Money 5/23/20151Econ 7920/Chatterjee. Serves as ◦ Medium of exchange ◦ Store of value ◦ Unit...

Money

04/18/23 1Econ 7920/Chatterjee

Serves as ◦Medium of exchange◦Store of value◦Unit of account

Helps measure “opportunity cost”

Types of Money: “Fiat” and “Commodity”

04/18/23Econ 7920/Chatterjee 2

Interest Rate: ◦ Opportunity cost of holding money◦ “Price” of money relative to time

Exchange Rate:◦ Price of one currency relative to another◦ “Price” of money relative to other foreign currencies

Aggregate Price Level:◦ Average “value” of all goods and services produced◦ “Price” of money relative to goods and services


Changes in the quantity of money affect

◦ Interest RatesInterest Rates: affect incentives to save and invest

◦ Exchange RatesExchange Rates: affect exports, imports, and international financial transactions

◦ Price LevelPrice Level: creates inflation/deflation; affects spending decisions

How does money affect these variables?04/18/23Econ 7920/Chatterjee 4

Think in terms of demand and supply

Demand for MoneyDemand for Money: households, firms, financial institutions, government, and foreigners

Supply of MoneySupply of Money: Central Bank◦ Examples: Federal Reserve, European Central Bank, etc.

When money supply changes, what happens to its three prices?


$6799

M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

M2

$1391C + demand deposits, travelers’ checks, other checkable deposits

M1

$739CurrencyC

amount ($ billions)

assets includedsymbol

Would you like to receive $100 today or a year from now?

The interest rate is the “opportunity cost” of holding money today

When money supply increases, short-term interest rates fall (why?)


How does the Federal Reserve alter the quantity of money in the economy?

Three tools of Monetary Policy:◦ Discount RateDiscount Rate: The rate at which commercial banks

can borrow from the Fed◦ Reserve RequirementReserve Requirement: The fraction of each deposit

a bank must maintain as reserves (not to be lent)◦ Federal Funds RateFederal Funds Rate: The interest rate commercial

banks charge each other for overnight loans (guaranteed by deposits at the Fed) benchmark nominal interest rate in the economy


The Fed usually targets the Federal Funds Rate through its Open Market Operations

Open Market Purchase: Open Market Purchase: The Fed buys government bonds and other financial assets injects cash into the economy (money supply increases)

Open Market Sale:Open Market Sale: The Fed sells government bonds and other financial assets withdraws cash from the economy (money supply falls)


How many units of a foreign currency can one unit of the Home currency buy?

The US-Euro exchange rate: 0.7 Euros/$ (09/05/2008)

Example: What does it mean when ◦ the exchange rate falls to 0.6 Euros/$◦ the exchange rate rises to 0.8 Euros/$

Understanding “depreciation” and “appreciation” of an exchange rate


Country July 14, 2006 Sept 5, 2008

Euro 0.79 Euro/$ 0.70 Euro/$

Japan 116.3 Yen/$ 107.75 Yen/$

Mexico 11.0 Pesos/$ 10.46 Pesos/$

Russia 27.0 Rubles/$ 25.48 Rubles/$

South Africa 7.2 Rand/$ 7.99 Rand/$

U.K. 0.54 Pounds/$ 0.57 Pounds/$

Exchange Rate DepreciationDepreciation: a unit of the home currency can buy fewer units of a foreign currency

Exchange Rate AppreciationAppreciation: a unit of the home currency can buy more units of a foreign currency

If the US dollar has depreciated against the Euro, then the Euro has appreciated against the dollar


Consequences of a currency depreciation:◦Domestic (Home) goods are cheaper to the rest

of the world exports increase◦Foreign goods are expensive at Home imports

decrease

Anything that increases the demand for a country’s currency (money) will appreciateappreciate its exchange rate

When money supply increases, short-term exchange rates tend to depreciatedepreciate (why?)


An increase in money supply higher spending on goods and services increase in aggregate demand

If supply of goods and services cannot meet up with demand excess demand is created higher prices to clear markets inflationinflation

In general, an increase in money supply creates inflation

Countries that have high growth rates of money supply also tend to have higher rates of inflation


0%

3%

6%

9%

12%

15%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

M2 growth rate

inflation rate

Over the long run, the inflation and money growth rates move together,

as the quantity theory predicts.

Over the long run, the inflation and money growth rates move together,

as the quantity theory predicts.

0.1

1

10

100

1 10 100Money Supply Growth (percent, logarithmic scale)

Inflation rate (percent,

logarithmic scale)

0.1

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10

100

1 10 100Money Supply Growth (percent, logarithmic scale)

Inflation rate (percent,

logarithmic scale)

Singapore

U.S.

Switzerland

Argentina

Indonesia

Turkey

BelarusEcuador

International data on inflation and money growth, 1996-2004

Increase in Money Supply

The ultimate (long-run) effect on the economy is determined by the interaction of these three factors


Reduces interest rates

Depreciates exchange rate

Creates inflation

percent per year

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0

5

10

15

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

inflation rate

nominal interest rate

1

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0.1 1 10 100 1000

Inflation Rate (percent, logarithmic scale)

Nominal Interest Rate

(percent, logarithmic scale)

1

10

100

0.1 1 10 100 1000

Inflation Rate (percent, logarithmic scale)

Nominal Interest Rate

(percent, logarithmic scale)

Switzerland

Germany

Brazil

Romania

Zimbabwe

Bulgaria

U.S.

Israel

“Nominal” variables: measured in monetary units

◦ Examples: “dollar” value of GDP, wages and salaries, market interest rates and exchange rates

“Real” variables: measured in physical units

◦ Examples: above variables adjusted for prices and/or inflation Physical output produced (real GDP), wages adjusted for the price level (real wage), etc.


A country produces 100 units of output in 2006, at a price level of $5 per unit of output. ◦ Nominal GDP = 100 x 5 = $500◦ Real GDP = 100 units of output

In 2007, the country produced 100 units of output, but prices doubled to $10 per unit.◦ Nominal GDP = 100 x 10 = $1000◦ Real GDP = 100 units of output

Nominal GDP doubled, but real GDP remained unchanged: is the country richer or better off?


A country’s well-being is determined by changes in its real GDP real GDP and not nominal GDP

Economic Growth: percentage change in real GDP over time

Real GDP = Nominal GDP/Price level GDP deflator (Price Level)

= Nominal GDP/Real GDP


“Real” interest rate = Nominal interest rate – Rate of inflation

The real interest rate is determined by the demand for investment and the supply of savings

Nominal interest rate = real interest rate + rate of inflation

Positive relationship between nominal interest rates and inflation


Nominal Interest Rates tend to rise with inflation as creditors care about their command over future output (i.e., they care about the “real” interest rate)

An increase in money supply may reduce short-term interest rates, but by increasing inflationary expectations, can lead to an increase in the long-term interest rate.


Real exchange rates track changes in the value of goods across countries after adjusting for inflation

Example: ◦Suppose US-Mexico exchange rate is 1 Peso/$

today◦A shirt in the US costs $1, and in Mexico it costs

0.80 Pesos◦So, shirts are cheaper in Mexico relative to the US◦Americans will choose to buy Mexican shirts


Now, suppose the US-Mexico exchange rate falls by 25%◦ The new exchange rate is: 0.75 Pesos/$◦ The US currency has depreciated against the Peso◦ If prices remain constant, then the $1 shirt in the US will

cost 0.75 Pesos to Mexicans◦ The 0.80 Pesos Mexican shirt would now cost $1.07 to

Americans (=0.8/0.75)◦ American shirts cheaper to Mexicans, and Mexican

shirts more expensive for Americans◦ US exports to Mexico rise, but imports fall US trade

balance improves LessonLesson: an exchange rate depreciation

improves the trade balance


Let’s complicate things…Let’s complicate things… Next year, US inflation rose from 0 to 30%,

while in Mexico, prices remained stable.◦ So, the $1 shirt in the US now costs $1.30 ◦ The $1.30 shirt in the US will cost 0.98 Pesos to Mexicans

(=1.30 x 0.75)◦ To Americans, the cost of a Mexican shirt is still $1.07

(=0.80/0.75)◦ Mexican shirts now cheaper than American shirts◦ American exports decrease and imports increase US trade

balance worsens LessonLesson: it’s just not enough to compare changes in

“nominal” exchange rates when comparing goods prices one must keep track of inflation rates across countries too


% in real exchange rate = % in nominal exchange rate – (inflation rate in foreign – inflation rate at home)

In our example: though the US nominal exchange rate depreciated, its real exchange rate (relative to the Peso) appreciated

Inflation differential across countries (if large enough) can offset the effects of a nominal depreciation of the exchange rate


If a country is experiencing a rapid growth in money supply, then

◦Nominal exchange rates can depreciate

◦But inflation can cause a real exchange rate appreciation

◦Eventually, exports can fall and imports rise worsening of the trade balance


10

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7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95

U.S

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U.S. goods suddenly more expensive to Mexicans◦U.S. firms lost revenue◦Hundreds of bankruptcies along U.S.-Mexican

border

Mexican assets worth less in dollars◦Reduced wealth of millions of U.S. citizens as

there was substantial US investment in Mexican assets (through mutual funds, pension funds, 401 k’s, etc…)

In the early 1990s, Mexico was an attractive place for foreign investment:

◦ Mexican interest rates were high promise of higher returns on investment

◦ Mexican Central Bank maintained and had committed to a fixed exchange rate against the dollar

◦ This made returns from foreign investment very stable

◦ There were large capital inflows into Mexico in the early 1990’s, including a substantial portion from the US

The high interest rate in Mexico reflected inherent risk:risk:◦ During 1994, political developments made Mexico a risky place

to invest (peasant uprising in the Chiapas and assassination of leading presidential candidate)

◦ Capital outflows started as early as December 1993, but the information was concealed by the Central Bank

Mexican inflation rate was much higher than the US rate◦ The Federal Reserve raised U.S. interest rates several times

during 1994 to prevent U.S. inflation Though the Mexican nominal exchange rate was fixed,

there was substantial real exchange rate appreciation of the Peso

Maintaining the peg became increasingly difficult for the Mexican Central Bank


These events put downward pressure on the peso

Mexico’s central bank had repeatedly promised

foreign investors that it would not allow the peso’s value to fall, so it bought pesos and sold dollars to “prop up” the peso exchange rate

Doing this requires that Mexico’s central bank have adequate reserves of dollars Did it?

December 1993 ……………… $28 billion

August 17, 1994 ……………… $17 billion

December 1, 1994 …………… $ 9 billion

December 15, 1994 ………… $ 7 billion

December 1993 ……………… $28 billion

August 17, 1994 ……………… $17 billion

December 1, 1994 …………… $ 9 billion

December 15, 1994 ………… $ 7 billion

During 1994, Mexico’s central bank hid the fact that its reserves were being depleted.

Dec. 20, 1994: Mexico devalues the peso by 13% (fixes the Peso at 25 cents instead of 29 cents per $)

Investors are SHOCKED!SHOCKED! – they had nono idea Mexico was running out of reserves.

nvestors start dumping Mexican assets, pulling their capital out of Mexico.

Dec. 22, 1994: central bank’s reserves nearly gone. It abandons the fixed rate and lets the Peso float.

Within a week, the Peso falls another 30%.

1995: U.S. & IMF set up $50b line of credit to provide loan guarantees to Mexico’s govt.

This helped restore confidence in Mexico, and reduced the risk premium on their interest rate.

After a hard recession in 1995, Mexico began a strong recovery from the crisis (also helped by NAFTA)

Moral of the Story: Had investors paid attention to the Peso’s real exchange rate, they could have saved millions of dollars

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Money 5/23/20151Econ 7920/Chatterjee. Serves as ◦ Medium of exchange ◦ Store of value ◦ Unit...

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