Interest rate and exchange rate
FINC5090 Finance in The Global Economy DR HENRY LEUNG
The University of 1
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Lecture 5 Interest rates and foreign exchange rates
– Themeaningofinterestrates
– A model of money market
– Interest rates and foreign exchange rates
– The changes in money supply: short-run analysis
– The changes in money supply: long-run analysis
The University of 2
1. The meaning of interest rates
– Interest rate is the amount a lender charges for the use of their money, expressed as a percentage of the principal.
• It’s defined for interest bearing securities (e.g. bills, notes, bonds, etc.)
• It’s different from the rate of return (holding period return/total return)
because capital gains/losses are not interest income.
The University of 3
2. A model of money market: the demand for money
– From topic 4 we know that:
Aggregate demand for money is a function of price level, interest rate and national income/output.
Md =PL(R,Y)or
Md =L(R,Y) P
real income increases from Y1 to Y2 causes L to increase per level of R
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets L(R,Y) is the aggregate demand of real monetary assets
• Money/monetary assets are transacted in the money market, where demand and supply of money meet to determine the price of money: interest rate.
The University of 4
2. A model of money market: the equilibrium
– When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium:
– Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium:
Ms =L(R,Y) P
The University of 5
2. A model of money market: the equilibrium
– Given excess supply of monetary assets, there is excess demand for interest- bearing assets like bonds, loans, and deposits.
• People with excess supply of monetary assets willing to offer or accept interest-bearing assets (by giving up their money) at lower interest rates.
• As interest rates (opportunity cost of holding monetary assets) fall, others more willing to hold additional monetary assets.
– Given excess demand of monetary assets, there is excess supply for interest- bearing assets like bonds, loans, and deposits.
• People with excess demand of monetary assets willing to offer or accept interest-bearing assets (by giving up their money) at higher interest rates.
• As interest rates (opportunity cost of holding monetary assets) increase, others less willing to hold additional monetary assets.
The University of 6
Figure 15.3 Determination of the Equilibrium Interest Rate
at point 1. At this point, aggregate real money demand and the real money
supply are equal and the equilibrium interest rate is R1. The University of P and Y given and a real money supply of
Figure 15.4 Effect of an Increase in the Money Supply on the Interest Rate
For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2 reduces the interest rate from R1 (point 1) to R2 (point 2).
The University of 8
Figure 15.5 Effect on the Interest Rate of a Rise in Real Income
Given the real money supply,
MS (= Q1), a rise in real income from Y1 to Y2 P
raises the interest rate from R1 (point 1) to R2 (point 2). The University of 9
3. Interest rates and foreign exchange rates
Turn Figure 15.3 clockwise 90°and combine with interest parity graph.
Both asset markets are in equilibrium at interest rate R1 and exchange rate E1; at these values, money supply equals money demand (point 1) and interest parity condition holds (point 1’).
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The University of 10
3. Interest rates and foreign exchange rates
Monetary policy actions by the Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The ECB can affect the exchange rate by changing the European money supply and interest rate.
The University of 11
4. The changes in money supply: short-run analysis
– In the short run, prices of factors of production and of output do not have sufficient time to adjust to market conditions.
– Theanalysisheretoforehasbeenashort-runanalysis.
– The change in R will not cause any corresponding change in P and Y. – Rather,domesticcurrencyfluctuates.
The University of 12
4. The changes in money supply: short-run analysis
– An increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.
– A decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate.
The University of 13
4. The changes in money supply: short-run analysis
Given PUS and YUS when the money supply rises from M1 to M2 the dollar interest rate declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates against the euro (as foreign exchange market equilibrium is reestablished at point 2’).
The University of 14
4. The changes in money supply: short-run analysis
– How would a change in the supply of euros affect the U.S. money market and foreign exchange markets?
• An increase in the supply of euros causes a depreciation of the euro (an appreciation of the dollar).
• A decrease in the supply of euros causes an appreciation of the euro (a depreciation of the dollar).
The University of 15
4. The changes in money supply: short-run analysis
– Lowering dollar interest rates on euro deposits (shown as a leftward shift in the expected euro return curve) accompanied by increase in Europe’s money supply
– Causes dollar to appreciate against euro (euro depreciates).
– Equilibrium in foreign exchange market shifts from point 1’ to point 2’
– But equilibrium in U.S. money market remains at point 1 (no change in U.S. money market due to change in supply of euros)
Figure 15.9 Effect of an Increase in the European Money
Supply on the Dollar/Euro Exchange Rate
The University of 16
5. The changes in money supply: long-run analysis
– In long run, prices of factors of production and of output have sufficient time to adjust to market conditions.
• Wages adjust to demand and supply of labor.
• Real output and income are determined by amount of workers and other factors of production—by economy’s productive capacity—not by quantity of money supplied.
• (Real) interest rates depend on supply of saved funds and demand of saved funds.
The University of 17
5. The changes in money supply: long-run analysis
– In long run, quantity of money supplied is predicted not to influence amount of output, (real) interest rates, and aggregate demand of real monetary assets L(R,Y).
– BUT rather make level of average prices adjust proportionally in long run.
• Equilibrium condition shows that P is predicted to adjust proportionally
when Ms adjusts, because L(R,Y) does not change.
MS =L(R,Y) P
The University of 18
5. The changes in money supply: long-run analysis
– In long run, there is direct relationship between inflation rate and changes in money supply.
MS =PL(R,Y) P = MS
L(R,Y) P = MS −L
– Inflation rate is predicted to equal growth rate in money supply minus the growth rate in money demand.
The University of 19
Figure 15.10 Average Money Growth and Inflation in Western Hemisphere Developing Countries, by Year, 1987–2014
Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation. (Both axes have logarithmic scales.)
Source: World Bank development indicators database and own calculations. Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP.
The University of 20
5. The changes in money supply: long-run analysis
– How does a change in the money supply cause prices of output and inputs to change?
1. Excess demand of goods and services: a higher quantity of money supplied implies that people have more funds available to pay for goods and services.
• To meet high demand, producers hire more workers, creating a strong demand of labor services, or make existing employees work harder.
• Wages rise to attract more workers or to compensate workers for overtime.
• Prices of output will eventually rise to compensate for higher costs.
• Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the high demand.
The University of 21
5. The changes in money supply: long-run analysis
– How does a change in the money supply cause prices of output and inputs to change?
2. Inflationary expectations:
• If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated.
• And if producers expect the same, they are more willing to raise wages.
• Producers will be able to match higher costs if they expect to raise prices.
• Result: expectations about inflation caused by an expected increase in the money supply causes actual inflation.
The University of 22
5. The changes in money supply: long-run analysis
Much greater month-to-month variability of exchange rate suggests price levels are relatively sticky in short run.
Source: Price levels from International Monetary Fund, International Financial Statistics. Exchange rate from Global Financial Data.
The University of 23
Figure 15.11 Month-to-Month Variability of the Dollar/Yen Exchange Rate and of the U.S./Japan Price Level Ratio, 1980–2016
5. The changes in money supply: long-run analysis
When foreign exchange market participants form expectations on inflation:
(a) Short-run adjustment of asset markets.
1->2 causes 1’->2’ via 3’
(b) How interest rate, price level, and exchange rate move over time as economy approaches its long-run equilibrium.
The University of 24
5. The changes in money supply: long-run analysis
– A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency.
• However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.
– A permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency.
• However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.
The University of 25
5. The changes in money supply: long-run analysis
After money supply increases at t0 in panel (a), the interest rate [in panel (b)], price level [in panel (c)], and exchange rate [in panel (d)] move as shown toward their long-run levels.
As indicated in panel (d) by initial jump from E1 to E2 , the exchange rate overshoots in the short run before settling down to its long-run level, E3.
The University of 26
Figure 15.13 Time Paths of U.S. Economic Variables after a Permanent Increase in the U.S. Money Supply
5. The changes in money supply: long-run analysis
– Exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response.
– Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.
– Overshooting helps explain why exchange rates are so volatile.
The University of 27
– Purchasing power parity
The University of 28
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