Slide 1 - Faculty Web Server

							Equilibrium Interest Rates and Exchange Rates
Money-Market/Exchange Rate Linkages
United States Federal Reserve System MSUS (United States money supply) Europe European System of Central Banks MS E (European money supply)

United States money market
R$ (Dollar interest rate) Foreign exchange market

European money market
R€ (Euro interest rate)

E$/€ (Dollar/Euro exchange rate)

Money, Interest, and the Exchange Rate

MONEY
Medium of Exchange Unit of Account
– Express prices, keep records,…write contracts!

Store of Value … Low risk
• Other, riskier assets are less liquid but pay higher return.
Money Supply (Ms)

Ms = Currency + Checkable Deposits
Controlled by central bank

Aggregate Money Demand
Md = P x L(R,Y)
where: P = price level Y = real national income R = interest rate

• The demand for money can be expressed as the demand for real balances:
Md/P = L(R,Y)

Aggregate Money Demand
Aggregate Real Money Demand and the Interest Rate
Interest rate, R

Md/P = L(R,Y) Aggregate real money demand

Effect on Aggregate Real Money Demand of Rise in Real Income

Interest rate, R

Increase in real income

L(R,Y2) L(R,Y1) Aggregate real money demand

Equilibrium in the Money Market: Md = Ms or Ms/P = L(R,Y)
Interest rate, R

Real money supply 2

R2

R1
R3

1
3

Aggregate real money demand, L(R,Y)

Q2

MS ( = Q 1 ) P

Q3

Real money holdings

Money Supply and Exchange Rate
Short run analysis: The price level and real output are given  sticky prices
Assume real output (Y) starts at full-employment

Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment.
Short – run Long – run

Linking Money, the Interest Rate, and the Exchange Rate
United States Federal Reserve System MSUS (United States money supply) Europe European System of Central Banks MS E (European money supply)

United States money market
R$ (Dollar interest rate) Foreign exchange market

European money market
R€ (Euro interest rate)

E$/€ (Dollar/Euro exchange rate)

Money Market and Exchange Market Interaction: Our Elaborated Model
Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market
Dollar/euro exchange Rate, E$/€ Return on dollar deposits

Foreign exchange market

E1$/€

1'

Expected return on euro deposits L(R$, YUS) U.S. real money supply

0
Money market MSUS PUS
(increasing)

R1$

Rates of return (in dollar terms)

1

U.S. real money holdings

Money, Price Level, & Exchange Rate: the Long Run
• Long-run equilibrium: Prices are perfectly flexible  adjust to preserve full employment. • Money and Money Prices From the money market equilibrium condition, Ms/P = L(R,Y) P = Ms/L(R,Y) The Classical Dichotomy: Ms  proportional P – A change in Ms has no effect on the long-run values of R (the relative price of money) or Y (full employment output). • In order for E to remain stable, R must return to R* in the long-run. – This long-run equilibrium condition implies that P/P = Ms/Ms - L/L. The inflation rate equals the growth rate of Ms minus the growth rate of the demand for money (real balances). – In long-run, E adjusts to P, keeping relative prices (foreign and domestic) constant  purchasing power parity. – If E in long-run, Ee right away. (We’ve read the textbook).

Permanent Money Supply Changes and the Exchange Rate
Short-run and Long-run Effects of an Increase in the U.S.Money Supply
Dollar/euro exchange Rate, E$/€ Dollar return Dollar/euro exchange Rate, E$/€ Dollar return 2' 3' Expected euro return 1' Rates of return (in dollar 0 terms) 2

E2$/€

E2$/€

2' 4'

E3$/€

Expected euro return

E1$/€ 0 M1US P1US M2US P1US

R2$ R1$ L(R , Y ) $ US
1 2

M US P2US M2US P1US

R2$

R1$
4

L(R$, YUS)

U.S. real money supply

2

(a) Short-run effects
U.S. real money holdings U.S. real money holdings

(b) Adjustment to longrun equilibrium

Permanent Money Supply Changes and the Exchange Rate
Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply
(a) U.S. money supply, MUS M2US M1US (b) Dollar interest rate, R$

R1$

R2$ t0 Time
E2$/€

t0

Time

(c) U.S. price level, PUS P2US P1US t0 Time

(d) Dollar/euro exchange rate, E$/€

E3$/€ E1$/€ t0 Time

Effect of an Increase in the European Money Supply on Dollar/Euro Exchange Rate: Short-run response
Expected return on euro holdings declines both because R* falls and Ee declines (euro is expected to depreciate). Increase in European money supply Expected euro return R1$ L(R$, YUS) U.S. real money supply

Dollar/euro exchange Rate, E$/€ E1$/€ E2$/€

Dollar return 1'
2'

0
MSUS PUS

Rates of return (in dollar terms)

1

U.S. real money holdings