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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
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/
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)
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
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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