Lecture 13
MONEY and EXCHANGE RATES

Key concepts

• Demand, supply and equilibrium in the money market
• Interest rates, prices and exchange rates

1. The Market for Money

1.1 Demand for money

• Factors that affect the demand for money
• Interest rate (r):
  Higher interest rates lead to less money demanded (why?)
• Price level (P):
  Higher price level leads to an increase in money demand (why?)
• Real income or GDP (Y):
  Higher income leads to greater demand for money (why?)

• Equation
  • M^d = P L(Y,r)
  • M^d represents the nominal demand for money
  • Negatively-sloped curve: M^d vs. r

1.2 Supply of money

• M^s is set by the central bank at any desired level, M (this is a fairly reasonable assumption)
• M^s is the nominal money supply

1.3 Equilibrium in the money market

• Real money supply = Real money demand:
  M / P = L(Y,R)

• Given M, P and Y: Obtain the equilibrium nominal interest rate

1.4 Real interest rates

• R_real = R_nominal - Expected rate of inflation

2. The Money Market and Exchange Rates in the Short Run

• Set M^d = M^s to obtain eqbm r
• Using r (and r* and E^e) in the foreign-exchange market, obtain the eqbm spot exchange rate

Case: Suppose the Fed increases money supply

• In the money market:
  - M^s will shift to the right
  - The U.S. interest rate will fall

• In the foreign-exchange market:
  - The dollar-return-on-dollar-deposits will fall (shift to the left)
  - The dollar will depreciate (E will rise)