Analysis a news article and summary. You need to make connection with provided concepts.

The assignment is intended to focus your attention on the financial press as it relates to investments. A good analysis will summarize the story and show how the reported phenomenon conforms to the theory or diverges from what the theory predicts. You are encouraged to introduce material from other sources where you feel this will help the class to put the story into proper context.Please try to make connection with money market equilibrium in the short run; increase in money demand’s effect of curve; money market equilibrium in the short run;increase in money demand. You don’t need to connect with all, just choose one or two that you think are most connect with.(Or you think easier to explain and also has some connection with article.)Here is a Power Point about those concepts that helps you understand better.
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Section 3
The Money Market
1
Content
•
•
•
•
•
•
•
•
Objectives
A Definition of Money
The Demand for Money
The Money Market Equilibrium
The Exchange Rate in the Short Run
The Exchange Rate in the Long Run
Exchange Rate Dynamics
Summary
2
Objectives
• To know the roles of money.
• To know how to determine the money market
equilibrium.
• To know how to relate the money market to
exchange rates via the foreign exchange market
and the uncovered interest parity condition.
• To understand exchange rate overshooting.
3
A Definition of Money
• Money
– Commodity money versus fiat money
– Assets widely used and accepted as a means of
payment.
– Money is very liquid, but pays little or no return.
4
A Definition of Money
• The roles of money
– Unit of Account
• A widely recognized measure of value.
• If N goods, there are N(N-1)/2 prices. But, if one of those
goods is the unit of account, need to know only (N-1) prices.
– Store of Value
• Transfer wealth or purchasing power through time.
• Money is dominated in returns.
– Medium of Exchange
• A generally accepted means of payment.
• The double coincidence of wants.
5
A Definition of Money
• Money Supply
– An economy’s money supply is controlled by its central
bank.
– Money Supply: Currency + Checkable Deposits
• The value of Money
– Commodity money: The marginal cost of producing the
money.
– Fiat money: The inverse of the price level (1/P)
6
The Demand for Money
• Factors that affect money demand:
– Expected Return
• The interest rate measures the opportunity cost of
holding money rather than interest-bearing bonds.
• A rise in the interest rate raises the cost of holding
money and causes money demand to fall
7
The Demand for Money
– Risk
• Holding money is risky.
• An unexpected increase in the prices of goods and
services could reduce the value of money in terms of
the commodities consumed.
• Changes in the riskiness of money causes an equal
change in the riskiness of bonds.
8
The Demand for Money
– Liquidity
• The main benefit of holding money comes from its
liquidity.
• Households and firms hold money because it is an
accepted medium of exchange.
• A rise in the average value of transactions carried
out by a household or firm causes its demand for
money to rise.
9
The Demand for Money
• The aggregate demand for money is
M ? PL(i, Y )
d
P is the price level
Y is real national income
L(i,Y) is the aggregate real money demand
– A rise in i lowers real money demand.
– A rise in Y raises real money demand
10
The Demand for Money
i
L(i,Y)
M/P
11
The Demand for Money
A rise in real income
i
L(i,Y)
L(i,Y)
M/P
12
The Money Market Equilibrium
• The supply of money is: Ms = M
• The equilibrium in the money market requires:
Ms = Md
• The money market equilibrium condition can be
expressed in terms of aggregate real money
demand as:
M/P = L(i,Y)
13
The Money Market Equilibrium
i
i
Md/P = L(i,Y)
Ms/P
M/P
14
The Money Market Equilibrium
• For a given level of output and price, an increase
in the money supply reduces the interest rate.
• Open market operations.
– To raise the stock of money, the central bank purchases
government bonds on the open market.
– This raises the price of bonds q.
– This lowers interest rates, because (1+i) = 1/q.
15
The Money Market Equilibrium
An rise in M, fixing P and Y
i
i
i
L(i,Y)
M
P
M
P
M/P
16
The Money Market Equilibrium
• For a given level of money and price, an increase
in real output raises the interest rate.
17
The Money Market Equilibrium
An rise in Y, fixing P and M
i
i
i
L(i,Y)
L(i,Y)
M
P
M/P
18
The Money Market Equilibrium
• For the remainder of this section.
– Prices are sticky: They are fixed in the very
short run, but perfectly flexible in the long run.
– Real output is constant in the very short run,
and at constant at its full employment level in
the long run.
19
The Exchange Rate in the Short Run
• The U.S. money market determines the USD
interest rate i.
• The Foreign (Canadian) money market determines
the CAD interest rate i*.
• The, interest parity condition links interest rates
and exchange rate.
• Thus, home and foreign monetary policy affect
both interest rates and exchange rate.
20
The Exchange Rate in the Short Run
• U.S. Money Market: M/P = L(i,Y)
• Canadian Money Market: M*/P* = L(i*,Y*)
• Foreign Exchange Market (via UIP):
i = i* + (Se – S)/S
where S is the price of the CAD.
• For now, we abstract from changes abroad.
21
The Exchange Rate in the Short Run
S
Foreign
exchange
market
S
i* + (Se– S)/S
0
Money
market
i
L(i, Y)
USD
Returns
M/P
M/P
22
The Exchange Rate in the Short Run
• Home monetary policy
– In the short run, an increase in USD money
supply reduces the USD interest rate.
– A fall in USD interest rate causes the USD to
depreciate in the foreign exchange market.
23
The Exchange Rate in the Short Run
S
A rise in M, fixing P, Y, and i*
S2
S1
i* + (Se-S)/S
0
i2
i1
L(i, Y)
USD Rates
of return
M1/P
M2/P
M/P
24
The Exchange Rate in the Short Run
• Foreign monetary policy
– An increase in foreign money supply reduces
foreign interest rates i*.
– A reduction in foreign interest rates causes an
appreciation of the USD on the foreign
exchange market (a fall in S).
25
The Exchange Rate in the Short Run
A rise in M*, fixing P, Y, and M
S
S1
S2
i* + (Se-S)/S
0
L(i, Y)
USD Rates of
return
M
P
M/P
26
The Exchange Rate in the Long Run
• The Long-run equilibrium
– Prices are perfectly flexible and adjust to
maintain output at full employment.
– The money market equilibrium yields the long
run price level:
P = M/L(i,Y)
– An increase in money supply causes a
proportional increase in prices.
27
The Exchange Rate in the Long Run
• The Long-Run Effects of Monetary Policy
– Monetary policy is neutral in the long run: It has no
effect on the long-run values of the interest rate or
output.
– In the long run, a permanent increase in money causes a
proportional increase in prices: p ? ?P/P = ?M/M
– In the long-run, inflation is a monetary phenomenon:
The inflation rate equals the growth rate of money.
28
The Exchange Rate in the Long Run
• Empirically, long-run changes in money supply
and price levels are positively correlated.
• A permanent increase in a USD money supply
causes a proportional long-run depreciation of the
USD against foreign currencies.
– Purchasing Power Parity: P = SP*
– An increase in the supply of a good reduces its price!
29
The Exchange Rate in the Long Run
30
Exchange Rate Dynamics
• Sticky or rigid prices:
– In the very short-run, prices are fixed.
– In the long-run, prices are perfectly flexible.
– Prices adjust slowly to their long-run
equilibrium.
– Asset prices react much more rapidly than
goods prices to economic events.
31
Exchange Rate Dynamics
• The effects of a permanent increase in USD
money supply.
– In the short-run, prices are fixed and output constant.
The rise in M reduces i, which causes a depreciation of
the USD against foreign currencies (a rise in S).
– In the long-run prices are flexible and output at full
employment. The rise in M does not affect i, but cause
a depreciation of the USD (a rise in S).
32
Exchange Rate Dynamics
A permanent rise in M
S
S
S2
S2
S3
S1
S3
I* +
0
M1
i2
i1
I* + (Se-S)/S
(Se-S)/S
USD Rates
of return
L(i, Y)
0
M2
P1
P2
M2
P1
M2
P1
i2
i1
L(i, Y)
(b) long-run effects
(a) Short-run effects
M/P
USD Rates
of return
M/P
33
Exchange Rate Dynamics
M
Time Paths of US Variables
M2
i1
M1
i2
t0
i
t
P
t0
t
t0
t
S
S2
P2
S3
P1
S1
t0
t
34
Exchange Rate Dynamics
• Exchange Rate Overshooting
– In the very short run, the exchange rate overshoots its
long run value.
– This occurs because American investors expect an of
the USD (depreciation of foreign currency).
– This appreciation is required for the equilibrium in the
foreign exchange market. That is, the foreign rate of
returns i* + (Se – S)/S must fall to mimic the fall in
USD returns i.
35
Exchange Rate Dynamics
• Exchange Rate Overshooting
– The overshooting behavior is a direct result of
sticky prices and the uncovered interest parity
condition.
– Overshooting helps explain the large observed
volatility of exchange rates.
36
Summary
• Aggregate money demand: Md = PL(i,Y), where
Li<0 and LY>0.
• Aggregate money supply: Ms = M
• The money market equilibrium: Md = Ms
• An increase in money supply reduces interest
rates, and cause a depreciation of the home
currency against foreign currencies.
37
Summary
• Permanent changes in the money supply are
neutral in the long run:
– They do not affect output and interest rates in
the long run.
– The generate a proportional rise in prices in the
long run.
• A permanent increase in the money supply causes
the exchange rate to overshoot its long-run level in
the short run.
38

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