Quiz 15: Money, Interest Rates, and Exchange Rates


To trace the short-run and long-run effects of a reduction in the aggregate real money demand on the exchange rate, interest rate, and price level, one must link the money market to the foreign exchange market. The money market establishes the equilibrium interest rate by satisfying the condition: img Or img (Real money supply)= img (Real money demand)Alternatively, img = img . On the other hand, the foreign exchange rate equilibrium is established by the interest parity condition between the domestic currency and the foreign currency. The simultaneous equilibrium in the money market and exchange market is shown below: img Both asset markets are in equilibrium at the interest rate R 1 and exchange rate E 1 ; at these values, real money supply equals real money demand (point 1')and the interest parity condition holds (point 1)Now, when aggregate real money demand reduces, it shifts the real money demand schedule towards the left from L 1 to L 2. In the short run, a decrease in the real money demand will push the interest rate down from R 1 to R 2 ; also the price level, which will have immediate repercussions in the exchange market. In an open economy, where interest parity between countries must be preserved, the exchange rate will increase (currency depreciation)to create the expectation that it will fall faster in the future. It should be noted that, the depreciation of the currency would depend on whether the contraction in money demand is deemed permanent or temporary. If the reduction in money demand is temporary, the currency will depreciate from E 1 to E 2 and if the reduction is permanent, it will depreciate to E 3. However, in the long run, there is a permanent reduction in money demand. As a result, the price level rises so that real money supply adjusts to become img in order to match the fall in real money demand, making the interest rate equal to its initial value. In addition, the domestic currency will depreciate as exchange rate moves to E 4 in proportion to the fall in real money demand. To sum up, a reduction in the aggregate real money demand will lead to a new equilibrium point 2' in the money market, simultaneous short run equilibrium at point 2, and long run equilibrium at point 3 in the foreign exchange market.

Aggregate money demand refers to the total of all expenditures in the economy (which equals the GDP). Several factors cause changes in the aggregate money demand. One of the important factors that influence aggregate money demand is the population of the country. If a country's population falls, various components of expenditure falls. A reducing population will have low consumption expenditure. Therefore, aggregate money demand falls. Now, if the fall in population is due to a fall in the number of households, the reducing effect on the aggregate money demand will be more. It reveals the fact that, there is a direct relationship between trends in population and consumption expenditures; thus with the aggregate money demand. However, if the fall in population is due to the fall in the size of the average household, the reducing effect on the aggregate money demand will be less. A fall in the size of the average household implies the variation in the composition of a household; that is a household consists of more middle aged people and older people whose marginal propensity ( MPC )to consume is higher and fewer children whose MPC is low. Moreover, such a small size of average household does not reduce the income level of the household and thus cannot affect the consumption expenditure. Therefore, a fall in the number of households affects the aggregate money demand more than the fall in the size of the average household.

Velocity of money refers to the number of times that a unit of money spent on the total value of goods and services produced per year. It is defined as the ratio of real GNP to real money holdings and is given as: img …… (1)Now, equation (15-4)of the chapter is as follows: img …… (2)Substituting the value for img in equation (1), we can derive an expression for velocity as img …… (3)The money demand is negatively correlated with the interest rate, an increase in interest rate will increase the opportunity cost of holding money. Thus, aggregate demand for money img falls. It is revealed from the above expression that; velocity and interest rate move in the same direction. An increase in the value of R will result in a decrease in the value for liquidity preference img and thus an increase in the velocity of money. An increase in the value of Y , will result in a smaller increase in the value of liquidity preference; img . The increase in img is small because the elasticity of aggregate money demand is less than one; with respect to real output. Thus, an increase in Y , results in an increase in the fraction img . The value of velocity V increases, with an increase in interest rate or with an increase in income. Since the increase in velocity is associated with an increase in income as well as an increase in interest rates; the increase in velocity is said to be associated with an appreciation of the exchange rate. Now, to recall, according to interest parity condition, an increase in interest rate leads to fall in the exchange rate; that is the domestic currency will appreciate. As an increase in interest rate causes the money velocity to increase as per the equation (3)and since that increase in interest rate causes exchange rate to fall, an increase in money velocity will cause exchange rate to fall; that is appreciation of the domestic currency. Therefore, the relationship between velocity of money and the exchange rate is inverse i.e. greater is the velocity of money, lower is the exchange rate; resulting in the appreciation of the currency.