EQUILIBRIUM IN MONEY,

EXCHANGE RATE &

THEORY
 EQUILIBRIUM IN MONEY MARKET

• Money market is the interaction among institutions through which money is

supplied to individuals, firms, and other institutions that demand money.

• Money market equilibrium occurs at the interest rate at which the quantity of
money demanded is equal to the quantity of money supplied.
 EQUATION OF EXCHANGE
Quantity theory of money
- this theory indicates that the quantity of money available determines the
price level and the growth rate in the quantity of money determines the
inflation rate.
- When the money supply changes by a certain level, the price level changes
by the same percentage.

MV=PQ
• Where M = money supply; V = velocity of circulation; P = price level of
goods and services; and Q = quantity of goods and services
 The equation starts off with the fact that MV= GDP and PQ= GDP; then
MV = PQ.
 EQUILIBRIUM IN THE FOREIGN EXCHANGE MARKET
Foreign exchange market
• is like any other market insofar as something is being bought and sold.
However, the foreign exchange market is unique in two ways:
1. A currency is being bought and sold, rather than a good or service
2. The currency being bought and sold is being bought with a different
currency.
 

The equilibrium exchange rate is the interaction of the supply of a

currency and the demand for a currency
• As in any market, the foreign exchange market will be in equilibrium when
the quantity supplied of a currency is equal to the quantity demanded of a
currency. If the market has a surplus or a shortage, the exchange rate will
adjust until an equilibrium is achieved.
 BALANCE OF PAYMENTS
• also known as balance of international payments, summarizes all transactions that a country's
individuals, companies, and government bodies complete with individuals, companies, and government
bodies outside the country.

• these transactions consist of imports and exports of goods, services, and capital, as well as transfer
payments, such as foreign aid and remittances.

The balance of payments divides transactions in two accounts: 

 
 CURRENT ACCOUNT. The current account includes transactions in goods, services, investment
income, and current transfer. 

 CAPITAL ACCOUNT. Sometimes the capital account is called the financial account, with a separate,
usually very small, capital account listed separately. The capital account, broadly defined, includes
transactions in financial instruments and central bank reserves. Narrowly defined, it includes only
transactions in financial instruments.
 The current account is included in calculations of national output, while the capital account is not. 
 EXCHANGE RATE
• the value of one nation's currency versus the currency of another nation or economic zone.

Exchange rates can be fixed or floating

• A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the
official exchange rate. A set price will be determined against a major world currency (usually
the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of
currencies). In order to maintain the local exchange rate, the central bank buys and sells its
own currency on the foreign exchange market in return for the currency to which it is pegged.

• A floating exchange rate is determined by the private market through supply and demand. A
floating rate is often termed "self-correcting," as any differences in supply and demand will
automatically be corrected in the market. Look at this simplified model: if demand for a
currency is low, its value will decrease, thus making imported goods more expensive and
stimulating demand for local goods and services. This, in turn, will generate more jobs, causing
an auto-correction in the market. A floating exchange rate is constantly changing.
 PURCHASING POWER THEORY

• is the value of a currency expressed in terms of the amount

of goods or services that one unit of money can buy.

• it is important because, all else being

equal, inflation decreases the amount of goods or services
you would be able to purchase.