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Chapter 15 (4)
Money, Interest Rates, and Exchange Rates
◼ Chapter Organization
Money Defined: A Brief Review
Money as a Medium of Exchange
Money as a Unit of Account
Money as a Store of Value
What Is Money?
How the Money Supply Is Determined
The Demand for Money by Individuals
Expected Return
Risk
Liquidity
Aggregate Money Demand
The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
Equilibrium in the Money Market
Interest Rates and the Money Supply
Output and the Interest Rate
The Money Supply and the Exchange Rate in the Short Run
Linking Money, the Interest Rate, and the Exchange Rate
U.S. Money Supply and the Dollar/Euro Exchange Rate
Europe’s Money Supply and the Dollar/Euro Exchange Rate
Money, the Price Level, and the Exchange Rate in the Long Run
Money and Money Prices
The Long-Run Effects of Money Supply Changes
Empirical Evidence on Money Supplies and Price Levels
Money and the Exchange Rate in the Long Run
84 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
Inflation and Exchange Rate Dynamics
Short-Run Price Rigidity versus Long-Run Price Flexibility
Box: Money Supply Growth and Hyperinflation in Zimbabwe
Permanent Money Supply Changes and the Exchange Rate
Exchange Rate Overshooting
Case Study: Can Higher Inflation Lead to Currency Appreciation? The Implications of Inflation
Targeting
Summary
◼ Chapter Overview
This chapter combines the foreign-exchange market model of the previous chapter with an analysis of the
demand for and supply of money to provide a more complete analysis of exchange rate determination in
the short run. The chapter also introduces the concept of the long-run neutrality of money, which allows an
examination of exchange rate dynamics. These elements are brought together at the end of the chapter in a
model of exchange rate overshooting.
The chapter begins by reviewing the roles played by money. Money supply is determined by the central bank;
for a given price level, the central bank’s choice of a nominal money supply determines the real money
supply. An aggregate demand function for real money balances is motivated and presented. Money-market
equilibrium—the equality of real money demand and the supply of real money balances—determines the
equilibrium interest rate.
A familiar diagram portraying money-market equilibrium is combined with the interest rate parity
diagram presented in the previous chapter to give a simple model of monetary influences on exchange
rate determination. The domestic interest rate, determined in the domestic money market, affects the
exchange rate through the interest parity mechanism. Thus, an increase in domestic money supply leads to
a fall in the domestic interest rate. The home currency depreciates until its expected future appreciation is
large enough to equate expected returns on interest-bearing assets denominated in domestic currency and
in foreign currency. A contraction in the money supply leads to an exchange rate appreciation through a
similar argument. Throughout this part of the chapter, the expected future exchange rate is still regarded
as fixed.
The analysis is then extended to incorporate the dynamics of long-run adjustment to monetary changes.
The long run is defined as the equilibrium that would be maintained after all wages and prices fully
adjusted to their market-clearing levels. Thus, the long-run analysis is based on the long-run neutrality
of money: All else being equal, a permanent increase in the money supply affects only the general price
level—and not interest rates, relative prices, or real output—in the long run. Money prices, including,
importantly, the money prices of foreign currencies, move in the long run in proportion to any change in
the money supply’s level. Thus, an increase in the money supply, for example, ultimately results in a
proportional exchange rate depreciation. The link between money supply growth, inflation, and exchange
rates is highlighted with a case study on the recent hyperinflation in Zimbabwe. Rampant money supply
growth led to prices in Zimbabwe doubling nearly every day at the peak of the hyperinflation and only
ended when Zimbabwe legalized the use of foreign currencies for domestic transactions.
The combination of these long-run effects with the short-run static model allows consideration of exchange
rate dynamics. In particular, the long-run results are suggestive of how long-run exchange rate expectations
change after permanent money-supply changes. One dynamic result that emerges from this model is
exchange rate overshooting in response to a change in the money supply. For example, a permanent money-
supply expansion leads to expectations of a proportional long-run currency depreciation. Foreign-exchange
market equilibrium requires an initial depreciation of the currency large enough to equate expected returns
Chapter 15 (4) Money, Interest Rates, and Exchange Rates 85
on foreign and domestic bonds. But because the domestic interest rate falls in the short run, the currency
must actually depreciate beyond (and thus overshoot) its new expected long-run level in the short run to
maintain interest parity. As domestic prices rise and M/P falls, the interest rate returns to its previous level
and the exchange rate falls (appreciates) back to its long-run level, higher than the starting point, but not as
high as the initial reaction.
The chapter concludes with a useful case study that helps bridge the gap between the stylized world of the
model and the real world of central bank policy making where the central bank sets the interest rate rather
than money and news about inflation may change expectations about future money supply changes when
the central bank has committed to a particular level of inflation.
◼ Answers to Textbook Problems
1. A reduction in the home money demand causes interest rates in the home country to fall from Rh,1 to
Rh,2. With no change in expectations, there will be a depreciation of the home currency from E1 to E2
as investors shift their savings into higher-interest-paying foreign assets.
2. Yes, the interest rate and inflation are directly correlated. A country with high inflation generally
tends to have high interest rate. Similarly, the interest rate and money demand are directly correlated.
A higher interest rate lowers the money demand as the borrowing becomes costly. On the other hand,
a lower interest rate increases the money demand. This increases the consumer spending in the
3. Equation 15(4)-4 is Ms/P = L(R, Y). The velocity of money, V = Y/(M/P). Thus, when there is
equilibrium in the money market such that money demand equals money supply, V = Y/L(R, Y). When R
increases, L(R, Y) falls and thus velocity rises. When Y increases, L(R, Y) rises by a smaller amount
86 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
© 2015 Pearson Education Limited
(because the elasticity of aggregate money demand with respect to real output is less than one), and
the fraction Y/L(R, Y) rises. Thus, velocity rises with either an increase in the interest rate or an increase
in income. Because an increase in interest rates as well as an increase in income causes the exchange
rate to appreciate, an increase in velocity is associated with an appreciation of the exchange rate.
4. An increase in domestic real GNP will cause domestic real money demand to rise. This will cause
5. In case of Japan, the real gain in interest rate is = Nominal interest rate – Inflation rate = (12 - 7)% =
5%
6. An increase in interest rate increases the expected return on the rupee deposits, greater than that of
dollar deposits. Holders of dollar deposits therefore try to sell them for rupee deposits. The dollar
On the other hand, when the money supply (rupee) increases, fearing the onset of recession in the
Indian economy the following events occur—first, the initial interest rate in the Indian economy falls
7. a. As we would expect, the price level rises consistently with the increase in the Bolivian money
supply. The long-run price level is defined as P = MS/L(R,Y), so an increase in the money supply
Chapter 15 (4) Money, Interest Rates, and Exchange Rates 87
b. Between April 1984 and July 1985, the price level rose by 22,908 percent, while the exchange rate
increased by 24,662 percent. Over this same period, the money supply increased by 17,434
percent. We should expect the price level and the exchange rate to move by the same proportion,
as the value of the Bolivian peso is determined by its purchasing power (eroded by inflation). As
c. The stabilization plan was effective at reducing the increase in the price level and arresting the
depreciation of the Bolivian peso as supported by the price and exchange rate figures for
September–October 1985. Interestingly, the money supply continued to grow (albeit at a reduced
8. The chart below gives inflation rates since 1980 for New Zealand, Chile, Canada, and Israel:
In every case (as well as for those countries not included in the chart above), inflation is significantly
88 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
9. If an increase in the money supply induces an increase in real output in the short run, then the short-run
resulting shifts lead to a reduction in interest rates from Rh,1 to Rh,2, which is a smaller drop in interest
rates than would have prevailed had real money demand not shifted. (Note that it is possible that interest
rates could have actually increased if the increase in real money demand was proportionately larger
prices rise in the future. This shifts the expected return on foreign assets from
,1
e
f
R
to
,2 .
e
f
R
As a result
of these shifts, the home currency depreciates from E1 to E2. However, the drop in the value of the
home currency is not as severe as it would have been had output not increased (thus limiting the
decrease in interest rates).
In the long run, prices in the home country will rise, shifting real money supply back to its original
level and according to the text of the question, dropping output back to Y1. This will cause interest
rates to rise and, with no change in the expected return on foreign assets, cause the exchange rate to
10. A change in interest rate does not affect the total money supply in the economy. The total money
supply remains constant at a particular time, as it is supplied by the central bank of a country. That is
the reason why the money supply curve is vertical line parallel to Y-axis.
Suppose the initial interest rate is R2, which is higher than the equilibrium R1. At a higher interest
rate the money demand falls short of the money supply. This shows an excess supply of money. With
higher interest rate, people reduce the money holdings and prefer to buy interest bearing assets. As
the money supply is higher, people tend to lend their money to others, with the market dealing at a
Chapter 15 (4) Money, Interest Rates, and Exchange Rates 89
© 2015 Pearson Education Limited
rate continues until the interest rate meets the market clearing level, where the demand for money
becomes equal to the supply.
11. One clear complication that a zero interest rate introduces is that the central bank is “out of ammunition.”
It literally cannot reduce interest rates any further and thus may struggle to respond to additional shocks
that hit the economy over time. The central bank is still not completely powerless; it can print more
12. a. If money adjusts automatically to changes in the price level, then any number of combinations of
b. Yes, a rule such as this one would help anchor the price level and imply there is no longer an
c. A one-time permanent unexpected fall in “u” would imply that R would have to fall until prices
have a chance to rise and balance out the equation. As prices rise, R would return to its initial
level. The story described is essentially identical to that in Figure 15(4)-13. The interest rate
90 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
13. Because Panama uses the US dollar as its currency, we would expect that, all else being equal,
inflation in Panama and that in the United States should be identical. The chart below gives inflation
rates in Panama and the United States over the past 20 years. On one hand, the inflation rates in the
two countries tend to move together, as we would expect because they share the same money supply.
In other words, an increase in the U.S. money supply should cause prices to rise in both Panama and
