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					INTERNATIONAL
 INTERNATIONAL
   FINANCE
   FINANCE
    CHAPTER 14

Money, Interest Rates, and
     Exchange Rates
Money Defined:
a Brief Review
   Money as a Medium of Exchange
   Money as a Unit of Account
   Money as a Store of Value
   What Is Money?
How the Money Supply Is
Determined
        R         3
                  3        0
                  3        5   Ms




                      Ms            Ms




 An economy’s money supply is
 controlled by its central bank.
The Demand For Money by
Individuals
 Expected    Return
  The expected return the asset offers
 Risk
   compared with the returns offered by
  The riskiness of the asset’s expected return
   other assets
 Liquidity
 The asset’s liquidity
Aggregate Money Demand (I)
                                                                                                -
                                                                                      Md   = f (R)
    The          interest rate (R )
                  Figure 14-1 Aggregate Real Money Demand and the Interest Rate

  A rise in the interest rate cause each
      Interest rate, R


                                 R
  individual in the economy to reduce her
  demand for money.
  All else equal, aggregate money demand
  therefore falls when the interest rate
         R



  rises.
                                                                           L( R ,Y)


                                              L             Aggregate real money demand
   Aggregate Money Demand (II)
 The   price level ( P )
  P is price level a broad reference
 If thethe price of rises, people would like
 to demand for more money in order to
  basket of goods and services in terms
 maintain the same level liquidity as
  of currency.
 before.
 Therefore Md and P are positively correlated.
                            +
                  Md = f (P)
Aggregate Money Demand (III)
                                                                                                           +
   Real national income (Y )                                                                    Md   = f (Y)
    When real national (GNP) rises, more
                      Figure 14-2 Effect on the Aggregate Real Money Demand Schedule of a
           Interest rate, R                     Rise in Real Income


    goods and services are being sold in the
                                 Y
    economy.
    This increase in the real value of
               R



    transactions raises the demand for money,
    given the price level.                                                         1
                                                                            L(R, Y 2 )




                                           L1                      Aggregate real money demand
                                            2
     Aggregate Money Demand
     (IV)
   How is L(R, Y) determined by the three main
              - + +
    Md = f(R, P, and Y?
    factors, R, P Y)       or
    Md = P x L(R, Y)              (14-1)
    The equivalent form of (14-1) is:
    Md/P = L(R, Y)                   (14-2)
    where L(R, Y) is aggregate real money
    demand.
The Equilibrium Interest Rate: The
Interaction of Money Supply And
Demand

 Equilibrium     in the Money Market

 Interest   Rates and the Money Supply

 Output     and the Interest Rate
 Equilibrium
 in the Money Market
   s
If M is the money supply, the condition
for equilibrium in the money market is:
      Ms = M d              (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    Figure 14-3 Determination of the Equilibrium Interest Rate
    Interest rate, R
                                                                                       Ms/P = L(R, Y)
                                                        Real money
                                                          supply




        1
                                                    1
                                                    2
       R2


                                                                                Aggregate real
                                                                                money demand
                                                                                   L(R,Y)


                          R
                                               s         1                 Real money holdings
                                            M /P ( = Q )



Given P, Y and Ms/P, money market
equilibrium is at point 1.
Therefore the equilibrium interest rate is R1
   Interest Rates
   & the Money Supply
                        Figure 14-4 Effect of a Change in the Money Supply on the Interest Rate
            Interest rate, R
                    1. 6%




                                                                          Real money                 s
                                                                            supply                  M /P
                    1. 2%




                   1
                                                                      1
                 R2 0. 8%
                                                                      2

                                                                                                     Aggregate real
                                                                                                     money demand
                    0. 4%
                                                                                                        L(R,Y)




                    0. 0%


                            3E+13     7E+13          1. 1E+14                 1. 5E+14   1. 9E+14           2. 3E+14


                                                                  2
                                                                M 1 /P                         Real money holdings




Given P and Y, an increase in the money
supply reduces interest rate, and vice versus.
 Output and the Interest Rate
               Figure 14-5 Effect on the Interest Rate of a Change in Real Income
     Interest rate, R



                                                                         Y



                                                 1'
                                                 1
        R2
         1                                       2


                                                                    L(R,Y 2 )
                                                                          1




                                                               Real money holdings
                                               (2
                                         M s /PQ =Q 1 )




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 Rate
 U.S. Money Supply and the Dollar/Euro
  Exchange Rate
 Europe’sMoney Supply and the
 Dollar/Euro Exchange Rate
              Linking Money, the Interest Rate,
              and the Exchange Rate
                               Foreign-Exchange Market
                                                                Figure14-6 Simultaneous Equilibrium in the U.S. Money
            Figure14-6 Simultaneous Equilibrium in the U.S. Money MarketMarket and the Foreign-Exchange Market
                                                                        and the
                                                                                         Return on
                                                                                                                U.S. real
                                                                                                              money supply

Dollar/euro                                           E $/€
exchange
                                          Return on                                        dollar
                                            dollar
 rate,E $/€
                                          deposits
                                                                                         deposits                      Rates of
                                                                                                                         return
                                                                                                                       (in dollar
             Foreign                                                                                                    terms)


             exchange                                                                    1'     R$1
                                                                                                          Expected
                                                                                                          return on




                                                                                                                   1
                                                   E $/€ 1    Rates of return

E $/€   1
             market                       1'                  (in dollar terms)
                                                                 Expected
                                                                                                            euro
                                                                                                          deposits
                                                                  return on
                                                              euro deposits


                                                                                                                                    L(R$,Yus)
                                                                                                       Rates of return
                                                                                         R $1          (in dollar terms)
                                          R$1

                                                                                                          L(R$,Yus)
                                                                                                                  U.S. real
                                                                                                              M us /Pus
             Money                                M us /P us
                                                                                         1
                                                                                                                   money
                                                                                                                   supply
             market
Money-Market/
Exchange Rate Linkages
Federal Reserve              European System of
System (the Fed)             Central Banks (ESCB)
  Msus                                   MsE


USD money market             EUR money market

    R$                                  R€


                   FX market

                      E$/€
              U.S. Money Supply and the
              Dollar/Euro Exchange Rate
            Figure14-8 Effect on the Dollar/Euro Exchange Rate and
              Dollar Interest Rate of an Increase in the U.S. Money
                                      Supply
Dollar/euro
exchange
 rate,E $/€
                               Dollar return
                                                                         Given Pus and Yus, when
                                                                         the money supply rises
    E $/€ 2                 2'
                                      1'
                                                                         from M1us to M2us, the dollar
    E $/€ 1                                            Expected
                                                       euro return       interest rate decline( as
                                                                         money-market equilibrium
                           R $2       R $1
                                                     Rates of return
                                                     (in dollar terms)
                                                                         is reestablished at point 2)
                                                     L(R$,Yus)           and the dollar depreciates
M us 1 /P us
                                      1
                                                                         against the euro( as
M us 2 /P us
                            2                                            foreign exchange market
                                                 M us /P us
                                                                         equilibrium is reestablished
U.S. real
 money                                                                   at point 2’)
holdings
                Europe’s Money Supply and the
 Dollar/euro
                Dollar/Euro Exchange Rate
                 Figure14-12 (a) Short-run effects

 exchange
  rate,E $/€
                                      Dollar
                                      return
                                                                    By lowering the dollar return
                                                                    on euro deposits( shown as a
                                                                    leftward shift in the expected
      E 1 $/€                         1'                            euro return curve), an
        2                                             Expected
      E $/€                           2'
                                                      euro return
                                                                    increase in Europe’s money
                                                                    supply causes the dollar to
                                      R $1
                                                                    appreciate against the euro.
                                                     L(R $ ,Y u
                                                         s)
                                                                    Equilibrium in the foreign
        s
 M us /P                                                            exchange market shifts from
                                      1
      us
                                                                    point 1’ to point 2’, but
U.S. real
                                                     M s€           equilibrium in the U.S. money
 money
holdings                                                            market remains at point 1.
Money, the Price Level, and the
Exchange Rate in the Long Run

     Money and Money Price
 The Long-Run Effects of Money Supply
  Changes
 Money and the Exchange Rate in the Long
  Run
 Money and Money Price
If the price level and output are fixed in
the short run, the condition ( 14 - 4 ) of
money market equilibrium,
             +
         Ms/P = L(R,Y)          (14-5)
                                (14-4)
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)                    (14-5)
 Permanent increase

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 Flexibility
 Permanent Money Supply Changes and
  the Exchange Rate
 Exchange   Rate Overshooting
  Short-Run Price Rigidity versus
             Price Flexibility on
  Long-Runprices depend heavily(I)
Since output
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
Dollar/euro
exchange
                            and the Exchange Rate (I)
                 Figure14-12 (a) Short-run effects


                                     Dollar
                                                                               Figure14-12 (b) Adjustment to long-run equilibrium

                                                                           E $/€
                                                                                                            Dollar
 rate,E $/€
                                     return
                                                                        R$/€=R€+(Ee/E-1)
                                                                        R$ 2 €+(Ee/E- return                                                In the Short Run
                                                                        E $                                                                   Hi! This part is
                                                                        1)
                                                                                                                                           about the theory of
     E $/€ 1
       $/€
           2
                                     1'               Expected
                                                      euro return
                                                                         E $/€ 3                                                           exchange rate over
                                                                                                                                               shooting put
                                                                                                                                             forward by me.
                                    R $2
                                      $
                                        1
                                                                                                           R $2
                                                                                                             $
                                                                                                               1
                                                                                                                       Rates of return
                                                                                                                       (in dollar terms)
                                                                                                                                            In the Long Run
                                                     L(R $ ,Y us )                                                        L(R $ ,Y us )

     2
M us 1 /P us                         2                               M us 1 /P us
                                                                          2
                                     1                                 us      us                          2
                                                                                                           1




                                          M us /P us
                                                                             M/P =
                                                                             M/P = L( R$,Y)
                                                                             M/P
U.S. real
 money
                                                                             L(R$,Y)
holdings                                  M us / P us


                                                                                           Rudi Dornbusch
                                                                            (b) How the R$, Pus, and E$/€
               (a) Short-run                                                       鲁迪·多恩布什
                                                                            move over time as the
               adjustment of the
                                                                            economy approaches its
               asset markets.
                                                                            long-run equilibrium
             Permanent Money Supply Changes
             and the Exchange Rate (II)
                               ( a) U. S. money suppl y, Mus
                                                                                     R$
                                                                                                           ( b) Dol l ar i nt er est r at e, R $
                                                                                                                                                                          超调
                      Mus
                                                 (a) U.S. money supply, Mus                                              (b) Dollar interest rate, R $
                                                                                                      R$
                                  Mus


As the time goes                                                                                                                                 phenomenon
                                                                                                                                 is an important When Ms
                                                                                                                                                 As P keeps
                                                                                          1
                     M us 1                                                          R$
by, Ms remains
    At t0, Ms                                                                                                                                    increases at
                                                                                                                                                 rising R rises
                                                                                                                                 because it helps explain why
unchanged at a
    increases
                                M us 1                                                                R $1


higher level.
                                                                                                                                                 until falls
                                                                                                                                 exchange ratest0, R itsso sharply
                                                                                                                                                  move original
                                                                       Ti me                                                              Ti me  down. reached.
                                                                                                                                                 level is
                                                                                 t                                               from day to day.
                               ( c) U. S. pr i ce l evel , Pus                   Time             ( d) Dol l ar / eur o exchange r at e, E $/ €
                                                                                                                      o exchange r at e, $/ €                   Time

                       P us                                                       E $/ €          t                              Only if the dollar/euro exchange
    When Ms                       P us                                                                                                                           E $/ €

As increases
     the time goes                                                                                                               rate overshoots E initially will
     P keeps
by,and R falls                                                                                                                                    As expect E
                                                                                                                                                         rises,
                                                                                                                                 market participants R falls a
rising until t , P
    down at 0                                                                                                                                     keeps falling
                                                                                                                                                  down at of the
                                                                                                                                 subsequent appreciationt0, E
M2/P2=M1/P1
    remains           P us
                           1
                           1
                                                                                  E $/ €
                                                                                              1
                                                                                                                                                  jumps up.
                                                                                                                                                  until its long-run
                                 P us 1
                                                                      Ti me                       E $/ € 1
                                                                                                                                 dollar against the euro. reached.
                                                                                                                                           Ti m
                                                                                                                                           Ti me
                                                                                                                                               e  level is
    unchanged.
                                                                                 Time                                                                           Time

                                                     (c) U.S. price level, Pus                                          (d) Dollar/euro exchange rate, E $/ €




  Exchange rate overshooting
Question
Thanks

				
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