ECON303 Topic 2 - TOPIC 2 Interest rates and exchange rates...

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TOPIC 2 Interest rates and exchange rates in monetary equilibrium, PPP, real exchange rate determination 1
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hat Is Money? What Is Money? Money is an asset that is widely used and accepted as a means of payment. Different groups of assets may be classified as oney money. Money is very liquid and pays little or no rate of return . 2
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oney Supply Money Supply Central banks can influence the money supply by directly regulating the amount of currency in circulation. indirectly controlling the amount of deposits issued by rivate banks. private banks. 3
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oney Demand Money Demand e amount of assets that people are willing to hold as T he amount of assets that people are willing to hold as money (instead of illiquid assets) depends on: . xpected returns/interest rate n money relative to the 1. Expected returns/interest rate on money relative to the expected returns on other assets. 2. Risk : the risk of holding money principally comes from unexpected inflation, which unexpectedly reduces the purchasing power of money. but most financial assets have this risk too, so this risk is not very important in money demand 3. Liquidity : A need for greater liquidity occurs when either the rice or the quantity of goods bought in transactions increases price or the quantity of goods bought in transactions increases, ie when GNP rises. 4
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Model of Aggregate Money Demand A Model of Aggregate Money Demand The aggregate real money demand is: L Y M d /P = ( R,Y ) + here: where: P is the price level Y is real national income R is interest rate L ( ) is the aggregate real money demand 5
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A Model of Aggregate Money Demand (cont.) For a given level of income, real money demand decreases as the interest rate increases. 6
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A Model of Aggregate Money Demand (cont.) When income increases, real money demand increases at very interest rate 7 every interest rate.
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e Money Market The Money Market The condition for equilibrium in the money market is: M s = M d or s = L ,Y M /P L ( R,Y ) This equilibrium condition will yield an equilibrium interest rate. 8
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oney Market Equilibrium Money Market Equilibrium 9
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hanges in the Money Supply Changes in the Money Supply decrease in the money supply raises the interest rate for a given price level. An increase in e money supply the money supply lowers the interest rate for a given price level. 10
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hanges in National Income Changes in National Income An increase in national income increases equilibrium interest rates for a iven price level 11 given price level.
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Linking the Money Market to the Foreign Exchange Market 12
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How does the graphic change if central banks control the interest rate? 13
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Simultaneous Equilibrium in the U.S. Money Market nd the Foreign Exchange Market and the Foreign Exchange Market
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Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an g Increase in the U.S. Money Supply
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Effect of an Increase in the European Money Supply n the Dollar/Euro Exchange Rate on the Dollar/Euro Exchange Rate
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ng Run and Short Run Long Run and Short Run In the short run
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This note was uploaded on 05/26/2010 for the course ECON 1160 taught by Professor Byrke during the Spring '10 term at Macomb Community College.

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ECON303 Topic 2 - TOPIC 2 Interest rates and exchange rates...

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