Chapter 10: Building Blocks Money Market and Foreign Exchange Rate Flashcards
What does a foreign currency deposit value depend on
(i) the interest rate and
(ii) the expected exchange rate against other currencies.
What is the real rate of return?
measured in some broad representative basket of goods that savers regularly buy
Imagine that an asset increases in nominal value by 10 percent but the price level increases by 15 percent. The real rate of return on the asset is then negative.
What are assets characterized by (List 2)
- Risk
- An asset with a high expected rate of return may be less desirable if the realized rate of
return fluctuates a lot - Liquidity
- savers prefer to save assets that can be easily disposed (stocks)
What does the interest rate offered by dollar deposits of different countries tell us
The interest rates offered by a dollar deposit and a euro deposit tells us how their US dollar and euro values will change in one year.
Considerations when saving in US Dollar or Euro
1. Use today’s dollar/euro exchange rate to find the dollar price of a euro deposit.
- Use the euro interest rate to find the amount of euros you would have in one year if you buy the euro deposit today.
- Use the exchange rate you expect one year from now to calculate the expected dollar value of the deposit in step 2.
- Calculate the expected dollar rate of return on the euro deposit.
- Compare the expected dollar rate of return on the euro deposit with the dollar rate of return on an equal-sized dollar deposit.
Explain the rate of depreciation of dollar against euro
The rate of depreciation of the dollar against the euro is the percentage increase in the dollar/euro exchange rate over for example one year.
How to calculate dollar rate of return on euro deposits
The dollar rate of return on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar against the euro.
= Re(today interest on one year deposit) + percentage increase in dollar/euro exchange rate
Main point is you care about expected rate of return the difference between the dollar and the euro deposit
What is the interest parity condition
Based on the fact that the Foreign exchange market is in equilibrium when deposits of all currencies offer same expected rate of return
Implies that deposits in all currencies are equally desirable
arbitrage in FOREX market not possible
Draw the determination of the equilibrium dollar/euro exchange rate graph
Refer to page 6 of notes
What happens when there is higher interest rate on dollar denominated assets
Cause dollar to appreciate
What happens when there is higher interest rate on euro denominated assets
Cause dollar to depreciate
What is money supply M1
Money supply M1 = total amount of currency and checking deposits held by households and firms.
Who control money supply M1?
Central Bank of country controls money supply. Assume CB can set whatever level of money supply it wants
Effect of interest rate on money demand
a rise in the interest rate causes money demand to fall.
How is money demand affected by interest rate, price level, real national income
The interest rate
An increase in the interest rate makes people want to exchange money for illiquid (interest-bearing) assets, and money demand falls.
The price level
If the price level rises, individual households and firms must spend more money than before to buy the same consumption basket, and money demand rises.
Real national income
When GNP rises, more goods and services are sold in the economy. Real value of transactions increases, and money demand rises given the price level.
How to calculate aggregate money demand
Money demand = price level x aggregate demand of monetary assets
What is the money market equilibrium
Money supply by CB = money demand
M(S)/P = M(D)/P = L(R,Y)
What happens when there is excess demand and supply of money?
If there is excess supply of money, the interest rate falls. If there is excess demand for money, the interest rate rises. An increase in the money supply lowers the interest rate. A decrease in the money supply increases the interest rate.
Draw determination of equilibrium interest rate and increase in money supply graph
refer to page 13 notes
How does the increase in domestic money supply affect domestic currency?
Increase in money supply cause i/r to go down
i/r go down (rate of return) goes down
cause exchange rate currency to depreciate since less dollar return
How does increase in foreign money supply affect domestic currency
Increase in european money supply –> means fall in europe interest rate
therefore lower dollar return on euro deposit
Expected euro return decreases
Whats the difference in the short run and long run
SR: Prices do not have sufficient time to adjust to market conditions
LR: prices of FOP and output have sufficient time to adjust to market conditions
eg. wages adjust to demand and supply of labour
output and income determined by amount of workers and FOP and not quantity of money supplied
How does quantity of money supplied affect output, real interest rate, and aggregate demand of real money assets in the LR?
However what does it affect?
In the long run, the quantity of money supplied is predicted not to influence the amount of output, (real) interest rates, and the aggregate demand of real monetary assets L(R,Y).
However, the quantity of money supplied is predicted to make the level of average prices adjust proportionally in the long run.
Since L(R,Y) does not change, given M(S) change, p needs to move as well
Thus in the long run, direct relationship btw inflation rate (P)
What is inflation rate equal to: also known as the growth rate of the long-run price level
The inflation rate (the growth rate of the long-run price level) is predicted to equal the growth rate in money supply minus the growth rate in real money demand.
If money demand does not change (gL(R,Y) = 0), an increase in the money supply of the country causes a proportional increase in the price level.
gP =gMs −gL(R,Y)
What factors affect inflation?
- Excess demand of goods and services
- a higher quantity of money supplied implies that people have more funds available to pay for goods and services. - Inflationary expectations
- If everyone expects the price level to rise in the future, this expectation will increase the rate of inflation today. - Raw materials prices
- raw materials used in production sold on markets where prices adjust sharply in SR
How does inflation expectations affect foreign exchange markets
A permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency.
However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.
A permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency.
However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.
What is exchange rate overshooting. When does overshooting occur
The exchange rate is said to overshoot when its immediate response to a change is greater than its long run response
Overshooting occur when monetary policy has effect on interest rate but not on prices and expected inflation
What is the law of one price
The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important.
P (pen in sg) = E (SGD?MYR) x P (pen in MY)
What is the purchasing power parity
Purchasing power parity is the application of law of one price across countries for all goods and services for groups of goods and services
Implies that exchange rate is determined by relative prices of goods across countries
E(SGD/MYR) = P(pen in SG)/ P(pen in MY) (known as absolute PPP)
Differences between Absolute and relative PPP
Absolute PPP: Exchange rate equal changes in relative average price
Relative PPP: refers that changes in exchange rates equal to the changes in price between two periods (inflation)
Write out formula of Relative PPP
Refer to page 25 of chapter 10 notes
How to use monetary approach to attain exchange rates
Use formula of absolute ppp:
E($/Eur) = P(US)/P(EU)
Use formula of money supply = money demand
The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries.
How do changes in money supply M(US) affect exchange rate E (US/EUR)
- increase in money supply M(US) cause proportionate increase in US price level P(US)
- cause depreciation in dollar since E(US/EUR) increases
How do interest rates affect Exchange rate
Permanent increase in interest rate lowers aggregate demand.
decrease in aggregate demand cause price to increase in US
cause depreciation of USD since E(US/EUR) goes up
How do increase in output level affect excahnge rate
- increase in output level leads to a rise in US level of production and income
- raise US aggregate demand for assets
-cause decreasing level of average US prices - cause appreciation of USD
What do CB do when it comes to controlling money supply
It is more realistic to think that the central bank chooses a growth rate for the money supply and then allow the money supply to grow gradually.
A change in the money supply results in a change in the level of average prices.
A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation). Continued money supply growth leads to a continuing rise of prices – ongoing inflation.
How is the fisher effect formed?
Since relative PPP holds, can use the interest parity condition together to show that the change in inflation rate can be correlated to the change in interest rate across countries
inflation (US) - Inflation (EU) = R (US) - R (EU)
Definition of the fisher effect
All else equal, a rise in a country’s expected inflation rate will cause an equal rise in the interest rate that deposits of its currency offer.
All else equal, a fall in the domestic expected inflation rate will cause a fall in the domestic interest rate.
What does the fisher effect got to do with depreciation
Start with US increase growth rate of money supply
When US Fed increase growth rate of money supply , this causes an increase in inflation
This results in the depreciation of the USD by the same amount as the growth in the money supply
Characteristics of money market under asset approach in the LR
Changes in the level of money supply lead to changes in the level of average prices.
No inflation is predict to occur in the long run, but only during the transition to the long-run equilibrium.
During the transition, inflation causes the nominal interest rate to increase to its long-run value.
Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition
period.
The level of average prices does not immediately adjust even if expectations of inflation
adjust,
Characteristics of money market under asset approach in the monetary approach
The rate of inflation increases permanently when the growth rate of the money supply increases permanently.
With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate.
Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate.
The level of average prices adjusts with expectations of inflation, ⋆ causing the US dollar to depreciate, but with no overshooting.
Shortcomings of PPP
little empirical support for absolute PPP, prices of identical basket of goods differ across countries
Relative PPP more consistent with data, but also performs poorly to predict exchange rate
Reasons for inaccuracy:
- trade barriers and non-tradeable products
- imperfect competition
- differences in measure of average prices
What is real exchange rate
The real exchange rate is the rate of exchange for goods and services across countries.
In other words, it is the relative value/price/cost of goods and services across countries.
For example, it is the Singapore dollar price of a European group of goods and services relative to the Singapore dollar price of a Singaporean group of goods and services:
What happens when there is a real depreciation of the value of SG products
