Money, Interest Rates and the Exchange Rate cont.

“The double diagram” steps

1. The US federal reserve sets the US money supply

2. US money market then sets the interest rate for dollar (R$)

3. The European Central Bank Sets the money supply for the European Nations, which determines the rate of return of inventing in euro converted into dollars

4. The foreign exchange market sets the exchange rate

What happens when the money supply in the us increases?

1. The MS supply curve in the money market shift right (or down).

2. This causes a left shift in the US interest rate, meaning that the interest rate goes down in the us. Which makes sense since there are money circulating the economy than there is a need for them. More people start using that money to invest on assets

3. The decrease in the US interest rate increases the exchange rate meaning that the dollar depreciates. This makes sense because investors are moving money away from US assets and into european assets

What happens if the european money supply increases?

although it’s not explicitly labeled, we can infer that if the EMS decreases, the interest rate would go up. And if the EMS increases, the interest rate would go down. Interest rate going down in the EU means the euro depreciates while the dollar appreciate.

1. The decrease in the EIR causes the rate of return in euros in dollars to also decrease. This shift the curve to the left

2. The money market is left unchanged because the change in ems does not impact the us ms or the us interest rate.

3. the shift in the rate of euro return casues the exchange rate to fall, meaning that the dollar appreciated and the euro depreciate.

Price level and exchange rates

• There are more factors affecting exchange rates than just R and Y.

• We are under the assumption that the expected exchange rate is constant

• But we will make price level flexible now!

Is price level discrete or continuous?

We are talking about discrete changes in the price level currently.

P = Ms/l(R,Y)

if prices are flexible then the price level will adjust to make this statement work.

• if the money supply increases while real money demand remains constant, then the price level will also increase

• if the real money demand increases but the money supply remains constant, then the price level will decrease.

We’re also focusing on the long-run output.

When the price level changes, what happens to the exchange rate?

If the price level doubles than so does the exchange rate

• 2*P = 2*E

Long-run neutrality of money

economic theory that states changed in the money supply only impacts nominal variables like prices and wages and have no lasting effect on real variables like employment, output, and real GDP in the long-run

• money is considered to be neutral (to output) in the short run

Is money neutral in the short-run?

NOOOO. Price take time to adjust which can create shor-run changes in economic spending. If the money supply goes up but price hasn’t adjusted, this extra income impacts the interest rate, spending, and output.

When can LR neutrality money not hold?

• when the economy is below full employment because an increase in the money supply can stimulate aggregate demand and move the economy towards a higher output.

  • for example if the firm is earning 5% higher inflation on their goods but only paying their workers 2% of the higher inflation then the firms are making more profit hence hire more workers.

• so monetary policies can have real effects while the economy has slack.

Change in monetary policy in the short run?

• m increases

• i decreases

• I increases

• AD increases

• Y increases

• unemployment decrease

Change in the price level in the long run?

• money supply increases

• price level increases

• output remains and the same

• unemployment rate remains the same

Why does it take time for price levels to adjust?

Because of stickiness of wages and prices!

This means that prices and wages tend to remain the same even when there are economic condition changes

Menu costs

transaction costs in changing prices

Why are wages and exchange rates sticky downwards than upwards?

it’s easier to increase prices than to decrease prices. Firms don’t want to cut wages of their workers either.

Exchange Rate overshooting

• exchange rates adjusts very very quickly, however, the price level adjusts very slowly

• the exchange rate might increase higher than expected, but relaxes once the price level starts increasing