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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,44,Money and Exchange Rate,WONGKaFu,2 February 2000,Money,as amediumof exchange,eliminates enormoussearch costsconnected witha bartersystem,as aunit ofaccount,translates differentcountriesmoney pricesinto comparableterms,as astore of value,transferpurchasingpower from the present intothefuture,Money supply,manydefinitionsofmoney supply,M1,M2,M3,etc.,these definitions include assetsthat perform the functionsof moneyatdifferent degrees,M1:thetotal amountofcurrencyandchecking deposits heldby households and firms,Money demanded by individuals depends on,theexpectedreturnmoney relative to the returns offered byother assets,theriskiness ofmoneysexpected return,inflation,moneysliquidity,a rise in the average valueof transactionscarriedoutby ahousehold or firm causes its demandforliquidity and hencemoney,Aggregate moneydemand,Nominaldemand:M,d,= P,L (R, Y),P =price level,R =interestrate (of assets ),Y =Realnational income,Realdemand:M,d,/ P=L (R, Y),L(R,Y) riseswhen Rfalls,R,L(R,Y),Realmoney holdings,Aggregate real moneydemand,L(R,Y) riseswhen Yincreases,R,L(R,Y,1,),Realmoney holdings,Aggregate real moneydemand,Y,2, Y,1,L(R,Y,2,),Determination oftheequilibriuminterest rate,R,L(R,Y),Realmoney holdings,realmoney supply,M,s,/ P,R,*,Effect of anincrease inmoney supply ontheinterest rate,R,L(R,Y),Realmoney holdings,M,1,/P,R,1,M,2,/P,R,2,Effect of anincrease inreal incomeontheinterestrate,R,L(R,Y,1,),Realmoney holdings,M,s,/P,R,1,L(R,Y,2,),R,2,Determination ofexchange rate,homemoney market equilibrium determineshome interest rate,homeinterest rate =rate ofreturnon homedeposit,interestparitydetermines exchangerateconditionalonforeignmonetarypolicyandexpectedreturnon foreign deposit,Rateofreturn,(inhomecurrency,),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchangerate,0,(,M,s,H,/P,H,),1,L(R,H,Y,H,),1,1,E,H/F,1,Real money holdings,RelationshipbetweenExchangerate andmoneysupply,Rate of return,(inhomecurrency),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchangerate,0,(,M,s,H,/P,H,),1,L(R,H,Y,H,),1,1,E,H/F,1,Real money holdings,2,2,E,H/F,2,(,M,s,H,/P,H,),2,EffectofanincreaseinRealMoneysupply,Rate of return,(inhomecurrency),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchangerate,0,(,M,s,H,/P,H,),1,L(R,H,Y,H,),1,1,E,H/F,1,Real money holdings,E,H/F,2,2,Effectofadecreaseinforeign interest rate,Moneyandmoneyprices,Moneymarketequilibrium:,M,s,/ P=L(R,Y ),I.e.P=M,s,/ L(R,Y ),and2P= 2M,s,/ L(R,Y ), or generally,kP=kM,s,/ L(R,Y ),MonetaryGrowthand Price-Level ChangeofG7countries(1973-1998),Empiricalevidence,Long-runmoneysuppliesandpricelevels,(AlsoseeKrugmanandObstfeld: Figure14-10),Roughly,moneygrowthratesarepositively correlatedwith inflationrate (I.e.,pricelevelchanges),z %change in money supplyisrelated toslightlyless thanz %change in price level.,Here,weassumez% changeinmoneysupplyisrelatedtoz %change in price level,inthelongrun.,VariabilityoftheDollar/DMExchangeRateandtheU.S./GermanPrice-LevelRatio,Empiricalevidence,VariabilityoftheDollar/DM Exchange Rateand of theU.S./GermanPrice-levelRatio(AlsoseeKrugmanandObstfeld: figure14-11),Pricesare rigid in thetheshortrun butflexibleinthelongrun,Exchangerate is muchmoreflexiblethan prices,Rate of return,(inhomecurrency),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchangerate,0,M,H,1,/P,H,1,L(R,H,Y,H,),1,1,E,H/F,1,Real money holdings,2,2,E,H/F,2,M,H,2,/P,H,1,Givenexpectedforeign depositreturn,Aninitial increase in homemoneysupply,Time,t,0,M,H,1,M,H,2,Home money supply,M,H,Time,t,0,P,H,1,P,H,2,Home price level,P,H,Time,t,0,R,H,2,R,H,1,Home interest rate, R,H,Time,t,0,E,H/F,2,Home /foreignexchangerate,E,H/F,E,H/F,1,Conclusion:,A permanentmoneysupplyincreasehas no effectonexchangerate levelinthelongrun.,Wrong!,Rate of return,(inhomecurrency),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchangerate,0,M,H,1,/P,H,1,L(R,H,Y,H,),1,1,E,H/F,1,Real money holdings,2,2,E,H/F,2,M,H,2,/P,H,1,Givenexpectedforeign depositreturn,Aninitial increase in homemoneysupply,Rate of return,(inhomecurrency),Expectedreturnon,foreign deposit,Returnonhomedeposit,HD/FD,exchange rate,0,M,H,1,/P,H,1,L(R,H,Y,H,),1,1,E,H/F,1,Realmoneyholdings,2,2,E,H/F,2,M,H,2,/P,H,1,Expected FD return increases because expectedincreasein all dollar prices,An initialincreasein home money supply,Rateof return,(in home currency),Expected returnon,foreign deposit,Return onhomedeposit,HD/FD,exchange rate,0,M,H,2,/P,H,2,= M,H,1,/P,H,1,L(R,H,Y,H,),1,1,E,H/F,1,Realmoneyholdings,2,2,E,H/F,2,M,H,2,/P,H,1,In the long run, home prices adjustfromP,H,1,to P,H,2,An initialincreasein home money supply,4,E,H/F,4,Time,t,0,M,H,1,M,H,2,Homemoneysupply,M,H,Time,t,0,P,H,1,P,H,2,Homepricelevel, P,H,Time,t,0,R,H,2,R,H,1,Homeinterest rate,R,H,Time,t,0,E,H/F,3,Home/ foreignexchange rate,E,H/F,E,H/F,1,E,H/F,2,Overshooting,Whenthe immediate response ofexchangerateto adisturbance (e.g., apermanentchange inmoney supply)is greaterthanitslong-run response.,Short-runpricerigidityis only one ofthe reasonforovershooting.,“It takestimeto learn what had happened” maybe another reason.,ThaiBaht,SouthKorean Won,BrazilianReals,Wantto know more.,Chapter 14of Krugman & Obstfeld,Search theEconLit for “overshooting”:,201 itemsreturn,
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