ECO230Y1 Lecture Notes - Lecture 18: Market Liquidity, Lead, Interest Rate

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Published on 30 Apr 2016
School
UTSG
Department
Economics
Course
ECO230Y1
MONEY, INTEREST RATE, AND EXCHANGE RATE
Chapter 15
Money, Interest Rate, and Exchange Rate
In asset approach to exchange rate determination, the interest rate determines the
nominal exchange rate. But what determines interest rate?
Two types of assets:
1. Money  needed for transactions, but no return
2. Bonds  not good for transactions, but have return
Money vs, Bonds  Liquidity vs. Return
- Money + Bonds = Wealth
Bonds:
Assumption: There are only one-year bonds,
i.e. if someone buys them and keep them for
one year, the face value will be paid. The
interest rate, R, is defined as the rate returns
on the one-year bonds.
Important: Price of bonds, Pb, and the interest rate, R, have inverse relationship
with each to other.
R increases  Pb decreases
R decreases  Pb increases
Money:
What is money? There is no unique definition of money.
The issue of bond vs. money is the issue of liquidity. Money gives you
liquidity, but liquidity is not a black and white thing. The problem is that
liquidity is the range. Cash is 100% liquid, but a piece of agricultural land is a
very illiquid asset  not everything is so black and white.
Several definitions of money: M1, M2,M3  as it goes up it means less and
less liquidity
M1 is the most liquid definition of money
M1= Currency in circulation + personal chequeing accounts at chartered banks +
current accounts at chartered banks
M2= Cash (currency) in circulation + demand deposits (chequeing accounts)
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MONEY, INTEREST RATE, AND EXCHANGE RATE
Chapter 15
Demand for Money:
Real Money:
Purchase Power of
Money
Supply of Money is determined by the Central Bank:
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Document Summary

In asset approach to exchange rate determination, the interest rate determines the nominal exchange rate. Two types of assets: money needed for transactions, but no return, bonds not good for transactions, but have return. Assumption: there are only one-year bonds, i. e. if someone buys them and keep them for one year, the face value will be paid. The interest rate, r, is defined as the rate returns on the one-year bonds. Important: price of bonds, pb, and the interest rate, r, have inverse relationship with each to other. The issue of bond vs. money is the issue of liquidity. Money gives you liquidity, but liquidity is not a black and white thing. The problem is that liquidity is the range. Cash is 100% liquid, but a piece of agricultural land is a very illiquid asset not everything is so black and white. Several definitions of money: m1, m2,m3 as it goes up it means less and less liquidity.