EC3343 International Finance

Lecture 4
Money, Interest Rates, and Exchange Rates

1
Recap

Exchange rates can be quoted as units of home currency per

unit of foreign currency.
• Currency becomes more valuable → appreciation
• Currency becomes less valuable → depreciation

2
Recap
Interest Parity Condition: in equilibrium, expected rates of
return of home and foreign currency deposits are equal
𝟏
𝟏+𝑹= 𝟏 + 𝑹′ 𝑬𝒆
𝑬
Rate of return on home
𝑬
deposit, 𝑹

Expected rate of return (ROR) on

𝟏 1+𝑅 ′ 𝐸 𝑒
𝑬𝟏 foreign deposit, −1
𝐸

𝑹
𝑹𝟏 3
Learning Outcomes

1. Learn how monetary policy affects exchange rate

• using a model of real monetary assets, interest rates and
exchange rates

2. Learn about exchange rate overshooting

3. Explain the impossible trinity

4
Part 1

Money market

• Definition of money

• Supply and demand of money

• Money market equilibrium and equilibrium interest rate

5
We decided today to lower the
target for the federal funds rate by
¼ percentage point to a range of 2
percent to 2¼ percent. The outlook
for the U.S. economy remains
favorable, and this action is designed
to support that outlook. It is intended
to insure against downside risks from
weak global growth and trade policy
uncertainty, to help offset the effects
these factors are currently having on
the economy, and to promote a
faster return of inflation to our Jerome Powell
symmetric 2 percent objective. Chair of the Board of
Governors of the Federal
Reserve System
Press Conference, July 31, 2019
https://www.federalreserve.gov/mediacent
er/files/FOMCpresconf20190731.pdf
6
Based on our regular economic
and monetary analyses, we
decided to keep the key ECB
interest rates unchanged. We
expect them to remain at their Mario Draghi
present or lower levels at least President of the ECB
Press Conference, July 25, 2019
through the first half of 2020, https://www.ecb.europa.eu/press/pressconf/
and in any case for as long as 2019/html/ecb.is190725~547f29c369.en.html

necessary to ensure the

continued sustained convergence
of inflation to our aim over the
medium term.

7
What Is Money?
Money is:
• Medium of exchange
• Unit of account
• Store of wealth

Money has narrow and broad definitions:

• M0: currency in circulation
• M1: currency + checkable deposits
• M2: currency + checkable deposits + saving deposits

8
Money Supply

Central banks (CB) control the quantity of money that

circulates in an economy.

• Directly regulates the amount of currency in circulation

• Indirectly influences the amount of checking deposits,

debit card accounts, and other monetary assets.

• Conventional monetary policy: open market operations,

required reserved ratio

• Unconventional monetary policy: quantitative easing (QE)

9
Money Demand

Money demand is the amount of money that people are

willing to hold.

Factors that influence money demand:

• Interest rates:
• Higher interest rate → higher opportunity cost of holding money
→ lower demand of money
• Price level:
• Higher price → greater need for liquidity to buy the same
amount of goods and services → higher demand of money
• Income level:
• Higher income → higher demand for goods and services and
higher need for liquidity → higher demand of money

10
Money Demand
The nominal demand of money is:

𝑴𝒅 = 𝑷 × 𝑳(𝑹, 𝒀)

The real demand of money is:

𝑴𝒅
= 𝑳 𝑹, 𝒀
𝑷
where:
𝑷 is price level
𝒀 is national income
𝑹 is interest rate (assume no inflation: real = nominal)
11
Money Demand

𝑴𝒅
= 𝑳 𝑹, 𝒀
Interest rate 𝑹 𝑷
(−)(+)

The downward-sloping
curve shows that for a given
real income level 𝑌, real
money demand falls as the
interest rate rises.

𝑳 𝑹, 𝒀

Real money demand/supply

12
Money Demand Higher income
→ higher demand for transactions
→ higher need for liquidity
→ higher demand of money.
Interest rate 𝑹
Higher income 𝑌

𝑳 𝑹, 𝒀𝟐
𝑳 𝑹, 𝒀𝟏

Real money demand/supply

13
Money Market Equilibrium

Money market is in equilibrium if nominal money supply

equates nominal money demand:

𝑴𝒔 = 𝑴𝒅

In real term:

𝑴𝒔
= 𝑳(𝑹, 𝒀)
𝑷

14
Money Market Equilibrium
At money market equilibrium, the interest rate R is the
market-clearing price
Interest rate 𝑹

𝑴𝒅
= 𝑳 𝑹, 𝒀
𝑷

𝑴𝑠 Real money demand/supply

𝑷

15
Change in Money Market Equilibrium

Two common factors that change the equilibrium interest rate:

Nominal money supply 𝑴𝒔 ;
Output / income 𝒀.

16
Increase in Money Supply 𝑴𝒔
An increase in money supply leads to a decline in the interest rate.

Interest rate 𝑹 Increase in money supply 𝑀 𝑠

𝑹𝟏

𝑹𝟐
𝑳 𝑹, 𝒀

𝑴𝒔𝟏 𝑴𝒔𝟐 Real money demand/supply

𝑷 𝑷

17
Increase in Income 𝒀
An increase in income leads to a rise in the interest rate.
Interest rate 𝑹

𝑹𝟐 Increase in income 𝑌

𝑹𝟏 𝑳 𝑹, 𝒀𝟐

𝑳 𝑹, 𝒀𝟏

𝑴𝑠 Real money demand/supply

𝑷

18
How CB conduct Monetary Policy?

In most developed economies, central bank does not directly

target the money supply. Rather, central bank targets the
interest rate.

Central bank buys or sells government bonds, a process called

the open market operation (OMO), to achieve the desired
level of interest rate:
CB buys bonds to lower the interest rate;
CB sells bonds to raise the interest rate.

19 19
Part 2

Interest rate and exchange rate in the short run

• A model of money market and foreign exchange market

• Effect of money supply on exchange rate

20
Equilibriums in Money Market and Forex Market

In the short run, 𝑷 and 𝒀 are given.

Money market and foreign exchange market are linked via the
interest rate.

𝑴𝒔 𝑹′ + 𝟏 𝑬𝒆
= 𝑳 𝑹, 𝒀 𝑹= −𝟏
𝑷 𝑬

Money Market Foreign Exchange Market

Where 𝑹′ is foreign interest rate, 𝑬𝒆 is expected exchange rate.

21
Money Market and Foreign Exchange Market

22
 Money Market and Forex Market
𝑬 Forex market Money market
𝑹

𝑹𝟏
𝑬𝟏

𝑹𝑶𝑹 𝑳(𝑹, 𝒀)
𝑹
𝑹𝟏 𝑴𝒔 Real money
𝑷 holding

Forex market: Money market:

𝑹′ + 𝟏 𝑬𝒆 𝑴𝒔
𝑹= −𝟏 = 𝑳 𝑹, 𝒀
𝑬 𝑷
Exchange rate clears the market. Interest rate clears the market.
23
 Money Market and Forex Market
𝑬

Forex market:
𝑹′ + 𝟏 𝑬𝒆
Forex market

𝑹= −𝟏
𝑬
𝑬𝟏
Exchange rate clears
𝑹𝑶𝑹
the market.
𝑹
𝑹𝟏
𝑳(𝑹, 𝒀)
Money market

Money market:
𝑴𝒔 𝑴𝒔
= 𝑳 𝑹, 𝒀
𝑷 𝑷
Interest rate clears the
Real money
market.
holding
24
 Increase in Domestic Money Supply
𝑬
Domestic Domestic money market:
interest rate 1. Increase in domestic money
𝑹↓ supply
𝑬𝟐 2. Real money supply exceeds
demand
𝑬𝟏 3. Domestic interest rate drops

Forex market:
𝑹𝑶𝑹
1. Lower rate of return on
𝑹 domestic currency deposits
𝑹𝟐 𝑹𝟏
𝑳(𝑹, 𝒀) 2. Reduced demand for domestic
currency
𝑴𝒔𝟏 3. Domestic currency less valuable
𝑷 4. Domestic currency depreciates
𝑴𝒔𝟐 5. Exchange rate rises

𝑷 Domesic Foreign money market:

money 1. No change
Real money
supply 𝑴𝒔 ↑
holding 25
 Increase in Foreign Money Supply
𝑬
Foreign money market:
1. Increase in foreign money
Foreign supply
𝑬𝟏 interest 2. Real money supply exceeds
rate 𝑹′ ↓ demand
3. Foreign Interest rate drops
𝑬𝟐
𝑹𝑶𝑹𝟏 Forex market
𝑹𝑶𝑹𝟐 1. Lower rate of return on foreign
currency deposits
𝑹 2. Higher demand for domestic
𝑹𝟏
𝑳(𝑹, 𝒀) currency
3. Domestic currency more
valuable
𝑴𝒔 4. Domestic currency appreciates
𝑷 5. Exchange rate falls

Domestic money market:

1. No change
Real money
holding 26
Money Market and the Foreign Exchange Market

The link between the money market and the foreign exchange
market:
• The increase of domestic money supply → lower domestic
interest rate → domestic currency depreciation;
• The increase of foreign money supply → lower foreign
interest rate → domestic currency appreciation → no
change in domestic money market;

Two assumptions:
• Short run – price rigidity
• Flexible exchange rate

27 27
Part 3

Interest rate and exchange rate in the long run

• Key difference between the short run and long run

• Increase of money supply on exchange rate in the long
run
• Exchange rate overshooting

28
Short Run vs. Long Run

In the short run, general price level is sticky.

• Our analysis so far has been short-run analysis.

In the long run, general price level adjusts proportionally to

changes in money supply.
• Money is neutral in the long run.

In the long run, increase in nominal money supply cannot

change the real income 𝒀, real interest rates 𝑹, nor real
money demand 𝑳(𝑹, 𝒀).

29
 Money Growth Rate and Inflation

Source: World Bank development indicators database and own calculations. Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP..
Chart: Figure 4.10 of adopted text, International Finance: Theory and Policy, Global Edition, 11th Edition, Krugman et al. (2018). 30
Exchange Rate Overshoot

When investors consider price adjustment in the long run,

expectation on future inflation will have an effect in the forex
market.
• A permanent increase in money supply → higher price
in the long run → currency depreciation in the long run
(purchasing power parity (PPP), next class)

Expectation of inflation and currency depreciation takes effect

immediately, even though general price level adjusts slowly.

31
Exchange Rate Overshoot

In the short run, a permanent increase in money supply leads

to:
• Decrease in interest rate and depreciation of domestic
currency;
• Expected inflation in the future price level
• Expected depreciation in future exchange rate (self-
fulfilling prophecy);
• Further depreciation of domestic currency
(overshooting).

In the long run, real interest rate returns to original level, and
exchange rate adjusts from short-run overshooting.

32
Short Run vs. Long Run
𝑬 𝑬

𝟑 𝑬𝟑
𝑬𝟑 𝟑
𝑬𝒆 ↑ 𝟒
𝑬𝟒
𝑬𝟐 𝟐
𝑬𝟏 𝟏 𝑹𝑶𝑹𝟐 𝑹𝑶𝑹𝟐
𝑹𝑶𝑹𝟏
𝑹 𝑹
𝑹𝟐 𝑹𝟏 𝑹𝟐 𝑹𝟏
𝑳(𝑹, 𝒀) 𝑳(𝑹, 𝒀)
𝑴𝒔𝟏 𝑴𝒔𝟐
𝑷𝟏 𝑷𝟐
𝑴𝒔𝟐 𝑴𝒔𝟐
𝑷𝟏 𝑷𝟏
𝑴𝒔 ↑ 𝑷↑
Short-run equilibrium: Long-run equilibrium:
point 3 point 4 33
Dynamics after Increase in Money Supply
Money supply 𝑴𝒔 Interest rate 𝑹

𝒕𝟎 Time 𝒕 𝒕𝟎 Time 𝒕
Price level 𝑷 Exchange rate 𝑬

𝒕𝟎 Time 𝒕 𝒕𝟎 Time 𝒕
34
Exchange Rate Overshoot

The exchange rate is said to overshoot when the

immediate/short-run response is greater than its long-run
response.
• A permanent increase in domestic money supply
reduces interest rate and depreciates exchange rate in
the short run;
• Investors expect long-run price increase (inflation) will
cause long-run depreciation of domestic currency.
• Expected depreciation leads to further depreciation in
the short run.
• Short-run depreciation is larger than long-run
depreciation.

Overshooting helps to explain why exchange rates are volatile.

35
Exchange Rate Overshoot

• The exchange rate is said to overshoot when the

immediate/short-run response is greater than its long-run
response.

• Exchange rate overshoots because people changes their

expectation on future exchange rate;

• Any permanent policy changes may lead to change in

expectation and thus exchange rate overshooting.

36
Exchange Rate Volatility vs. Price Stickiness

Source: Price levels from International Monetary Fund, International Financial Statistics
Chart: Figure 4.11 of adopted text, International Finance: Theory and Policy, Global Edition, 11th Edition, Krugman et al. (2018). 37
Impossible Trinity

• How is monetary policy applied in real life?

• Some countries target interest rate:
• United States, EU, UK, Japan;
• Some countries target exchange rate:
• Singapore, Hong Kong;

• Why not target both interest rate and exchange rate?

• Impossible Trinity

38
Impossible Trinity

If a country has free capital mobility, it cannot target interest

rate and exchange rate at the same time.

𝑹′ + 𝟏 𝑬𝒆
𝑹= −𝟏
𝑬
either interest rate or exchange rate

Impossible Trinity: impossible to achieve more than two goals:

1. Free capital mobility
2. Monetary autonomy
3. Exchange rate management
39
Active Learning: Impossible Trinity
Interest Parity Condition:

𝑹′ + 𝟏 𝑬𝒆
𝑹= −𝟏
𝑬

“Pick one side of the triangle”:

1. China,
2. Hong Kong,
3. Japan,
4. Singapore,
5. United States.

40
Case Study: Singapore’s Monetary Policy
For most countries, monetary policy is managed by targeting
interest rate.
In Singapore, monetary policy is managed by targeting
exchange rate via a managed float regime.
• That is, the exchange rate is set against a basket of
currencies, and maintained within an undisclosed target
band.
In the context of Singapore's open capital account, “the
choice of the exchange rate as the intermediate target of
monetary policy implies that MAS gives up control over
domestic interest rates and money supply.”
MAS, 2001

41
Case Study: Singapore’s Monetary Policy

The MAS manages SGD against a trade-weighted basket of

currencies of Singapore’s major trading partners. We refer to
the SGD exchange rate as the nominal effective exchange rate
(NEER):

𝑹𝑩 + 𝟏 𝑬𝒆
𝑹𝑺𝑮 = −𝟏
𝑬
where 𝑹𝑩 denotes trade-weighted interest rate, and 𝐸 and 𝑬𝒆
denote trade-weighed exchange rate against a basket of
currencies of Singapore’s trading partners.

42
Case Study: Singapore’s Monetary Policy
US and Singapore interest rates are highly correlated.

43
APR 14, 2016 44
SOURCE: https://www.straitstimes.com/business/mas-monetary-policy-shift-whats-the-significance
Case Study: Singapore’s Monetary Policy
Change in S$NEER and MAS Core Inflation
(Q1 1991–Q2 2018)

Source: https://www.mas.gov.sg/monetary-policy/Singapores-Monetary-Policy-
Framework/faqs/section-4
45
 Case Study: Singapore’s Monetary Policy
Effect of changes in S$NEER on Macro Variables

Source: https://www.mas.gov.sg/-/media/MAS/Monetary-Policy-and-Economics/Monetary-
Policy/MP-Framework/StaffPaper37SEANZAexratev.pdf
46
APR 14, 2016
SOURCE: https://www.straitstimes.com/business/mas-monetary-policy-shift-whats-the-significance
47
Case Study: Singapore’s Monetary Policy

http://www.mas.gov.sg/~/media/resource/publications/macro_review/2017/April%202017/MRapr17_Chap4.pdf

48
Summary
Money market and foreign exchange market:

𝑴𝑺 𝑹′ + 𝟏 𝑬𝒆
= 𝑳 𝑹, 𝒀 and 𝑹 = −𝟏
𝑷 𝑬
An increase in the domestic money supply:
• In the short run, the general price level is sticky;
• Lower domestic interest rates and depreciation of
domestic currency;
• Exchange rate overshooting;
• In the long run, price adjusts proportionally,
• Real terms are unaffected.

Impossible Trinity

49