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Equilibrium Interest Rates and Exchange Rates

United States Federal Reserve System. Europe European System of Central Banks. (United States money supply). (European money supply). M S US. M S E. United States money market. European money market. Foreign exchange market. Equilibrium Interest Rates and Exchange Rates.

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Equilibrium Interest Rates and Exchange Rates

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  1. United States Federal Reserve System Europe European System of Central Banks (United States money supply) (European money supply) MSUS MSE United States money market European money market Foreign exchange market Equilibrium Interest Rates and Exchange Rates Money-Market/Exchange Rate Linkages R€ (Euro interest rate) R$ (Dollar interest rate) E$/€ (Dollar/Euro exchange rate)

  2. Money, Interest, and the Exchange Rate MONEY Medium of Exchange Unit of Account • Express prices, keep records,…write contracts! Store of Value … Low risk • Other, riskier assets are less liquid but pay higher return. • Money Supply (Ms) • Ms = Currency + Checkable Deposits • Controlled by central bank

  3. Aggregate Money Demand Md = P x L(R,Y) where: P = price level Y = real national income R = interest rate • The demand for money can be expressed as the demand for real balances: Md/P = L(R,Y)

  4. Interest rate, R Md/P = L(R,Y) Aggregate real money demand Aggregate Money Demand Aggregate Real Money Demand and the Interest Rate

  5. Interest rate, R Increase in real income L(R,Y2) L(R,Y1) Aggregate real money demand Effect on Aggregate Real Money Demand of Rise in Real Income

  6. Interest rate, R 2 R2 Aggregate real money demand, L(R,Y) 3 R3 MS P ( = Q1) Q3 Q2 Real money holdings Equilibrium in the Money Market: Md = Msor Ms/P = L(R,Y) Real money supply 1 R1

  7. Money Supply and Exchange Rate Short run analysis: The price level and real output are given  sticky prices Assume real output (Y) starts at full-employment Long run analysis: The price level is perfectly flexible and adjusts to preserve full employment. Short – run Long – run

  8. United States Federal Reserve System Europe European System of Central Banks (United States money supply) (European money supply) MSUS MSE United States money market European money market Foreign exchange market Linking Money, the Interest Rate, and the Exchange Rate R€ (Euro interest rate) R$ (Dollar interest rate) E$/€ (Dollar/Euro exchange rate)

  9. Dollar/euro exchange Rate, E$/€ Foreign exchange market 1' E1$/€ Rates of return (in dollar terms) 0 R1$ L(R$, YUS) MSUS PUS Money market U.S. real money supply (increasing) 1 U.S. real money holdings Money Market and Exchange Market Interaction: Our Elaborated Model Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market Return on dollar deposits Expected return on euro deposits

  10. Money, Price Level, & Exchange Rate: the Long Run • Long-run equilibrium: Prices are perfectly flexibleadjust to preserve full employment. • Money and Money Prices From the money market equilibrium condition, Ms/P = L(R,Y) P = Ms/L(R,Y) The Classical Dichotomy: Msproportional P • A change in Ms has no effect on the long-run values of R (the relative price of money) or Y (full employment output). • In order for E to remain stable, R must return to R* in the long-run. • This long-run equilibrium condition implies that P/P = Ms/Ms - L/L. The inflation rate equals the growth rate of Ms minus the growth rate of the demand for money (real balances). • In long-run, E adjusts to P, keeping relative prices (foreign and domestic) constant  purchasing power parity. • If E in long-run, Ee right away. (We’ve read the textbook).

  11. Permanent Money Supply Changes and the Exchange Rate Dollar/euro exchange Rate, E$/€ Dollar/euro exchange Rate, E$/€ Dollar return 2' E2$/€ 2' Expected euro return 4' Rates of return (in dollar terms) 0 0 R1$ R1$ R2$ R2$ L(R$, YUS) L(R$, YUS) M1US P1US M2US P2US M2US P1US 1 4 2 2 (b) Adjustment to long- run equilibrium (a) Short-run effects U.S. real money holdings U.S. real money holdings Short-run and Long-run Effects of an Increase in the U.S.Money Supply Dollar return Expected euro return E2$/€ 3' E3$/€ 1' E1$/€ U.S. real money supply M2US P1US

  12. Permanent Money Supply Changes and the Exchange Rate (b) Dollar interest rate, R$ (a) U.S. money supply, MUS M2US R1$ M1US R2$ Time Time t0 t0 (c) U.S. price level, PUS (d) Dollar/euro exchange rate, E$/€ E2$/€ P2US E3$/€ P1US E1$/€ Time Time t0 t0 Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply

  13. Dollar/euro exchange Rate, E$/€ Expected euro return Rates of return (in dollar terms) R1$ 0 L(R$, YUS) MSUS PUS U.S. real money supply 1 U.S. real money holdings Effect of an Increase in the European Money Supply on Dollar/Euro Exchange Rate: Short-run response Expected return on euro holdings declines both because R* falls and Ee declines (euro is expected to depreciate). Dollar return 1' E1$/€ Increase in European money supply 2' E2$/€

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