Money, Interest Rates And Exchange Rate Determination

Question 1

What is money supply?

Answer 1

• quantity of money that circulates in an economy and is determined by the CB

Question 2

What is money demand?

Answer 2

• represents amount of monetary assets that people are willing to hold instead of illiquid assets

Question 3

What affect do interest rates have on money demand ?

Answer 3

• the interest rate is the opportunity cost of holding monetary assets
• an increase in the interest rate increases this opportunity cost and decreases the demand for real monetary assets
• individuals wish to hold more illiquid assets

Question 4

What affect do prices have on real money demand?

Answer 4

• higher prices lean more money is required for transaction of goods and services
• so higher level of average prices increases real money demand

Question 5

What affect does income have on real money demand?

Answer 5

• greater income implies more purchases of goods and services
• higher GNP increases need for liquidity, leading to higher demand of money

Question 6

Describe the real money demand curve?

Answer 6

• downward sloping
• as interest rate falls real money demand rises

Question 7

What affect does an increase in income have on the real money demand curve?

Answer 7

• increased income increased the demand for real monetary assets
• shifts the money demand schedule up

Question 8

Describe money market equilibrium

Answer 8

• money market is in equilibrium when money demand = money supply

Question 9

What happens on the money market when money supply is increased by the CB?

Answer 9

• real money supply increases
• shifting money supply like eight wards
• now an excess demand for bonds
• excess supply of money
• price of bonds increases
• interest rate falls until money supply = money demand

Question 10

What happens in the money market when there is an increase in real income?

Answer 10

• increase in real income increases production lending more money is required for transactions
• demand schedule shifts up
• excess demand for money
• excess supply of bonds
• price of binds falls
• interest rate increases until MS=MD once again

Question 11

What happens in the money market and foreign exchange market when there is a temp. Increase in the MS in the home country?

Answer 11

Money market
- increase in the MS increases real money supply shifting MS line rightward
- excess supply of money
- excess demand for bonds
- bond price increases
- interest rate falls

Foreign exchange market
- decrease in the domestic interest rate shifts the RH leftward
- return on domestic assets decreases
- demand for the home currency decreases
- demand of foreign currency increases
- home currency depreciates
- foreign currency appreciates
- exchange rate rises until new equilibrium is reached

Question 12

What happens in the money market and foreign exchange market when there is a temporary increase in the MS in the foreign country?

Answer 12

Money market at home is unaffected
Foreign Exchange market
- by increasing the Ms abroad the return on foreign assets falls
- RF curve shifts down
- demand for the home currency increases
- supply of foreign currency increases
- home currency appreciates
- foreign currency depreciates
- E falls

Question 13

Describe assumptions for LR analysis

Answer 13

• prices are flexible
• everything in real terms is unchanged by Ms changes
• inflationary expectations will have effect in foreign exchange markets

Question 14

In what 3 ways does a MS change cause prices of output and inputs to change?

Answer 14

1. Excess demand of goods and services
2. Inflationary expectations
3. Price of raw materials

Question 15

Describe the effects in the short-run of a permanent increase in the Ms of the home country (money and foreign exchange markets)

Answer 15

Money market
- MS line shifts down
- there is now excess supply of money in the economy
- excess demand for bonds
- bond prices increases
- interest rate falls

Foreign exchange market
- interest rate falls which means the rate of return on domestic assets also falls
- RH line shifts inwards
- demand for home currency falls
- demand for foreign currency increases
- foreign currency appreciates
- home currency depreciates
- E rises

At some point we expect prices to inc. (proportionately) to increase in MS
- domestic goods and services become less competitive
- we expect home currency to depreciate
- meaning we expect E to increase
- leasing our expectations of the return abroad to increase
- foreign return curve shifts up
- the two shifts result in new equilibrium

Question 16

Describe the effect of a permanent increase in the Ms in the home country in the long run

Answer 16

Money market
- in the LR prices increase proportionately to MS
- real money supply is unaffected in the LR hence real money supply returns to original level

Foreign Exchange Market
- as Ms falls back to original level we now have excess demand for money
- excess supply of bonds
- price of bonds falls
- interest rate rises and returns to original level
- return on domestic assets increases
- demand for home currency increases
- supply of foreign currency increases
- home currency appreciates
- foreign currency depreciates
- E falls until new equilibrium reached

Question 17

When does the exchange rate overshoot?

Answer 17

• when it’s immediate response to change is greater than it’s LR response
• overshooting helps explain why exchange rates are so volatile

Question 18

What main difference do we note in the SR between a temp. And permanent increase in the Ms?

Answer 18

• exchange rate is much higher in the SR if we consider flexible prices in the LR