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Chapter 3

Study guide - Chapter 3 - Money, Interest Rate, and Exchange Rates

Course Code
ECON 345
David Cox

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Money, Interest Rates, and Exchange Rates
Exchange rate b/w currencies depends on 2 factors
oInterest rate earned on deposits
oExpected future exchange rate
Explain effects of money supply and money demand on its interest rate and exchange rate
Monetary developments influence the E both by changing the interest rates + by changing ppls
expectations about future exchange rates
Expectations of future exchange rates depend on many factors other than money
Money Demand: A Brief Review
Medium of exchange generally accepted means of payment, no more barter system
Unit of Account widely recognized measure of value, comparable terms, relative prices
Store of Value transfer purchasing power f/ present into future
What is Money?
Money supply monetary aggregate the Fed Reserve calls M1 total amt of currency + checking
deposits held by households + firms
How the money supply is determined
Controlled by central bank
Demand for Money by Individuals
Can be derived from the theory of asset demand
Base demand on 3 characteristics
oExpected return the asset offers compared w/ the returns offered by other assets
oRiskiness of the assets expected return
oAssets liquidity
o*households hold money only b/c of its liquidity, so liquidity matters (unlike FX market)
Expected Return
Currency pays NO interest opportunity cost when holding money
Other things equal, ppl prefer assets offering higher expected returns a rise in interest rate causes
demand for money to fall
Risk is NOT important in money demand
Any change in riskiness of money = change in riskiness of bonds
Main benefit of holding money
Rise in avg value of transactions carried out by a household or firm causes its demand for money to
Aggregate Money Demand
The total demand for money by all households + firms in economy sum of all economy’s individual
money demands
1)Interest rate rise in interest rate = reduce aggregate money demand
2)Price level higher price level = increase aggregate money demand
3)Real national income GNP rises = more goods sold in economy = increase aggregate money
demand (given the price level)
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P = Price Level, R = interest rate, Y= GNP
Md=Px L(R,Y)
Aggregate money demand is proportional to price level real incomes unchanged
Aggregate REAL money demand = Md/P = L(R,Y)
Demand to hold a certain amt of real purchasing power in liquid form
Also slopes downward
For a given level of real GNP, changes in interest rate cause movements ALONG L(R,Y), changes in
real GNP causes schedule to SHIFT
The Equilibrium Interest Rate: The Interaction of Money Supply + Demand
Money market in equilibrium when money supply = aggregate money demand
Equilibrium in the Money Market
Ms/P = L (R, Y)
*The market always moves toward an interest rate at which the real money supply equals aggregate
real money demand (excess demand/supply
Interest Rates + Money Supply
Rise in Ms increases real money supply from M1/P to M2/P
*An increase in Ms lowers interest rate, while a fall in Ms raises interest rate (given price level + output
Increase in output = aggregate real money demand shirt right
*An increase in Y raises interest rate (given price level and money supply) (vice versa)
The Money Supply + Exchange Rate in SR
An increase in country’s money supply causes its currency to depreciate in the FX market
SR take price level and real output as given (“sticky prices)
Linking Money, the Interest Rate, and the Exchange Rate
1st diagram equil in FX market
oDetermined given interest rates + expectations about future exchange rates
oDollar interest rate determined in money market vertical
oDownward-sloping schedule effect of current exchange rate changes on expectations of
future depreciation
oEx: strengthening of dollar (fall in E) relative to its given expected future level makes euro
deposits more attractive lead ppl to anticipate a sharper dollar depreciation in future
oIntersection = EQUILIBRIUM E RATE interest parity holds
2nd diagram relationship b/w money + E equilibrium interest rate is determined in money market
oDollar interest rate R induces ppl to demand real balances equal to real money supply Ms/P
Money market determines dollar interest rate
Affects E that maintains interest parity
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