Transcript Money

Money
Econ 7920/Chatterjee
3/28/2016
1

Serves as
◦ Medium of exchange
◦ Store of value
◦ Unit of account

Helps measure “opportunity cost”

Types of Money: “Fiat” and “Commodity”
Econ 7920/Chatterjee
3/28/2016
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
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
Econ 7920/Chatterjee
3/28/2016
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
Changes in the quantity of money affect
◦ Interest Rates: affect incentives to save and invest
◦ Exchange Rates: affect exports,
international financial transactions
imports,
and
◦ Price Level: creates inflation/deflation; affects spending
decisions

How does money affect these variables?
Econ 7920/Chatterjee
3/28/2016
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
Think in terms of demand and supply

Demand for Money: households, firms, financial
institutions, government, and foreigners

Supply of Money: Central Bank
◦ Examples: Federal Reserve, European Central Bank, etc.

When money supply changes, what happens to its
three prices?
Econ 7920/Chatterjee
3/28/2016
5
symbol assets included
C
amount
($ billions)
Currency
$739
M1
C + demand deposits,
travelers’ checks,
other checkable deposits
$1391
M2
M1 + small time deposits,
savings deposits,
money market mutual funds,
money market deposit accounts
$6799

Would you like to receive $100 today or a year
from now?

The interest rate is the “opportunity cost” of
holding money today

When money supply increases, short-term interest
rates fall (why?)
Econ 7920/Chatterjee
3/28/2016
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
How does the Federal Reserve alter the quantity of money in
the economy?

Three tools of Monetary Policy:
◦ Discount Rate: The rate at which commercial banks can
borrow from the Fed
◦ Reserve Requirement: The fraction of each deposit a bank
must maintain as reserves (not to be lent)
◦ Federal Funds Rate: The interest rate commercial banks
charge each other for overnight loans (guaranteed by
deposits at the Fed)  benchmark nominal interest rate in the
economy
Econ 7920/Chatterjee
3/28/2016
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
The Fed usually targets the Federal Funds Rate
through its Open Market Operations

Open Market Purchase: The Fed buys government
bonds and other financial assets  injects cash
into the economy (money supply increases)

Open Market Sale: The Fed sells government
bonds and other financial assets  withdraws
cash from the economy (money supply falls)
Econ 7920/Chatterjee
3/28/2016
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
How many units of a foreign currency can one unit of the
Home currency buy?

The US-Euro exchange rate: 0.7 Euros/$ (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
Econ 7920/Chatterjee
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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/$
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Exchange Rate Depreciation: a unit of the home
currency can buy fewer units of a foreign currency

Exchange Rate Appreciation: 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
Econ 7920/Chatterjee
3/28/2016
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
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 appreciate its exchange rate

When money supply increases, short-term exchange
rates tend to depreciate (why?)
Econ 7920/Chatterjee
3/28/2016
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
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  inflation

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
Econ 7920/Chatterjee
3/28/2016
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15%
12%
Over the long run, the inflation and
money growth rates move together,
M2 growth
as the quantity
theory rate
predicts.
9%
6%
3%
0%
1960 1965
inflation
rate
1970 1975
1980 1985
1990 1995
2000 2005
100
Inflation rate
Turkey
Ecuador
Indonesia
(percent,
logarithmic scale)
Belarus
10
1
Argentina
U.S.
Singapore
Switzerland
0.1
1
International data on inflation and money
growth, 1996-2004
10
100
Money Supply Growth
(percent, logarithmic scale)
Increase in Money Supply
Reduces
interest
rates

Depreciates
exchange rate
Creates
inflation
The ultimate (long-run) effect on the economy is
determined by the interaction of these three
factors
Econ 7920/Chatterjee
3/28/2016
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percent
per year
15
nominal
interest rate
10
5
0
inflation rate
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Nominal 100
Interest Rate
Romania
(percent,
logarithmic scale)
Zimbabwe
Brazil
10
Bulgaria
Israel
U.S.
Germany
Switzerland
1
0.1
1
10
100
1000
Inflation Rate
(percent, logarithmic scale)

“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.
Econ 7920/Chatterjee
3/28/2016
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
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 = $1000
◦ Real GDP = 100 units of output

Nominal GDP doubled, but real GDP remained unchanged: is the
country richer or better off?
Econ 7920/Chatterjee
3/28/2016
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
A country’s well-being is determined by changes in
its real GDP and not nominal GDP

Economic Growth: percentage change in real GDP
over time

Real GDP = Nominal GDP/Price level
 GDP deflator (Price Level)
= Nominal GDP/Real GDP
Econ 7920/Chatterjee
3/28/2016
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
“Real” interest rate = Nominal interest rate – Rate of
inflation

The real interest rate is determined by the demand for
investment and the supply of savings

Nominal interest rate = real interest rate + rate of
inflation

Positive relationship between nominal interest rates and
inflation
Econ 7920/Chatterjee
3/28/2016
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
Nominal Interest Rates tend to rise with inflation
as creditors care about their command over future
output (i.e., they care about the “real” interest
rate)

An increase in money supply may reduce shortterm interest rates, but by increasing inflationary
expectations, can lead to an increase in the longterm interest rate.
Econ 7920/Chatterjee
3/28/2016
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
Real exchange rates track changes in the value of
goods across countries after adjusting for inflation

Example:
◦ Suppose US-Mexico exchange rate is 1 Peso/$ today
◦ A shirt in the US costs $1, and in Mexico it costs 0.80
Pesos
◦ So, shirts are cheaper in Mexico relative to the US
◦ Americans will choose to buy Mexican shirts
Econ 7920/Chatterjee
3/28/2016
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
Now, suppose the US-Mexico exchange rate falls
by 25%
◦ The new exchange rate is: 0.75 Pesos/$
◦ 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

Lesson: an exchange rate depreciation improves
the trade balance
Econ 7920/Chatterjee
3/28/2016
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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

Lesson: 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
Econ 7920/Chatterjee
3/28/2016
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
% 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
Econ 7920/Chatterjee
3/28/2016
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
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
Econ 7920/Chatterjee
3/28/2016
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U.S. Cents per Mexican Peso
35
30
25
20
15
10
7/10/94
8/29/94
10/18/94
12/7/94
1/26/95
3/17/95
5/6/95
U.S. Cents per Mexican Peso
35
30
25
20
15
10
7/10/94
8/29/94
10/18/94
12/7/94
1/26/95
3/17/95
5/6/95

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:
◦ 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
Econ 7920/Chatterjee
3/28/2016
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
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
During 1994, Mexico’s central bank hid the
fact that its reserves were being depleted.
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



Dec. 20, 1994: Mexico devalues the peso by
13% (fixes the Pesoat 25 cents instead of 29 cents
per $)
Investors are SHOCKED! – they had no idea
Mexico was running out of reserves.
Investors 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