Chapter 10: Building Blocks Money Market and Foreign Exchange Rate

Question 1

What does a foreign currency deposit value depend on

Answer 1

(i) the interest rate and

(ii) the expected exchange rate against other currencies.

Question 2

What is the real rate of return?

Answer 2

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.

Question 3

What are assets characterized by (List 2)

Answer 3

1. Risk
   - An asset with a high expected rate of return may be less desirable if the realized rate of
   return fluctuates a lot
2. Liquidity
   - savers prefer to save assets that can be easily disposed (stocks)

Question 4

What does the interest rate offered by dollar deposits of different countries tell us

Answer 4

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.

Question 5

Considerations when saving in US Dollar or Euro

Answer 5

􏰀 1. Use today’s dollar/euro exchange rate to find the dollar price of a euro deposit.

2. Use the euro interest rate to find the amount of euros you would have in one year if you buy the euro deposit today.
3. Use the exchange rate you expect one year from now to calculate the expected dollar value of the deposit in step 2.
4. Calculate the expected dollar rate of return on the euro deposit.
5. Compare the expected dollar rate of return on the euro deposit with the dollar rate of return on an equal-sized dollar deposit.

Question 6

Explain the rate of depreciation of dollar against euro

Answer 6

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.

Question 7

How to calculate dollar rate of return on euro deposits

Answer 7

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

Question 8

What is the interest parity condition

Answer 8

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

Question 9

Draw the determination of the equilibrium dollar/euro exchange rate graph

Answer 9

Refer to page 6 of notes

Question 10

What happens when there is higher interest rate on dollar denominated assets

Answer 10

Cause dollar to appreciate

Question 11

What happens when there is higher interest rate on euro denominated assets

Answer 11

Cause dollar to depreciate

Question 12

What is money supply M1

Answer 12

Money supply M1 = total amount of currency and checking deposits held by households and firms.

Question 13

Who control money supply M1?

Answer 13

Central Bank of country controls money supply. Assume CB can set whatever level of money supply it wants

Question 14

Effect of interest rate on money demand

Answer 14

a rise in the interest rate causes money demand to fall.

Question 15

How is money demand affected by interest rate, price level, real national income

Answer 15

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.

Question 16

How to calculate aggregate money demand

Answer 16

Money demand = price level x aggregate demand of monetary assets

Question 17

What is the money market equilibrium

Answer 17

Money supply by CB = money demand

M(S)/P = M(D)/P = L(R,Y)

Question 18

What happens when there is excess demand and supply of money?

Answer 18

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.

Question 19

Draw determination of equilibrium interest rate and increase in money supply graph

Answer 19

refer to page 13 notes

Question 20

How does the increase in domestic money supply affect domestic currency?

Answer 20

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

Question 21

How does increase in foreign money supply affect domestic currency

Answer 21

Increase in european money supply –> means fall in europe interest rate

therefore lower dollar return on euro deposit

Expected euro return decreases

Question 22

Whats the difference in the short run and long run

Answer 22

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

Question 23

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?

Answer 23

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)

Question 24

What is inflation rate equal to: also known as the growth rate of the long-run price level

Answer 24

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)

Question 25

What factors affect inflation?

Answer 25

1. 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.
2. Inflationary expectations
   - If everyone expects the price level to rise in the future, this expectation will increase the rate of inflation today.
3. Raw materials prices
   - raw materials used in production sold on markets where prices adjust sharply in SR

Question 26

How does inflation expectations affect foreign exchange markets

Answer 26

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.

Question 27

What is exchange rate overshooting. When does overshooting occur

Answer 27

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

Question 28

What is the law of one price

Answer 28

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)

Question 29

What is the purchasing power parity

Answer 29

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)

Question 30

Differences between Absolute and relative PPP

Answer 30

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)

Question 31

Write out formula of Relative PPP

Answer 31

Refer to page 25 of chapter 10 notes

Question 32

How to use monetary approach to attain exchange rates

Answer 32

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.

Question 33

How do changes in money supply M(US) affect exchange rate E (US/EUR)

Answer 33

• increase in money supply M(US) cause proportionate increase in US price level P(US)
• cause depreciation in dollar since E(US/EUR) increases

Question 34

How do interest rates affect Exchange rate

Answer 34

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

Question 35

How do increase in output level affect excahnge rate

Answer 35

• 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

Question 36

What do CB do when it comes to controlling money supply

Answer 36

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.

Question 37

How is the fisher effect formed?

Answer 37

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)

Question 38

Definition of the fisher effect

Answer 38

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.

Question 39

What does the fisher effect got to do with depreciation

Start with US increase growth rate of money supply

Answer 39

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

Question 40

Characteristics of money market under asset approach in the LR

Answer 40

􏰀 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,

Question 41

Characteristics of money market under asset approach in the monetary approach

Answer 41

􏰀 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.

Question 42

Shortcomings of PPP

Answer 42

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

Question 43

What is real exchange rate

Answer 43

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:

Question 44

What happens when there is a real depreciation of the value of SG products