Understanding Money, Interest Rates, and Exchange Rates: A Comprehensive Guide, Slides of Economics

Download Understanding Money, Interest Rates, and Exchange Rates: A Comprehensive Guide and more Slides Economics in PDF only on Docsity! Money, Interest Rates, and the Exchange Rate CHAPTER 14 Docsity.com • Anything that can be used for final discharge a debt. – Credit card is not money – Balance in checking account is money – Coins and currency are money What is money? Docsity.com • Coins and paper currency act as primary mediums of exchange – money. • Demand deposits held at banks and depository institutions provide the same function as currency – money. What is the Supply of Money? Docsity.com • M1: • Is total quantity of currency plus demand deposits (narrow money, internationally). • There are broader measures of money such as M2, M3,…etc. They include other (less liquid) assets. • M1<M2<M3 The Supply of Money Docsity.com What is Monetary Base (B)? • Cash held by the public (C) and the total quantity of bank reserves (R) on deposit at central bank B = C +R Docsity.com Example • €80 = Cash in hands of the public • €230 = Bank Reserve • Required reserve = 0.1 • What is MS? • MS = 1/0.1 * (310) • MS = 3100 Docsity.com Monetary policy Refers to central bank changing money supply by changing the monetary base and/or the money multiplier. • MS = M1 = 1/r * B MS↑ if B↑ or if r↓ Docsity.com 1. Change the interest rate banks pay on borrowed money from the central bank  Discount Rate (US), Marginal Lending rate (Europe): • Lower interest rate  increase in borrowed reserves  B↑  MS↑ How can the central bank change B or r? Docsity.com Money Supply Curve Interest Rate (i) Money (M1) MS2 MS1 Money Supply (MS) Controlled by the central bank Expansionary monetary policy Contractionary monetary policy Docsity.com I received a question • Can you please explain again with some examples the open market operations? thank you Docsity.com Answer • Bank of Ireland has some government bonds. • If the central bank wants to increase the supply of money – Offer higher than normal prices for bonds – Bank of Ireland sell their €1000 bond to the central bank – Central bank makes a €1000 deposit into their Bank of Ireland Reserve Account at the central bank. – Bank of Ireland’s reserves goes up Bank of Ireland make more loans that means the people (borrowers) will have more money in their checking accounts (borrowed)  M1 goes up MS goes up Docsity.com • If interest rates go up, do we demand more or less money? – Less • interest rate is the opportunity cost of holding money • If the price level goes up, do we demand more or less money? – More • need more money to cover our purchases Three motivations for holding money combine to create the aggregate demand for money Docsity.com • If our income goes up, will we demand more or less money? – More • Can afford to buy more goods and services • Money demand related to interest rate, price level and real income as: MD = f(-i, +P, +Y) i = Interest rate P = Price level Y = Real GDP Docsity.com Money Demand Curve Interest Rate (i) Money (M) Demand for Money (MD) Shows the relationship between interest rate and the quantity of money demanded holding everything else constant Docsity.com i How does an increase in the price level affect the interest rates? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) MD2 i2 G E MD ↑ i↑ Docsity.com i How does a economic recession affect the interest rate? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) MD1 i1 E F MD↓ i↓ Docsity.com i How does an open market sale by the central bank affect the interest rate? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) i2 MS2 MS ↓ i↑ This is a contractionary monetary policy Docsity.com How does the interest rate relate to the exchange rate? • Interest Arbitrage: – Relationship between interest rates and the exchange rate in the short run Docsity.com • Example: – You own a company in U.S. looking to invest $10,000 cash. – Assume U.K. has the best rate of 12%. – You must first buy pounds in the foreign exchange market, then invest pounds in U.K. market. – If spot exchange rate is $2/pound, which gives you £5000 to invest The Interest Rate And the Exchange Rate in the Short Run Docsity.com • Example (continued): – In 3 months the money will be worth • 5000 (1+0.12/4) = £5,150 1. If the exchange rate is the same, you will get • 5,150 * 2 = $10,300 The Interest Rate And the Exchange Rate in the Short Run Docsity.com • If the pound appreciates by 5% – Total return is sum of annual interest rate in U.K. (12%) and appreciation of the pound (5%) = approx. 17% Similarly Docsity.com • Buy foreign currency in spot exchange market • At same time sell pound in forward exchange market delivering on date of investment’s maturity 1. If forward rate > current spot rate (pound is selling at a forward premium) – more profitable to invest in U.K. 2. If forward rate < current spot rate (pound is selling at forward discount) – must compare the gain in favorable interest rate to loss suffered by exchange rate To eliminate exchange-rate risk Docsity.com • Annual yield (interest rate) on US bond = 10% • Annual yield (interest rate) on Irish bond = 6% • Spot exchange rate  $1 = €1 • Forward exchange rate  $1 = €1 But really the story is more complicated than that. Here is a rough numerical example to show the interest rate parity Docsity.com • What does tightening of money in Ireland do to interest rates? – MS declines interest rates go up • What does this do in the market for euro? – Demand goes up euro appreciates – Supply goes down euro appreciates • This process continues until interest parity is achieved. The Interest Rate And the Exchange Rate in the Short Run Docsity.com • Changes in Interest Rates: – Increasing a country’s interest rate: • Causes capital inflow • Appreciation of a country’s currency – Decreasing a country’s interest rate: • Causes capital outflow • Depreciates a country’s currency – Movement of capital causes change exchange rates – Interest rate volatility  exchange rate volatility Interest Rates, the Exchange Rate, and the Balance of Payments Docsity.com Suppose there is no capital inflow or outflow S1 (imports of G & S) $/Euro 1.5 2.0 2.5 100 200 400 Euros D1 (exports of G $ S) 300 500 E At E, quantity demanded for euros = quantity supplied  current account balance D & S are due current account activities Docsity.com Asst 8 • Questions 9, 10, and 13, Page 338 • It is an individual assignment • Has 20 points • Is due before 10PM on Friday, November 30 • Do not attach the graphs in a separate document form the texts. Attach only one document to your email please. Docsity.com I will be flying back to the US • On Saturday, December 1 • We will have regular classes during the week of December 3 • Our class meets on MWF at 2 PM in Thomas 103 • See you on Monday, December 3 Docsity.com