Price-Level Ratio, 1974-2007


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§  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?


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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$/€


Expected euro return

L(i$, YUS)

Dollar return

M1US

P1US

Dollar/euro exchange Rate, E$/€



0

(a) Short-run effects

i1$

1 L(i$, YUS)

E1$/€ 1'


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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


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§  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.


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•  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?


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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.

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§  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

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