MGEC61 – Chapter 3 Iris Au 1
Chapter 3: Money, Interest Rate, and Exchange Rate
Learning Goals
This chapter builds on the asset approach of the exchange rate developed in Chapter 2 to determine
exchange rate in both short run and long run:
Discuss how interest rates are determined in the money market.
Examine the effect of money market shocks on the equilibrium interest rate.
Review the difference between the short run and the long run.
Examine the short run and long run effects of money market shock on the exchange rate, and
explain the concept of exchange rate overshooting.
Money Defined: A Brief Review
How the Money Supply Is Determined
Money supply: Currency in circulation + Demand deposit.
Assumption:
The central bank determines/controls the country’s money supply.
R
M/P
MS/P
MGEC61 – Chapter 3 Iris Au 2
Aggregate Money Demand
? Aggregate money demand: the total demand for money by all households and firms in the
economy.
? The real (aggregate) money demand function is given by:
Md
P
=L(R, Y),
where L(R, Y) = liquidity function
R = nominal interest rate
Y = real income = real GDP
R
M/P
MGEC61 – Chapter 3 Iris Au 3
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Equilibrium in the Money Market
Money market equilibrium is given by:
Given the price level (P) and real output (Y), the nominal interest rate (R) adjusts to ensure the
money market is in equilibrium (in the short run).
R
R0 A
L(R, Y)
M/P
MS/P
Note: Money market is always in equilibrium. Therefore, when there is excess supply of money
in the market, the interest rate falls for a given level of output and price, and vice versa.
MGEC61 – Chapter 3 Iris Au 4
Interest Rate and the Money Supply
Suppose money supply increases from MS0 to MS1:
For a given price level, P, and real income, Y, an expansion (reduction) in money supply lowers
(raises) the interest rate.
Output and the Interest Rate
Suppose real income increases from Y0 to Y1:
Holding other things constant, an increase (decrease) in real income raises (reduces) the
interest rate.
MGEC61 – Chapter 3 Iris Au 5
The Money Supply and the Exchange Rate in both the Short Run and the Long Run (The
Asset Approach to the Exchange Rate)
Short Run – Money, the Price Level, and the Exchange Rate
Short run: price is given or price is sticky.
Interest rates adjust to ensure the money markets are in equilibrium in both countries in the
short run.
Changes in domestic and/or foreign interest rates will trigger financial capital flows, which
cause the exchange rate to change.
Money, the Price Level, and the Exchange Rate in the Long Run
Long run: a situation in which all markets are clear and all variables are flexible.
Long Run – Money, the Price Level, and the Exchange Rate
Long run: a situation in which all markets are clear and all variables are flexible.
Money and Price Level in the Long Run
In the long run, the price level is determined in the money market:
An increase in the level of MS leads to a corresponding proportional increase in price level.
MGEC61 – Chapter 3 Iris Au 6
Changes in the level of MS have no effect on Y and R in the long run:
1) Output:
2) Interest rate:
MGEC61 – Chapter 3 Iris Au 7
Additional - Level Change vs. Growth Rate Change
Level Change
MS Before T0:
MSt =
After T0:
MSt =
time
T0
Growth Rate Change
MS Before T0:
MSt = MSt-1 × (1 + μ0)
After T0:
MSt = MSt-1 × (1 + μ1)
time
T0
MGEC61 – Chapter 3 Iris Au 8
Temporary Changes in the Level of Money Supply and the Exchange Rate
A temporary/transitory change is a change that will be reversed back to its initial level
before the long run arrives ? No change in Ee.
Temporary increase in domestic level of MS from MS0 to MS1:
MGEC61 – Chapter 3 Iris Au 9
Permanent Changes in the Level of Money Supply and the Exchange Rate
A permanent/once-and-for-all change is a change that has a long-lasting impact on the
economy (i.e., the change WILL NOT be reversed back to its initial level) change in Ee
in short run.
Suppose the domestic level of MS increases permanently from MS0 to MS1:
MGEC61 – Chapter 3 Iris Au 10
Permanent Changes in the Level of Money Supply and the Exchange Rate (Continued)
MGEC61 – Chapter 3 Iris Au 11
Exchange Rate Overshooting
Consider the case of a permanent increase in the level of MS:
Changes in E in the short run:
Changes in E in the long run:
Observation: By comparing the short-run equilibrium exchange rate with the long-run
equilibrium exchange rate; it is obvious that exchange rate changes by a larger magnitude in
the short run than in the long run. We call this phenomenon exchange rate overshooting
(undershooting) – the immediate depreciation (appreciation) of a currency to a shock is greater
than its long run response.
Exchange rate overshooting (undershooting) occurs because interest rate parity has to hold and
prices are sticky in the short run, so exchange rate has to bear the burden of adjustment to a
money market disturbance.