M14_KRUG8276_08_IM_C14

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Chapter 14 Money, Interest Rates, and Exchange Rates Chapter Organization Money Defined: A Brief Review Money as a Medium of Exchange Money as a Unit of Account Money as a Store of Value What is Money? How the Money Supply is Determined The Demand for Money by Individuals Expected Return Risk Liquidity Aggregate Money Demand The Equilibrium Interest Rate: The Interaction of Money Supply and Demand Equilibrium in the Money Market Interest Rates and the Money Supply Output and the Interest Rate The Money Supply and the Exchange Rate in the Short Run Linking Money, the Interest Rate, and the Exchange Rate U.S. Money Supply and the Dollar/Euro Exchange Rate Europe’s Money Supply and the Dollar/Euro Exchange Rate Money, the Price Level, and the Exchange Rate in the Long Run Money and Money Prices The Long-Run Effects of Money Supply Changes Empirical Evidence on Money Supplies and Price Levels Money and the Exchange Rate in the Long Run
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65 Krugman/Obstfeld • International Economics: Theory and Policy, Eighth Edition Inflation and Exchange Rate Dynamics Short-Run Price Rigidity versus Long-Run Price Flexibility Box: Money Supply Growth and Hyperinflation in Bolivia Permanent Money Supply Changes and the Exchange Rate Exchange Rate Overshooting Case Study: Can Higher Inflation Lead to Currency Appreciation? The Implications of Inflation Targeting Summary Chapter Overview This chapter combines the foreign-exchange market model of the previous chapter with an analysis of the demand for and supply of money to provide a more complete analysis of exchange rate determination in the short run. The chapter also introduces the concept of the long-run neutrality of money which allows an examination of exchange rate dynamics. These elements are brought together at the end of the chapter in a model of exchange rate overshooting. The chapter begins by reviewing the roles played by money. Money supply is determined by the central bank; for a given price level, the central bank’s choice of a nominal money supply determines the real money supply. An aggregate demand function for real money balances is motivated and presented. Money-market equilibrium—the equality of real money demand and the supply of real money balances— determines the equilibrium interest rate. A familiar diagram portraying money-market equilibrium is combined with the interest rate parity diagram presented in the previous chapter to give a simple model of monetary influences on exchange rate determination. The domestic interest rate, determined in the domestic money market, affects the exchange rate through the interest parity mechanism. Thus, an increase in domestic money supply leads to a fall in the domestic interest rate. The home currency depreciates until its expected future appreciation is large enough to equate expected returns on interest-bearing assets denominated in domestic currency and in foreign currency. A contraction in the money supply leads to an exchange rate appreciation through a
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