1 Chapter 4 Money, Interest Rates, and Exchange Rates 4-2 Floating exchange rates in the short run: the asset approach • Chapter 3: • equilibrium on fxm = interest parity condition R US = R EU + expected appreciation of EUR • E USD/EUR = f (R US , R EU , E e USD/EUR ) all given !! • Chapter 4: • determination of R US , R EU , E e USD/EUR • money market • interaction money demand and supply => R • ∆ money market => price level => E e • combination yields insight into: • ? ∆ money market => R => E • ? ∆ money market => P => E e => E • from short-run towards long-run, from partial picture to deeper understanding initially: R US , R EU , E e USD/EUR , P, Y all given
2 4-3 Structure of Chapter • definition of money • how is money supply determined? • how is money demand determined? • equilibrium in the money market (= determination of R) • mm (Ch. 4) + fxm (Ch. 3) = simultaneous equilibrium = short-run (!) equilibrium (P is given -- as is Y) • what if P is not given? = inflation and exchange rate dynamics = combination of short-run and long-run findings 4-4 Money, money, money (p. 102-103) • three characteristics of money - medium of exchange - unit of account - store of value => money is an asset => money is the most liquid asset • what is money? in this book: money supply is M1 ! foreign currency deposits (traded on fxm) Ï money ! • how is M s determined? controlled by central bank ass.: CB sets M s at desired level (Chapter 7)
3 4-5 Monetary aggregates Source: ECB, The Monetary Policy of the ECB , 2011, p. 50 4-6 Composition of M3 Source: ECB, The Monetary Policy of the ECB , 2011, p. 51
4 4-7 Money - that ’ s what I want … (p. 104-105) • The demand for money by individuals money is an asset, so ... theory of asset demand applies 1. expected return (opportunity cost): R - => M d ¯ 2. (riskiness) 3. liquidity (money is held to finance routine transactions) ~ average daily value of transactions • aggregate money demand Three main determinants: 1. interest rate 3a. price level 3b. real (!) national income M d = P * L(R, Y) note: proportional to P - + demand is demand for real holdings M d /P = L(R, Y) aggregate real money demand ( Fig 4-1 & 4-2) 4-8 What Influences Demand of Money for Individuals and Institutions? 1. Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non- monetary assets. 2. Risk : the risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money. – But many other assets have this risk too, so this risk is not very important in defining the demand of monetary assets versus nonmonetary assets. 3. Liquidity : A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases.
5 4-9 What Influences Aggregate Demand of Money?
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