Overviewofthemodel:Shortrunsticky

pricemodelofasmallopeneconomy
Bilateral(nominal)
exchangeRates(E)
R*
Assetmarket

Assetmarket

Ee ,R

Moneymarket

Moneymarket

Ms
Md (R,Y)

GoodsMarket

Y(C,I,G,NX)
NX(EX,EP*/P,Y)

GoodsMarket

NX

Foreigncountry
homecountry
1

Overviewofthemodel:Impactofthelong
runandadjustmenttolongrunequilibrium
Ee isaffectedbylongrunfactorsinarational
expectationmodel.Thesefactorsare
determinedunderconditionsofcompletely
flexibleprices
Whentheeconomymovesawayfromthelong
runequilibrium,adjustmenttonewlongrun
equilibriumhappensthroughEandP

Lecture3
Money,InterestRates,andExchange
Rates

Preview
Whatismoney?
Controlofthesupplyofmoney
Review
Thewillingnesstoholdmonetaryassets
Amodelofrealmonetaryassetsand
interestrates
Amodelofrealmonetaryassets,interestrates,
andexchangerates
Longruneffectsofchangesinmoneyonprices,
interestrates,andexchangerates

WhatIsMoney?
Moneyisanassetthatiswidelyusedasa
meansofpayment.
Differentgroupsofassetsmaybeclassifiedas
money.
Moneycanbedefinednarrowlyorbroadly.
Currencyincirculation,checkingdeposits,anddebit
cardaccountsformanarrowdefinitionofmoney.
Depositsofcurrencyareexcludedfromthisnarrow
definition,althoughtheymayactasasubstitutefor
moneyinabroaderdefinition.
5

WhatIsMoney?(cont.)
Moneyisaliquidasset:itcanbeeasilyusedtopay
forgoodsandservicesortorepaydebtwithout
substantialtransactioncosts.
Butmonetaryorliquidassetsearnlittleorno
interest.
Illiquidassetsrequiresubstantialtransactioncostsin
termsoftime,effort,orfeestoconvertthemto
fundsforpayment.
Buttheygenerallyearnahigherinterestrateor
rateofreturnthanmonetaryassets.
6

WhatIsMoney?(cont.)
Letsgroupassetsintomonetaryassets(or
liquidassets)andnonmonetaryassets(or
illiquidassets).
Thedemarcationbetweenthetwoisarbitrary,
butcurrencyincirculation,checkingdeposits,
debitcardaccounts,savingsdeposits,andtime
depositsaregenerallymoreliquidthanbonds,
loans,depositsofcurrencyintheforeign
exchangemarkets,stocks,realestate,andother
assets.
7

MoneySupply
Thecentralbanksubstantiallycontrolsthe
quantityofmoneythatcirculatesinaneconomy,
themoneysupply.
IntheU.S.,thecentralbankingsystemistheFederal
ReserveSystem.InSingapore,itistheMonetary
AuthorityofSingapore(MAS)
Thecentralbankdirectlyregulatestheamountofcurrency
incirculation.
Itindirectlyinfluencestheamountofcheckingdeposits,
debitcardaccounts,andothermonetaryassets.

MoneyDemand
Moneydemand representstheamountof
monetaryassetsthatpeoplearewillingto
hold(insteadofilliquidassets).
Whatinfluenceswillingnesstoholdmonetary
assets?
Weconsiderindividualdemandofmoneyand
aggregate demandofmoney.

WhatInfluencesDemandofMoneyforIndividuals and
Institutions?
1. Interestrates/expectedratesofreturn onmonetaryassets
relativetotheexpectedratesofreturnsonnonmonetary
assets.
2. Risk:theriskofholdingmonetaryassetsprincipallycomes
fromunexpectedinflation,whichreducesthepurchasing
powerofmoney.
Butmanyotherassetshavethisrisktoo,sothisriskis
notveryimportant indefiningthedemandofmonetary
assetsversusnonmonetaryassets.
3. Liquidity:Aneedforgreaterliquidityoccurswhentheprice
oftransactionsincreasesorthequantityofgoodsboughtin
transactionsincreases.
10

WhatInfluencesAggregate
DemandofMoney?
1. Interestrates(R)/expectedratesofreturn:monetaryassets
paylittleornointerest,sotheinterestrateonnonmonetary
assetslikebonds,loans,anddepositsistheopportunitycost
ofholdingmonetaryassets.
Ahigherinterestratemeansahigheropportunitycostof
holdingmonetaryassets lowerdemandofmoney.
2. Prices(P):thepricesofgoodsandservicesboughtin
transactionswillinfluencethewillingnesstoholdmoneyto
conductthosetransactions.
Ahigherlevelofaveragepricesmeansagreaterneedfor
liquiditytobuythesameamountofgoodsandservices
higherdemandofmoney.
11

WhatInfluencesAggregate
DemandofMoney?(cont.)
3.

Income(Y):greaterincomeimpliesmoregoodsand
servicescanbebought,sothatmoremoneyisneededto
conducttransactions.
Ahigherrealnationalincome(Y)alsomeansmoregoods
andservicesarebeingproducedandboughtin
transactions,increasingtheneedforliquidity higher
demandofmoney.

12

AModelofAggregateMoneyDemand
Theaggregatedemandofmoneycanbeexpressedas:
Md =PxL(R,Y)
where:
P isthepricelevel
Y isrealnationalincome
R isameasureofinterestratesonnonmonetaryassets
L(R,Y)istheaggregatedemandofreal monetaryassets

Alternatively: +
Md/P=L(R,Y)
Aggregatedemandofrealmonetaryassetsisafunctionofnational
incomeandinterestrates.

13

Fig.41:AggregateRealMoney
DemandandtheInterestRate

14

Fig.42:EffectontheAggregateRealMoneyDemandSchedule
ofaRiseinRealIncome

1515

AModeloftheMoneyMarket
Themoneymarketiswheremonetaryor
liquidassets,whicharelooselycalled
money,arelentandborrowed.
Monetaryassetsinthemoneymarketgenerally
havelowinterestratescomparedtointerestrates
onbonds,loans,anddepositsofcurrencyinthe
foreignexchangemarkets.
Domesticinterestratesdirectlyaffectratesof
returnondomesticcurrencydepositsinthe
foreignexchangemarkets.
16

AModeloftheMoneyMarket
Whennoshortages(excessdemand)orsurpluses
(excesssupply)ofmonetaryassetsexist,themodel
achievesanequilibrium:
Ms =Md
Alternatively,whenthequantityofrealmonetary
assetssuppliedmatchesthequantityofreal
monetaryassetsdemanded,themodelachievesan
equilibrium:
Ms/P=L(R,Y)
17

Fig.43:DeterminationoftheEquilibriumInterestRate

18

Fig.44:EffectofanIncreaseintheMoneySupplyon
theInterestRate

19

Fig.45:EffectontheInterest
RateofaRiseinRealIncome

20

Fig.46:Simultaneous
EquilibriumintheU.S.
MoneyMarketandthe
ForeignExchange
Market

21

Fig.47:MoneyMarket/ExchangeRateLinkages

22

Fig.48:Effectonthe
Dollar/EuroExchangeRate
andDollarInterestRateofan
IncreaseintheU.S.Money
Supply

23

ChangesintheDomesticMoneySupply

Anincreaseinacountrysmoneysupply
causesinterestratestofall,ratesofreturnon
domesticcurrencydepositstofall,andthe
domesticcurrencytodepreciate(asshownin
thepreviousslide).
Alternatively,adecreaseinacountrysmoney
supplycausesinterestratestorise,ratesof
returnondomesticcurrencydepositstorise,
andthedomesticcurrencytoappreciate.
24

Fig.49:EffectofanIncreasein
theEuropeanMoneySupplyon
theDollar/EuroExchangeRate

25

ChangesintheForeignMoneySupply

Howwouldachangeinthesupplyofeurosaffect
theU.S.moneymarketandforeignexchange
markets?
Anincreaseinthesupplyofeuroscausesa
depreciationoftheeuro(anappreciationof
thedollar).
Adecreaseinthesupplyofeuroscausesan
appreciationoftheeuro(adepreciationofthe
dollar).
26

ChangesintheForeignMoneySupply(cont.)

Theincreaseinthesupplyofeurosreduces
interestratesintheEU,reducingtheexpected
rateofreturnoneurodeposits.
Thisreductionintheexpectedrateofreturnon
eurodepositscausestheeurotodepreciate.
WepredictnochangeintheU.S.moneymarket
duetothechangeinthesupplyofeuros.

27

LongRunandShortRun
Intheshortrun,pricesdonothavesufficienttimetoadjust
tomarketconditions.
Theanalysisheretoforehasbeenashortrunanalysis.
Inthelongrun,pricesoffactorsofproductionandofoutput
havesufficienttimetoadjusttomarketconditions.
Wagesadjusttothedemandandsupplyoflabor.
Realoutputandincomearedeterminedbytheamount
ofworkersandotherfactorsofproductionbythe
economysproductivecapacitynotbythequantityof
moneysupplied,i.e.,realoutputispotentialoutput
(Real)interestrates(r =R )dependrealfactors(Ch 5).
28

ReviewofPrinc ofMacrowithstickypriceassumption
Supposemoneysupply
shiftsADandmoves
outputaboveitsnatural
orpotentialrate.
Economyoverheatsso

SRAS equation:

Y Y (P P e )
LRAS

SRAS2

P3 P3

P e rises,
SRAS shiftsup,
andoutputreturns
toitsnaturalrate.

SRAS1

P1 P1e
AD1

Y 3 Y1 Y

AD2

Y
2
29

MoneyandPricesintheLongRun
Howdoesachangeinthemoneysupply causepricesofoutputand
inputstochangeintheSRandLR?
1. Excessdemandofgoodsandservices:ahigherquantityof
moneysuppliedimpliesthatpeoplehavemorefundsavailableto
payforgoodsandservices.
Tomeethighdemand,producershiremoreworkers,creating
astrongdemandoflaborservices,ormakeexisting
employeesworkharder.
Wagepressure arisesasfirmstrytoattractmoreworkersorto
compensateworkersforworkingovertime.
Pricesofoutputwillalsobeunderpressuretorise
Intheshortrun,pricesaresticky soexcessADpersistsasAD
shiftstorightinthereviewgraph

30

MoneyandPricesintheLongRun(cont.)
2. Inflationaryexpectations:
Ifworkersexpectfuturepricestoriseduetoanexpected
moneysupplyincrease,theywillwanttobe
compensated.
Andifproducersexpectthesame,theyaremorewilling
toraisewages.
Producerswillbeabletomatchhighercostsiftheyexpect
toraiseprices(thisismovementfrompoint(P1,Y2)to
point(P3,Y3)asSRASshiftsup inthereviewgraph).
Result:expectationsofhigherpricescausedbyan
expectedincreaseinthemoneysupplycausesactual
pricestorise.
31

LongRunandShortRun(cont.)
Inthelongrun,thequantityofmoneysuppliedis
predictednottoinfluencetheamountofoutput,
(real)interestrates,andtheaggregatedemandof
realmonetaryassetsL(R,Y).
However,thequantityofmoneysuppliedis
predictedtomakethelevelofaverageprices
adjustproportionally inthelongrun.
TheequilibriumconditionMs/P=L(R,Y)showsthatP
ispredictedtoadjustproportionallywhenMs adjusts,
becauseL(R,Y)doesnotchange.
32

LongRunandShortRun(cont.)
Inthelongrun,thereisadirectrelationship
betweentheinflationrateandchangesinthe
moneysupply.
Ms =PxL(R,Y)
P=Ms/L(R,Y)

P/P=Ms/Ms L/L

Theinflationrateispredictedtoequalthegrowth
rateinmoneysupplyminusthegrowthratein
moneydemand.
33

Fig.410:AverageMoneyGrowth
andInflationinWesternHemisphereDevelopingCountries,byYear,1987
2007

Source:IMF,WorldEconomicOutlook,variousissues.RegionalaggregatesareweightedbysharesofdollarGDP
intotalregionaldollarGDP.
34

Fig.411:MonthtoMonthVariabilityoftheDollar/YenExchange
RateandoftheU.S./JapanPriceLevelRatio,19802013

35

Money,Prices,ExchangeRates,andExpectations
Whenweconsiderpricechangesinthelongrun,inflationary
expectationswillhaveaneffectinforeignexchangemarkets.
Supposethatexpectationsaboutinflationchangeaspeople
changetheirminds(Lecture4),butactualadjustmentof
pricesoccursafterwards(pricestickiness).

36

Fig.412:ShortRunandLongRunEffectsofaOneTimePermanent
IncreaseintheU.S.MoneySupply(GivenRealOutput,Y,isunchangedin
SR)

Re2
Re1

37

Money,Prices,andExchangeRatesin
theLongRun(cont.)
ShortrunisshowninFig412(a):
Moneysupplypermanently risesfromMUS,1 toMUS2 raisingreal
moneysupplyfromMUS,1 /PUS1 toMUS2 /PUS1 .Thisreduces
interestratesfromR$,1 toR$,2 (points(1)to(2))inthelower
graph(NOTE:ThisisachangeintheLEVELofmoneysupply)
Turningtotheexchangeratediagram(topgraphofFig412(a)),
thedropininterestratesshiftsthereturnonUSassetsfromR$,1
toR$,2andchangeinexpectationsaspeopleanticipatethatthe
USdollarwilldepreciatewhenUSpricesriseinthefuture.This
shiftstheexpectedreturnonforeignassetsfromRe1, toRe,2 .
ExchangeratedepreciatefromE$/1 toE$/2 (points1to2).Note
thatwithoutthechangeinexpectedeuroreturn,shortrun
equilibriumwouldhave3insteadof2.
38

Money,Prices,andExchangeRatesin
theLongRun(cont.)
LongrunisshowninFig412(b):
BottomgraphofFig412(b)showsthatinthelong
run,pricerisesPUS1 toPUS2 causingrealmoney
balancestoshiftfromMUS,2 /PUS1 toMUS2 /PUS2
(points2to4).
TopgraphofFig412(b)showsthatasrealmoney
balancesdrop,returnonUSassetsshiftsfromR$,2
backtoR$,1.ExchangerateappreciatefromE$/2 to
E$/3 (points2to4).
Inthelongrun,allpricesadjust!Thereisnoprice
stickiness!
39

Money,Prices,andExchangeRatesintheLongRun
(cont.)
Apermanent increaseinacountrysmoneysupplycausesa
proportionallongrundepreciationofitscurrency.
However,thedynamicsofthemodelpredictalargedepreciationfirst
andasmallersubsequentappreciation(illustratedinFigure1512).

Apermanent decreaseinacountrysmoneysupplycausesa
proportionallongrunappreciationofitscurrency.
However,thedynamicsofthemodelpredictalargeappreciationfirst
andasmallersubsequentdepreciation.

40

Fig.413:TimePathsofU.S.EconomicVariablesAftera
OneTimePermanentIncreaseintheU.S.MoneySupply

41

ExchangeRateOvershooting
Theexchangerateissaidtoovershoot whenits
immediateresponsetoachangeisgreaterthanits
longrunresponse.
Overshootingispredictedtooccurwhenmonetary
policyhasanimmediateeffectoninterestrates,but
notonpricesand(expected)inflation.
Overshootingmayhelpexplainwhyexchangerates
aresovolatile.

42

EndofLecture3
Thankyouforyourattention

43