monecon.2018S.ch4.pdf - Chapter 4 Money Interest Rates and Exchange Rates 4-1 Floating exchange rates in the short run the asset approach Chapter 3

monecon.2018S.ch4.pdf - Chapter 4 Money Interest Rates and...

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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
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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)
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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
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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.
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5 4-9 What Influences Aggregate Demand of Money?
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