Money, Interest Rates, and Exchange Rates: Interaction and Equilibrium - Prof. F. Koray, Study notes of Economics

Download Money, Interest Rates, and Exchange Rates: Interaction and Equilibrium - Prof. F. Koray and more Study notes Economics in PDF only on Docsity! CHAPTER 15 MONEY, INTEREST RATES, AND EXCHANGE RATES Monetary factors affect the exchange rate by changing (i) interest rates and (ii) expected future prices. THE EQUILIBRIUM INTEREST RATE: THE INTERACTION OF MONEY SUPPLY AND DEMAND The interest rate is determined by the interaction of money supply and money demand. Money supply refers to the monetary aggregate that the Federal Reserve calls M1 (currency and checking deposits). The money supply is assumed to be under the control of the Fed (the central bank). MONEY, THE PRICE LEVEL, AND THE EXCHANGE RATE IN THE LONG RUN In the long run all prices are flexible and the economy is at full employment. Using the money market equilibrium condition,the long run equilibrium price level can be expressed as follows: Everything else remaining constant, a permanent increase in the money supply causes a proportional increase in the price level. Example: Money and Exchange Rates in the Long Run A permanent increase (decrease) in a country’s money supply causes a proportional long-run depreciation (appreciation) of its currency against foreign currencies. Example: INFLATION AND EXCHANGE RATE DYNAMICS Short-Run Price Rigidity versus Long-Run Price Flexibility Figure 15-11 shows that the exchange rate is more variable than relative price levels. Figure 15-11 This observation can be explained by the exchange rate over- shooting hypothesis. Many prices in the economy are written into long-term contracts and cannot be changed immediately when changes in the money supply occur. A permanent increase in M, holding P constant, increases the real money supply (M/P) and lowers the nominal interest rate (R). This shifts the dollar return schedule left. A