INTERNATIONAL FINANCE LESSON 5

the interest rate is i 1  Clearly the demand for money exceeds the supply of money  As individuals shift out of bonds and into money, the price of bonds falls and interest rates ris

The Money Supply, Interest Rates, and the Exchange

Rate

Antu Panini Murshid

Today’s Agenda

 The money market

 The money market, interest rates and

exchange rates in the short run

 Exchange rate expectations given

 Changing expectations

Demand For Money

 What are the motives for holding

money?

 In his General Theory Keynes

identified three motives for holding money

 Transactions motive

 Precautionary motive

 Speculative motive

Transactions Motive

 The transactions motive is the primary

motive for holding cash, which is the most liquid of all assets

 Households would hold all of their money

as interest bearing securities if they could However securities are illiquid

There are costs associated with liquidating portfolios, both in terms of money and time

Tobin-Baumol Model of Money

Demand

 James Tobin and William Baumol developed

a theory of money demand based on the

transactions motive for holding money

 According to the Baumol-Tobin model,

households face a tradeoff between the

benefits provided by holding money, i.e

liquidity services, and the costs of holding money, i.e lost interest-earnings

Square-Root Formula

 The Baumol-Tobin model predicts that the demand

for money will be positively related to a household’s income, positively related to the transactions costs

associated with liquidating securities, and

negatively related to the interest rate

 Specifically the model predicts that the optimal

quantity of money demanded will be given by the following function:

Precautionary Motive

 The precautionary motive for money

arises as a precaution against an

unforeseen need for liquidity

 It is reasonable to suppose that the

precautionary motive for holding money will also be positively related to income

 Moreover the precautionary motive for

holding money should also be negatively related to the interest rate

Speculative Motive

 Keynes also identified the speculative

motive for holding money

 This is often misinterpreted

 “People also hold money for speculative

purposes, so they can respond to financially attractive opportunities”

 This is wrong…Keynes was actually

referring to shifts in households’ liquidity

preferences in response to shifts in

expectations regarding future developments

in financial markets

A Digression Into Bonds

 What determines the price of bonds?

 The price of bonds is inversely related to the interest rate An example will make this clear

 Consider a $100 bond w/coupon payment of $5

 That is the current interest rate or the yield of the bond is 5%

 Suppose the price of bond decreases to $50

 Now that same bond pays a yield of 10%

Interest-Elasticity of Money

Demand

 For Keynes the speculative motive was a

means of making money demand elastic

interest- Keynes argued that there should be a

negative relationship between money

demand and the interest rate Why?

 If interest rates are high (above normal), you

would expect rates to fall and the price of bonds

to rise Hence you shift your portfolio into bonds and out of money Conversely if rates are low you would expect to make a capital loss by holding bonds, so you shift into money

Money Demand Function

 In summary we expect money demand to be:

 A positive function of income

 Positively related to real incomes

 Proportional to prices

 A negative function of interest rates

 Hence our money demand function:

 y i, Pf

 y i, Pf

M d  Demand for balance real money

Demand for nominal money balances

 Money serves at least three roles It is a

unit of account, a medium of exchange and

a store of value

 Which financial assets satisfy this role? Two

accepted measures of money are:

 M1 (narrow money) = currency in circulation +

demand deposits + traveler’s checks

 M2 (broad money) = M1 + savings deposits +

small time deposits + …Money Supply

 The Federal Reserve controls the supply of

money balances by:

 Conducting open market operations (sale and

purchase of government securities)

 Adjusting the discount rate

 The Fed rarely changes reserve

requirements or the discount rate, and

almost never uses other tools for

discretionary monetary policy such as

regulation W

Control of Money Supply

 Throughout we will assume that

money supply is exogenous

 In fact we will assume that the Fed has

perfect control over the money supply and that the money supply function is not interest-elastic

Exogenous Money Supply

Money Market Equilibrium

 Suppose we are at point a, i.e the interest

rate is i 1

 Clearly the demand for money exceeds the supply of money

 As individuals shift out

of bonds and into money, the price of bonds falls and

interest rates rise choking of the excess money demand

M s

excess demand for money

real money balances

Money Market Equilibrium

 Now suppose we are at point b, i.e

the interest rate is i 2

 Clearly the supply of money exceeds the demand for money

 As individuals shift out of money and into bonds, the price

of bonds rises and interest rates fall restoring equilibrium

excess supply

of money

real money balances

Money Market Equilibrium

 Thus the equilibrium interest rate is determined

in the money market in

accordance to the demand for and supply of liquidity

Expansionary Monetary Policy

in the Short Run

 In the short-run we can take prices as given

 Suppose the Fed increases money supply from M1 to

M2

 This will lead to a decrease in the equilibrium interest rate

Expansionary Monetary Policy

in the Short Run

 The reduction in interest rates stimulates investment and raises income

 This shifts the money demand function to the right

 Thus the increase in output is partially crowded out and the interest rate settles at

Contractionary Monetary

Policy in the Short Run

 In the short-run we can take prices as given

 Suppose the Fed decreases money supply from M1 to

M2

 This will lead to an increase in the

equilibrium interest rate

Contractionary Monetary

Policy in the Short Run

 The increase in interest rates reduces investment and lowers income

 This shifts the money demand function to the left

 This will lead to an increase in the

equilibrium interest rate

Monetary Policy, Interest

Rates and Exchange Rates

 So far we have ignored the consequences

of monetary policy for the exchange rate

 However it should be clear that an

expansionary monetary policy, which lowers the interest rate will also lead to a

depreciation of the domestic currency (recall uncovered interest rate parity)

An Expansionary Monetary

Policy in the Short Run

 An increase in money will cause interest

rates to fall in the short-run

 If exchange rate expectations are given,

then UCIP no longer holds

 Domestic interest rates are lower Thus

investors will shift to foreign assets

 This will cause an increase in the demand for

foreign currency and a decrease in the demand for dollars The dollar will immediately

depreciate (e↑), such that UCIP is again restored

 Suppose i=10%, if=5%, et=1 and

E(et)=1.05

 Note that UCIP holds, i.e i=if+E(%  e)

 Now if i↓ to 5%, i≠if+E(%  e)

 However if et↑ to 1.05 then

E(%  e)=0%, hence UCIP is restored

Graphical Illustration

 First lets draw the

money market graph

real money balances Interest rate Money supply M 1 s /P

Graphical Illustration

 Now lets make

everything disappear…

i1=10%

Money demand L(i,y)

Equilibrium interest rate

real money balances Interest rate Money supply M 1 s /P

 …and reappear but

rotated clockwise

by 90 degrees

 Now lets add the

foreign exchange market graph

$/€ return on$ assets

e1=1.00

Expected return

on € assets

 Now suppose the

government raises money supply

$/€ return on$ assets

e1=1.00

Money supply M 2 s /P

Equilibrium interest rate ↓

i2=5%

Equilibrium exchange rate↑

e2=1.05

Expected return

on € assets

Are Our Assumptions

Reasonable?

 We have assumed that

 Exchange rate expectations are given

 Prices are given

 It is perhaps reasonable to assume that

prices are fixed in the short-run, but prices will most likely change in the long-run In that case is it reasonable to assume that exchange rate expectations will be

unchanged

The Long-Run

 In the long-run money is neutral; an x%

change in money supply will cause an x%

change in prices, but no change in output

 Thus in the long-run prices will adjust not the

interest rate to bring the money market back into equilibrium

 To see this consider our money market

equilibrium condition M s = PL(i,y) If M s

changes by x% but so does P then money

market equilibrium is restored

Exchange Rate Expectations

 If in the long run prices adjust not the

interest rate, what are the implications for

the exchange rate?

 The implication would be that in the long-run

monetary policy has no impact on the

exchange rate

 However one thing that we have not

considered is: what happens to exchange

rate expectations

Purchasing Power Parity

 In order to understand how these

expectations will change, we need some sort of understanding of what determines the exchange rate over a longer horizon

 Something we will study next lecture is

called purchasing power parity This says that the domestic price level, and therefore monetary policy, influences the long-run

behavior of the exchange rate

Implications of PPP

 PPP tells us that if the price level rises, the

exchange rate will depreciate

 To see this consider the implications of a

currency reform Suppose the Argentine government replaced its current peso with new pesos, worth twice as much as the old peso, what will happen to the peso/$ exchange rate?

 It will decrease by 50%, that is the peso will

appreciate by 100%, while prices in Argentina, in terms of the new peso, will decline by 50%

Monetary Policy and Long-Run Expectations

 Hence an expansionary (contractionary) monetary

policy that raises (lowers) the price level in the run will ultimately lead to a depreciation

long-(appreciation) of the currency

 But this should mean that future expectations

regarding the exchange rate will change

accordingly If an expansionary monetary policy is

permanent we would expect e to be higher in the

future and a contractionary policy means we will

expect e to be lower

balances Money demand L(i,y)

In the long-run the equilibrium interest rate does not change

$/€

But expectations change

e1=1.00

e2=1.05

Hence the equilibrium exchange rate rises

Exchange Rate Overshooting

in the Short-Run

 Our analysis of the short-run supposed that

expectations were given But this is not the case

 Once we allow for the fact that exchange

rate expectations change, then it should be apparent that exchange rates will overshoot past there long-run positions This is easy

to see graphically…

Illustration of Exchange Rate Overshooting

balances Money demand L(i,y)

In the short-run money supply increases and the equilibrium interest rate falls

$/€

expectations change

Why Does the Exchange Rate

Overshoot?

 Expansionary monetary policy implies US

interest rates fall The new equilibrium

exchange rate consistent with interest rate

parity is e 2 This assumes that expectations are fixed

 But in the long run prices will increase

(assuming that the shift in policy is

permanent) Since higher prices imply that the dollar will depreciate in the long run,

expectations must change

Why Does the Exchange Rate

Overshoot?

 As expectations change, the expected return

on foreign assets rises (because of the

expected appreciation in the foreign

currency)

 Thus e 2 can no longer be consistent with

UCIP and the exchange rate must overshoot

to e 3

 In the long-run prices will increase (real

money falls) and the equilibrium interest rate returns to i1 As this happens the economy

moves to point e 4