and Exchange Rates Udayan Roy ECO41 International Economics What is Money Money is any asset that is widely used and accepted as a means of payment So a countrys quantity of money M ID: 671961
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Slide1
Ch.
15: Money, Interest Rates,and Exchange Rates
Udayan Roy
ECO41 International EconomicsSlide2
What is Money?
Money is any asset that is widely used and accepted as a means of payment.So, a country’s
quantity of money
(
M
s
) includes
All
currency with the public
and
All
checkable deposits
bank deposits in a foreign currency are excluded from this definition.
M1
and
M2
are two well-known periodically published measures of the quantity of moneySlide3
Properties of Money: No Return
We can classify all assets into:Money, which earns no returnCurrency with the public
plus
checking accounts
Assets that earn a return
Stocks, bonds, real estate, etc.Slide4
Properties of Money: Liquid
Money is very liquid:
that is, it can easily and quickly be used to purchase goods and services.
Assets that earn a return are less liquid than money
So, when deciding how much of their wealth to keep in the form of money, people face a trade off between the convenience of liquid assets and the higher return from less-liquid assetsSlide5
Money Supply
The quantity of money is also called the money supplyWho controls the money supply?
Central banks
determine the money supply.
In the US, the central bank is the Federal Reserve.
The Federal Reserve
directly
regulates the amount of currency in circulation.
It
indirectly
controls the amount of checkable deposits issued by private banks.Slide6
Money Demand
Money demand is the amount of their wealth that people are willing to hold in the form of money …
(… instead of other assets that are less liquid but earn a higher return).Slide7
Money Demand: Individual
An individual’s money demand depends on:Interest
rate (on interest-earning assets)
: this is the cost (or, downside) of holding money.
Risk
: the risk of holding money principally comes from unexpected inflation, thereby unexpectedly reducing the purchasing power of money.
but many other assets have this risk too, so this risk is not very important in money demand
Liquidity
: A need for greater liquidity occurs when either the price of transactions increases or the quantity of goods bought in transactions increases.Slide8
Money Demand: Aggregate
Aggregate money demand depends on:Interest rateAverage level of pricesIncome How do these factors affect aggregate money demand?Slide9
Money Demand: Aggregate
Money pays little or no interest. So, the interest rate on interest-earning assets (such as bonds) is the opportunity cost of holding money (instead of non-money assets).
A higher interest rate means a higher opportunity cost of holding money
lower money demand
Therefore,
aggregate money demand
(
M
d
)
is
inversely
related to the interest rate (
R
)Slide10
Money Demand: Aggregate
The overall level of prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions.
A higher overall price level means a greater need for liquidity to buy the same amount of goods and services
higher money demand
Therefore,
aggregate money demand (
M
d
) is
directly
related to the overall level of prices (
P
)Slide11
Money Demand: Aggregate
Higher income implies more goods and services are being produced and bought
So, more money would be needed to conduct transactions.
A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity
higher money demand
Therefore,
aggregate money demand (
M
d
) is
directly
related to GNP (
Y
)Slide12
Money Demand: Aggregate
There are several other factors that affect the aggregate willingness of people to hold their wealth in monetary form:
Total wealth: the higher this is, the higher money demand will be
Anxiety over lending one’s money to others and fear that borrowers will default:
the higher this is, the higher money demand will
be
Let all these other factors be denoted
L
0
.
Therefore,
aggregate money demand (
M
d
) is
directly
related to
L
0
.Slide13
Money Demand: Aggregate
Combining the four previous slides, we get our aggregate money demand equation:
here
blue
indicates a
direct
effect and
red
indicates an
inverse
effect
Slide14
Equilibrium
For an economy to be in equilibrium, money supply must equal money demandA central bank may determine the money supply
But it cannot force people to hold exactly that much of their wealth in the form of money
Therefore,
is necessary for equilibrium
Slide15
Equilibrium
Therefore,
is
essential for equilibrium
Using our aggregate money demand equation, the
equilibrium condition becomes
Note that t
his
equation has five variables
So, if the values of any four of them are known, this equation will tell us the value of the fifth variable
Slide16
There’s more in Chapter 15 …
We will return to topics in this chapter later in the course