International Monetary Economics

Transcription

1 International Monetary Economics Lecture 4: Money, Interest Rates and Exchange Rates Master d Affaires Publiques SciencesPo Spring 2013 Pierre-Olivier Gourinchas

2 Roadmap Money and Interest Rates Introduction Money Defined: A Brief Review The Demand for Money by Individuals Aggregate Money Demand The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Money, the Price Level, and the Exchange Rate in the Long Run Inflation and Exchange Rate Dynamics Summary Slide 4-2

3 The Interaction of Money Supply and Demand Figure 4-1: Money-Market/Exchange Rate Linkages United States Federal Reserve System Europe European System of Central Banks M S (United States (European US money supply) MS E money supply) United States money market i $ (Dollar interest rate) Foreign exchange market European money market i (Euro interest rate) E $/ (Dollar/Euro exchange rate) Slide 4-3

4 Money Defined: A Brief Review Money as a Medium of Exchange Money as a Unit of Account Money as a Store of Value Slide 4-4

5 Money Defined: A Brief Review What Is Money? Assets widely used and accepted as a means of payment. Money is very liquid, but pays little or no return. Money Supply (M s ) M s = Currency + Checkable Deposits This corresponds to the monetary aggregate M1. Broader aggregates exist (M2, for instance, includes time deposits). In December 2012: ECB M1 stands at 5085 billion. ECB M2 stands at 8970 billion. ECB M3 stands at 9740 billion Slide 4-5

6 Money Defined: A Brief Review How the Money Supply Is Determined An economy s money supply is controlled by its central bank, both directly and indirectly. The central bank: Directly regulates the amount of currency; Indirectly controls the amount of checking deposits issued by private banks Slide 4-6

7 The explosion of the US Money Base Figure 4-2: Monetary Aggregates, billions USD, # 2600# 2100# 1600# 1100# 600# 2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012# M0# M1# Slide 4-7

8 The explosion of the US Money Base Figure 4-2b: The US money multiplier 2.00# 1.80# 1.60# 1.40# 1.20# 1.00# 0.80# 0.60# 0.40# 0.20# 0.00# 2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012# M1/M0# Slide 4-8

9 The Euro Money Multiplier Figure 4-2c: M3/M0, Euro area, # 10.00# 8.00# 6.00# 4.00# 2.00# 0.00# 2004# 2005# 2006# 2007# 2008# 2009# 2010# 2011# 2012# M3/M0# Slide 4-9

10 The Demand for Money by Individuals Three factors influence money demand: Expected Return Risk Liquidity Slide 4-10

11 Aggregate Money Demand Aggregate money demand The total demand for money by all households and firms in the economy. It is determined by three main factors: Interest rate Price level Real national income Slide 4-13

12 Aggregate Money Demand The aggregate demand for money can be expressed by: M d = P L(i,Y) where: P is the price level Y is real national income L(i,Y) is the aggregate real money demand Can also be written as: M d /P = L(i,Y) Slide 4-14

13 Aggregate Money Demand Figure 4-3: Aggregate Real Money Demand and the Interest Rate Interest rate, i L(i,Y) Aggregate real money demand Slide 4-15

14 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Equilibrium in the Money Market The condition for equilibrium in the money market is: M s = M d The money market equilibrium condition can be expressed in terms of aggregate real money demand as: M s /P = L(i,Y) Slide 4-17

15 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-4: Determination of the Equilibrium Interest Rate Interest rate, i L(i,Y) Aggregate real money demand Slide 4-18

16 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-5: Effect of an Increase in the Money Supply on the Interest Rate Interest rate, i Real money supply i 1 1 Aggregate real money demand, L(i,Y) M S P ( = Q1 ) Real money holdings Slide 4-20

17 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Interest Rates and the Money Supply An increase in the money supply lowers the interest rate, given the price level and output. A fall in the money supply raises the interest rate, given the price level and output. Slide 4-22

18 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-6: Effect on the Interest Rate of a Rise in Real Income Interest rate, i Real money supply i 1 1 Aggregate real money demand, L(i,Y) M S P ( = Q1 ) Real money holdings Slide 4-23

19 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Output and the Interest Rate An increase in real output raises the interest rate, given the price level and the money supply. An fall in real output lowers the interest rate, given the price level and the money supply. Slide 4-25

20 The Money Supply and the Exchange Rate in the Short Run Short run analysis The price level and the real output are given. Long run analysis The price level is perfectly flexible and always adjusted immediately to preserve full employment. Slide 4-26

21 The Money Supply and the Exchange Rate in the Short Run Linking Money, the Interest Rate, and the Exchange Rate The U.S. money market determines the dollar interest rate, The Japanese money market determines the yen interest rate, The dollar and yen interest rates determine the dollar/yen exchange rate that maintains the interest parity. Slide 4-27

22 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-7: Simultaneous Equilibrium in the U.S. Money Market and the Foreign-Exchange Market Foreign exchange market Money market Dollar/yen exchange Rate, E $/ 0 (increasing) E 1 $/ 1' M S US P US Return on dollar deposits 1 i 1 $ Expected return on yen deposits L(i $, Y US ) U.S. real money supply Rates of return (in dollar terms) U.S. real money holdings Slide 4-28

23 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand U.S. Money Supply and the Dollar/Yen Exchange Rate What happens when the Federal Reserve changes the U.S. money supply? Slide 4-29

24 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-8: Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply Foreign exchange market Money market Dollar/yen exchange Rate, E $/ 0 (increasing) E 1 $/ 1' M S US P US Return on dollar deposits 1 i 1 $ Expected return on yen deposits L(i $, Y US ) U.S. real money supply Rates of return (in dollar terms) U.S. real money holdings Slide 4-30

25 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Japan s Money Supply and the Dollar/Yen Exchange Rate What happens when the Bank of Japon changes the Japanese money supply? Slide 4-32

26 The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Figure 4-9: Effect an Increase in the Japanese Money Supply Foreign exchange market Dollar/yen exchange Rate, E $/ E 1 $/ 1' 0 Return on dollar deposits i 1 $ Expected return on yen deposits L(i $, Y US ) Rates of return (in dollar terms) Money market M S US P US (increasing) 1 U.S. real money supply U.S. real money holdings Slide 4-33

27 The Short Run vs. the Long Run Short run analysis The price level and real output are given. Long run analysis The price level is perfectly flexible and adjusts immediately to maintain the economy at its potential output. Slide 4-35

28 Money and the Price Level in the Long Run Long-run equilibrium: position the economy would reach if no new shocks were to occur, and prices and wages have time to adjust. In the long run, output (Y lr ) is determined by the supply of factors of production The long run real interest rate (r lr ) is determined by the return to capital The long run nominal interest rate (i lr ) is determined by the Fischer relationship Slide 4-36

29 Money and the Price Level in the Long Run Money and Prices In the long run, the money market equilibrium determines the equilibrium price level: [In the short run, the money market equilibrium determines the nominal interest rate] Slide 4-37

30 The Quantity Theory of Money Special case: The Quantity Theory of Money (QTM) The QTM assumes that the demand for real liquidity is proportional to real activity. (k is a constant) M s / P = k Y Equivalently, there is a constant velocity v: PY/ M s = 1/k = v In the long run, with Y = Y lr, this implies that inflation is proportional to the growth in money supply: π = ΔP/P = ΔM s /M s - ΔY lr /Y lr Inflation is a monetary phenomenon!! Slide 4-38

31 Money and the Price Level in the Long Run The Long-Run Effects of Money Supply Changes A change in the supply of money has no effect on the long-run values of the interest rate or real output (neutrality). A permanent increase in the money supply causes a proportional increase in the price level s long-run value. Think of a currency reform In general, changes in money demand affect long run inflation. Consider the money market equilibrium condition: P = M s /L(i,Y). This condition implies that ΔP/P = ΔM s /M s - ΔL/L. Slide 4-39

32 Money and the Price Level in the Long Run Empirical Evidence on Money Supplies and Price Levels In a cross-section of countries, long-term changes in money supplies and price levels show a clear positive correlation. Slide 4-40

33 Money and the Price Level in the Long Run Figure 4-10: Monetary Growth and Price-Level Change in the OECD, NZL IRL GBR SWE FIN DNK NOR AUS USA CAN BEL AUT JPN NTL DEU CHE ESP PRT GRE ISL Money Growth (percent per year), Slide 4-41

34 Money and the Price Level in the Long Run Money and the Exchange Rate 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. Why? Suppose the U.S. money supply doubles. Slide 4-43

35 Money, the Price Level, and the Exchange Rate in the Long Run Figure 4-11: The Swiss and the Saddam dinar The Swiss Dinar, used by the Kurds The Saddam Dinar, used in Iraq Slide 4-47

36 Money, the Price Level, and the Exchange Rate in the Long Run Figure 4-12: The Swiss and the Saddam dinar exchange rate Slide 4-48

37 Inflation and Exchange Rate Dynamics From the Short Run to the Long Run: Inflation and Exchange Rate Dynamics In the short run, prices and output are fixed and exchange rates can move. Changes in money supply affect interest rates and the exchange rate In the long run, price and exchange rate are flexible. Changes in money supply affect nominal variables (prices and the nominal exchange rate). Full employment output As we will see, this explains why exchange rates are very volatile in the short run. Slide 4-51

38 Inflation and Exchange Rate Dynamics Figure 4-13: Month-to-Month Variability of the USD/JPY Exchange Rate and of the U.S./Japan Price-Level Ratio, Slide 4-52

39 Inflation and Exchange Rate Dynamics Permanent Money Supply Changes and the Exchange Rate How does the dollar/euro exchange rate adjust to a permanent increase in the U.S. money supply? Slide 4-53

40 Inflation and Exchange Rate Dynamics Figure 4-14: Effects of an Increase in the U.S.Money Supply Dollar/euro exchange Rate, E $/ Dollar return Dollar/euro exchange Rate, E $/ E 1 $/ 1' 0 M 1 US P 1 US 1 i 1 $ L(i $, Y US ) Rates of return (in dollar terms) 0 Expected euro return L(i $, Y US ) U.S. real money holdings (a) Short-run effects U.S. real money holdings (b) Adjustment to longrun equilibrium Slide 4-54

41 Inflation and Exchange Rate Dynamics Figure 4-15: Time Paths of U.S. Economic Variables After a Permanent Increase in the U.S. Money Supply (a) U.S. money supply, M US (b) Dollar interest rate, i $ M 2 US i 1 $ M 1 US i 2 $ t 0 Time t 0 Time (c) U.S. price level, P US (d) Dollar/euro exchange rate, E $/ E 2 $/ P 2 US E 3 $/ P 1 US E 1 $/ t 0 Time t 0 Time Slide 4-56

42 Inflation and Exchange Rate Dynamics Exchange Rate Overshooting (Dornbusch, 1976) The exchange rate is said to overshoot when its immediate response to a disturbance is greater than its long-run response. It helps explain why exchange rates move so sharply form day to day. It is a direct result of sluggish short-run price level adjustment and the interest parity condition. Slide 4-57

43 Inflation and Exchange Rate Dynamics In the overshooting model, a permanent increase in money supply leads to a depreciation of the domestic currency (immediate) and an increase in inflation (gradual). Yet in many situations, we see a currency appreciate when inflation rises. How should we interpret this? Slide 4-58

44 Summary Money is held because of its liquidity. Aggregate real money demand depends negatively on the opportunity cost of holding money and positively on the volume of transactions in the economy. The money market is in equilibrium when the real money supply equals aggregate real money demand. By lowering the domestic interest rate, an increase in the money supply causes the domestic currency to depreciate in the foreign exchange market. Slide 4-59

45 Summary Permanent changes in the money supply push the long-run equilibrium price level proportionally in the same direction. These changes do not influence the long-run values of output, the interest rate, or any relative prices. An increase in the money supply can cause the exchange rate to overshoot its long-run level in the short run. The response of the monetary authorities to inflationary shocks can lead to a negative correlation between the exchange rate and the inflation rate. Slide 4-60