Money Interest Rates the Exchange Rate Chapter

Money, Interest Rates, & the Exchange Rate Chapter 14 1

The Money Market n Goal is a model of R based on money supply & money demand. R M/P R 1 L(R, Y) L, M/P 2

What is Money and What Makes it Increase and Decrease? 3

What Effect do Increases and Decreases in Money Have on: n Interest Rate? n Prices? n Exchange Rates? 4

Money n Money (M) - assets widely used & accepted as a means of payment M = Currency + Checkable Deposits n Money is very liquid, but pays little or no return n All other assets are referred to as bonds u Less liquid but pay higher return 5

Money November 2003 n Currency = $650 billion n Demand Deposits = $320 billion n Other “Checkable” Deposits = $310 billion n Total = $1280 billion = M 1 n M 2 = $6100 billion n M 3 = $8900 billion 6

Money Supply n M is the nominal supply of money, & is largely determined by the central bank. u Central bank is the only issuer of currency. u Central bank limits checking deposits through reserve requirements. 7

The Real Supply of Money n M/P is the real money supply u Measures supply of liquid purchasing power. n P is the price level & is taken as given in the short run (SR). u Keynesian economics 8

The Real Supply of Money n M/P is vertical R M/P 2 1 M/P 9

Real Demand for Money (L) n Real demand for money, Md/P = L(R, Y), is called liquidity preference (L) n Real demand depends on u Interest u GDP, rates, R Y 10

Money Demand & Interest Rates n When the interest rate (R) , the opportunity cost of holding money , & money demand (L) R 2 1 L(R, Y) L 11

Money Demand & GDP n When GDP (Y) , transactions , & money demand (L) R 1 2 L 1 L 2 Md 12

Equilibrium R n Monetary theory of R - equilibrium R equates money supply & money demand R R 2 R 1 R 3 M/P L(R, Y) L, M/P 13

Open Market Purchase n To increase the money supply (M), the central bank prints currency & uses it to buy bonds n The public deposits the currency in banks & banks cut interest rates (R ) n Alternatively when the central bank buys bonds, bond prices , & bond yields 14

Open Market Purchase R R 1 R 2 M/P 1 M/P 2 1 2 L(R, Y) R 15

Important Interest Rates n Prime rate - base rate for bank loans to corporate customers. n Federal Funds rate - rate banks charge each other for overnight loans of reserves. n Discount rate - rate the Fed charges banks for loans of reserves. 16

Christmas n What happens at Christmas assuming the Fed keeps M constant? R (M/P)1 R 1 L, M/P 17

Christmas n What happens at Christmas if the Fed is accommodative? R (M/P)1 R 1 L, M/P 18

The Money Supply & Exchange Rate (SR) n Next we want to link the money market and the exchange rate n We will make Keynesian assumptions u. P is fixed in the short run (SR) u P adjusts only in the long run (LR). n To link M, L, & E, we use our money market & interest parity graphs 19

Figure 14 -6 Simultaneous Equilibrium in the U. S. Money Market and the Foreign-Exchange Market Dollar/euro exchange Rate, E$/€ Foreign exchange market 1' E 1$/€ 0 Money market Return on dollar deposits MSUS PUS (increasing) R 1 $ 1 U. S. real money holdings Expected return on euro deposits L(R$, YUS) Rates of return (in dollar terms) U. S. real money supply 20

E$/€ R $1 E 1 1 $R€ L 1 L, M/P R M/P n The interest rate is determined in the money market n The exchange rate is determined by interest parity 21

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US Open Market Purchase n US is the home country n Fed buys bonds from public for M (M ) & bank deposits n Banks cut interest rates, from R 1 to R 2 n Bond traders shift out of $ bonds & into € bonds & the $ depreciates & the € appreciates (E ) 23

E$/€ E 2 R $1 2 1 E 1 2 L, M/P $R€ R L M 1/P 1 M 2/P 24

US Open Market Purchase n If the supply of $’s (MUS) , then the value of the $ . n What risks are associated w/ this policy shift? 25

Japanese Open Market Purchase n Japan is the foreign country n The BOJ buys bonds from the public w/ M (M ) & bank deposits 26

E$/¥ R $1 E 1 1 $R¥ L 1 L, M/P R M/P 27

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Long Run Effects of M n P now varies since we are dealing w/ the long run n If M , P & E proportionally. u Prediction is based on the money market equilibrium condition, M/P = L or P = M/L u Which implies P/P = M/M - L/L l. The inflation rate equals the monetary growth rate less the growth rate for money demand. 29

Figure 14 -10: Monetary Growth and Price-Level Change in the Seven Main Industrial Countries, 1973 -1997 30

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Long Run Effects of M on E n Exchange rates are prices n If M doubles, & all prices double, then the home currency value of the foreign currency (E) doubles. 33

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Hyperinflation n High inflation and rapid depreciation are the predictable long-run result of high money growth n There are no long-run benefits in the form of high output growth n Money supply is controlled by Central Banks n Why do they do it? 41

Central Bankers U. S. 2004 Germany 1923 42

B&B Theory of Hyperinflation Some Central Banks are run by Idiots 43

Hyperinflation n Cause of high inflation is high monetary growth. n Governments are most likely to resort to high monetary growth when they u have large spending needs u find it difficult to collect taxes u find it difficult to issue bonds (because lenders fear default) 44

Examples of Hyperinflation n US during the revolutionary war n Post WWI Germany 45

Examples of Hyperinflation n Brazil & Argentina - Large government budget deficits due to populism u Unions want subsidies for weak industries. u Poor want subsidies for food & housing u Rich want low taxes n Cannot finance them by borrowing u Debt is already large u Lenders want to be paid back 46

Cure for Hyperinflation n Hyperinflation is cured by monetary & fiscal reforms n Need lower monetary growth & lower government budget deficits u In Germany there were both monetary & fiscal reforms u The viability of reforms in Argentina & Brazil is open to question because the underlying fiscal problems are not yet resolved 47

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ECUADOR 1999 49

Business & Hyperinflation n Cash management becomes the top priority n Long term contracts are difficult to negotiate 50

The Fed n The fed was established to fight bank runs by acting as a lender of last resort. u In the late 1800’s & early 1900’s, the US economy was disrupted by bank runs u The pubic lost confidence in banks, withdrew their deposits and forced banks to sell assets at deep discounts u The Fed was supposed to lend to banks experiencing runs 51

The Fed n The Federal Reserve System consists of 12 regional banks, and a headquarters in Washington n At the top of the Federal Reserve System is the board of 7 governors n The Federal Open Market Committee (FOMC) makes decisions about M n To some extent, the Fed is insulated from politics n Along with several other government agencies, the Fed is responsible for examining banks 52

Exchange Rate Volatility n In 1973 the US and many other countries switched from fixed to floating exchange rates. u Exchange rates proved unexpectedly volatile, they were subject to abrupt & dramatic ‘s 53

Figure 14 -11 Month-to-Month Variability of the Dollar/DM Exchange Rate and of the U. S. /German Price-Level Ratio, 1974 -2001 54

Speculators Cause Volatility? n Critics of free markets argued greedy speculators drove currency prices up & then down in the pursuit of profits. n Milton Friedman – speculation should stabilize exchange rates 55

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Dornbush’s Theory of Overshooting n Alternative theory of volatility n E is volatile & overshoots its LR equilibrium because the prices of goods adjust slowly. u Financial markets react quickly & dramatically to disturbances, goods markets react more slowly. n The disturbance is a permanent 1% in M u US is home country, Britain is foreign country, & E is the $ value of £ 57

Dynamic Adjustment Paths P Overshooting Convergence Monotonic Convergence E PLR 2 ELR 1 PLR 1 t 0 time 58

Permanent in M n Sticky goods prices mean a temporary decrease in R M by buying bonds l. Bank deposits , & R from R 1 to R 2. u Eventually P by 1% l. Public needs more M for daily transactions l. Bank deposits , & R returns to its initial value u Fed 59

E$/€ R $2 2 R$1, 3 3 2 L, M/P $R€ 2 1 $R€ 1 R L (M/P)1, 3 (M/P)2 60

Permanent in M n Bond traders look to the future u See that E will eventually by 1% u Also see that there will be a temporary in R$ n The temporary in R$ means £ are even more attractive in the SR than the LR n The £ appreciates by more than 1% in the SR & overshoots its LR value 61

Initially R£ = 10% R$ = 10% E$/£ = 1. 50 M= 1000 P=1 Ee = 1. 50 ΔM = 100 (ΔM/M = 10%) 62

Eventually R£ = 10% P = 1. 10 E$/£ = 1. 65 R$ = 10% (ΔP/P = 10%) (ΔE/E = 10%) 63

Short Run R£ = 10% E 1. 65 1. 67 1. 69 1. 71 1. 73 R$ 6. 5% R£ + (Ee-E)/E R$ = 6. 5% (Ee = 1. 65) 10% 8. 8% 7. 6% 6. 5% 5. 4% 64

Inflation and Exchange Rate Dynamics (b) Dollar interest rate, R$ (a) U. S. money supply, MUS 1100 10% 1000 6. 5% t 0 (c) U. S. price level, PUS Time t 0 Time (d) Dollar/euro exchange rate, E$/€ 1. 71 1. 10 1. 65 1. 00 1. 50 t 0 Time 65

Overshooting - Summary n Because P adjusts slowly, E must over shoot its long run equilibrium. u With a 10% in M, both P & E by 10% in the LR u Sticky P implies a temporary in R$. u A temporary in R$ means the £ is even more attractive in the SR than the LR u The £ appreciates by more than 10% in the short run & overshoots its LR value 66

What Effect do Increases and Decreases in Money Have on: n Interest Rate? n Prices? n Exchange Rates? 67