Chapter 15 - Money, Interest Rates and Exchange Rates Flashcards
What is the purpose of financial markets in our model? Which two assets will be in our model of financial markets?
One purpose of financial markets is to allow agents to diversify risk. 1) Money - riskless and highly liquid, and can be used to make payments. 2) The other is risky and cannot be used to make payments, but pays a return in exchange for the risk.
What different groups of assets may be classified as money? (3)
1) Currency in circulation. 2) Checking deposits. 3) Debit card accounts.
Give one downside and one upside of illiquid assets. Give 4 examples of illiquid assets.
Downside: Require substantial transaction costs in terms of time, effort, or fees to convert them to funds for payment. Upside: They generally earn a higher interest rate of return than monetary assets. 1) Loans 2) Deposits of currency in the foreign exchange markets. 3) Stocks 4) Real estate
What is the key economic variable controlled by the central bank? What are the two main function of the Bank of England?
The central bank substantially controls the quantity of money that circulates in an economy, the money supply. Denoted by Ms. In the UK, the Bank of England regulates currency, the money in circulation and determines the interest rates.
What is used to construct a model of foreign exchange markets? (2)
1) Demand (rate of return on) dollar denominated deposits. 2) The demand (rate of return on) foreign currency denominated deposits.
When is the model of foreign exchange markets in equilibrium? What does interest parity imply? (2)
The model of foreign exchange markets is in equilibrium when deposits of all currencies have the same expected rate of return: interest parity. 1) Interest parity implies that deposits of all currencies are equally desirable assets. 2) Interest parity implies that arbitrage in the foreign exchange market is not possible.
How can exchange rates be defined? If we adopt the convention of $/£ what does an appreciation of the dollar involve?
Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. How much can be exchanged for £1? $1.4/£ How much can exchanged for $1? £0.71/$ We will adopt the convention of $/£. Therefore, an appreciation (depreciation) of the $ involves a decrease (increase) in the number of $/£.
What would it take for an individual to be indifferent between investing in a dollar denominated asset and a pound denominated asset?
The expected rate of return from holding either one must be equal to the other. In a well functioning foreign exchange market, any differences in returns will be arbitraged away, leading to ‘interest parity’.
What would be the effect of a permanent increase or decrease in a country’s money supply?
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.
How does a change in the money supply cause the prices of output and inputs to change?
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) To meet high demand, producers hire more workers, creating a strong demand of labor services, or make existing employees work harder. 3) Wages rise to attract more workers or to compensate workers for overtime. 4) Prices of output will eventually rise to compensate for higher costs.
What is the aggregate demand for moeny equation?
Show graphically, the relationship between money demand and the interest rate.
Show graphically, the effect of an increase in income on aggregate rela money demand.
Derive the model of the money market.
Show graphically the determination of the equilibrium interest rate.
Show graphically, the effect of an increase in income on the equilibrum interest rate.
What is the difference in the rate of return on dollar deposits and euro deposits?
Show graphically, the determination of the equilibrium dollar/euro exchange rate.
Show graphically, the effect of a rise in the dollar interest rate on the equilibrium exchange rate.
Show graphically, the simulataneous equilibrium in the US money market and the foreign exchange market.
Show graphically, the effect of an increase in the US money supply on the simulataneous equilibrium in the US money market and the foreign exchange market.
Show graphically, the effect of an increase in EU money supply on the simulataneous equilibrium in the US money market and the foreign exchange market.
Show graphically, the short run and long run effects of an increase in US money supply, given output, on the simulataneous equilibrium in the US moeny market and the foreign exchange market.
Show graphically, the time paths of U.S. economic variables after a permanent increase in the U.S. money supply.
