Chapter 14

Supplementary Notes

What is Money?

• Medium of Exchange– A generally accepted means of payment

• A Unit of Account– A widely recognized measure of value

• A Store of Value– A transfer of purchasing power from the

present into the future

• Money includes assets widely used and accepted as a means of payment.

• Money is very liquid, but pays little or no return.– All other assets are less liquid but pay higher

return.

• Money Supply (Ms)

Ms = Currency + Checkable Deposits

Money Supply

• How the Money Supply Is Determined– An economy’s money supply is controlled by

its central bank.– The central bank:

• Directly regulates the amount of currency in existence

• Indirectly controls the amount of checking deposits issued by private banks

Money Supply

• Demand for money is about why individuals choose money instead of other assets.

• Other assets include stocks, bonds, real estate, etc. These nonmonetary assets are collectively called “bonds.”

• Three factors influence money demand:– Expected return– Risk– Liquidity

The Demand for Money by Individuals

Money vs. Bonds

Money • Pay no interest.

Expected return is zero.

• Liquidity is higher.

Bonds • Pay interest.

Expected return is higher.

• Liquidity is lower.

Expected Return

• Money is held for liquidity purposes.

• The interest rate measures the opportunity cost of holding money rather than interest-bearing bonds.– A rise in the interest rate raises the cost of

holding money and causes money demand to fall.

Riskiness

• Holding money is risky. – Unexpected increase in the price level

reduces the value of money.

• Changes in riskiness equally affect both money and bonds.

• Thus, risk is not an important factor in money demand.

Liquidity

• Money is held for liquidity.• The value of holding liquidity increases with

transactions. The magnitude of transactions is positively related to income.

• When income rises, transaction volume increases and the demand for money rises.

• If the price level increases, nominal transaction volume increases and the demand for nominal money balance increases.

Aggregate Money Demand

• The total demand for money by all households and firms in the economy.

• It is determined by three main factors:– Interest rate

• Is negatively related to money demand.

– Real national income• Is positively related to money demand.

– Price level• Is positively related to money demand.

Aggregate Money Demand

The aggregate demand for money can be expressed by:Md = P x L(R,Y)

where:P is the price levelY is real national incomeR is a measure of interest ratesL(R,Y) is the aggregate real money demand

Alternatively:Md/P = L(R,Y)

Aggregate real money demand is a function of national income and interest rates.

Aggregate Money Demand

For a given level of income, real money demand decreasesas the interest rate increases.

Increase in Money Demand

When income increases, real money demand increases at every interest rate.

The Money Market

• The condition for equilibrium in the money market is:

Ms = Md or Ms/P = Md/P

Ms/P = L(R,Y)

• This equilibrium condition will yield an equilibrium interest rate.

Money Market Equilibrium

Changes in the Money SupplyAn increase in the money supply lowers the interest rate for a given price level.

Changes in National Income

An increase in national income increases equilibrium interest rates for a given price level.

Linking the Money Market to the Foreign Exchange Market

Linking the Money Market to the Foreign

Exchange Market

Changes in the Domestic Money

Supply

Changes in the Foreign Money

Supply

Money, Prices and the Exchange Rates in the Long Run

• Money is neutral in the long run.

– It has no effects on real variables. (Neutral)

– A permanent increase in a country’s money supply causes a proportional increase in the price level.

– The domestic currency depreciates proportionately.

Short Run and Long Run

In the short run (with fixed P), an increase in money supply

• Leaves P unaffected• Lowers R

In the long run (with flexible P), an increase in money supply

• Raises P proportionately

• Has no effect on R

Goods Prices in the Short Run and Long Run

• Observation: Prices are sticky. They move slowly.

• Theory (abstraction): We assume that prices are fixed in the short run but flexible in the long run.

• In the long run, nominal variables (M, P, and E) change proportionately.

• Individuals have rational expectations. They expect E and P to move according to the long-run rule. In other words, as M increases, Ee and Pe move in the same proportion as the increase in M now in the short run!

Money, Prices and the Exchange Rates in the Short Run

• In the short run, when money supply increases,– The price level (P) is fixed and the interest rate (R) declines to clear the

money market.

– The expected future exchange rate rises (Ee ). (A)

• How would the exchange rate move?– Because, the domestic interest is now lower than the foreign interest

rate, according to the interest parity condition, R-R* = (Ee-E)/E, the expected rate of depreciation must be negative.

– I.e., the domestic currency must be expected to appreciate! (B)

– (A) and (B) are simultaneously true only if the exchange rate (E) rises more in the short run than it would in the long run (as indicated by Ee).

– The exchange rate (E) overshoots its long-run level (Ee).

– After the overshooting, the exchange rate declines (appreciates) to its long-run level.

Money, Prices, the Exchange Rates, and ExpectationsChange in expected

return on euro deposits

The expected return on euro deposits rises because of inflationary expectations:•The dollar is expected to be less valuable when buying goods and services and less valuable when buying euros. •The dollar is expected to depreciate, increasing the return on deposits in euros.

Money, Prices and the

Exchange Rates in the Long Run

Original returnon dollar deposits

As prices increases,the real money supply decreases and the domestic interest rate returns to its long run rate.

Exchange Rate Overshooting

• The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response.

– We assume that changes in the money supply have immediate effects on interest rates and exchange rates.

– We assume that people change their expectations about inflation immediately after a change in the money supply.

• Overshooting helps explain why exchange rates are so volatile.

• Overshooting occurs in the model because prices do not adjust quickly, but expectations about prices do.

Exchange Rate Volatility

Changes in price levels are less volatile, suggestingthat price levelschange slowly.

Exchange rates are influenced by interest rates and expectations, which may change rapidly, making exchange rates volatile.