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The Goods Market, Money, and Foreign Exchange. The Linkages. Macroeconomic Measures. The national income analysis is generally done in terms of real goods and services. Most economic aggregate measures are more conceptual than real: The real market value of the economy’s output - PowerPoint PPT Presentation
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The Goods Market, Money, and Foreign Exchange
The Linkages
Macroeconomic Measures• The national income analysis is generally
done in terms of real goods and services.• Most economic aggregate measures are
more conceptual than real:• The real market value of the economy’s output• The overall price index • Labor force and employment measures• The interest rate as the price of capital• Money stock• Demand for money
• Often we use proxy indicators to measure macroeconomic aggregates
The Two Dimensions of Macroeconomics: The
“Real” Economy and the Monetary Economy
• The Real Economy and The Goods Market
• The Monetary Economy and the Money Market
• The linkages between the two markets:
The overall price and wage levels
The Interest rate
The foreign exchange rate (through
its impact on BOP)
The Central Role of the Interest Rate
• It plays a central role in the goods market as the price (a determinant) of capital
• It is the price of money in the money market
• It is an important factor in determining the exchange rate, especially in the short run
The linkGiven the price level and the exchange rate:
Y = C + I + G + (X – IMP)
I = I (i) Md = M (i)
IS
i
Q0
M0
i
DM
Money • The story of money: From the commodity money
to the modern fiat money • Stock of money
• Types of money– Notes and coins– Checkable deposits – Near moneys
• Money as an instrument of liquidity (medium of exchange)
• Other functions of money • Money as a form of asset• Real money versus nominal money• Money and the banking system
• How money is created• The central banking system
How does the Fed create money?
Day One
Assets Liabilities
--------------------------------------------------------
FX 100 Currency 200
Govt. bonds 100
Money stock = 200
Day Two
A commercial bank opens: Com Bank
Com Bank Fed
Assets Liabilities Assets Liabilities
------------------------ ------------------------Reserve 50
Net worth 50
FX 100
Govt. Bonds 100
Com B. Res. Dep. 50
Currency 150
Money stock = 150
Day Three: Com. Bank receives deposits.
Com Bank
Assts Lib
--------------------------------
The Fed
Assts Lib
-------------------------------Reserve 150 Deposits 100
Net worth 50
FX 100
Govt bonds 100
Com B Res Dep 150
Currency 50
*Note the ratio between the com. bank’s reserve and its demand deposit. Total money stock = 150
Day Four: Com. Bnk makes a loan.
Com Bank
Assts Lib
-------------------------------
The Fed
Assts Lib
------------------------------------Reserves 150
Loan papers 100
Deposits 200
Net worth 50
FX 100
Govt bonds 100
Com B Res Dep 150
Currency 50
Money stock: 250
Reserve/Deposit ratio: ¾ or 75%
Day Five: Com. Bnk makes more loans
Com Bank
Assts Lib
-------------------------------
The Fed
Assts Lib
------------------------------------Reserves 150
Loan papers 100Loan papers 100
Deposits 300
Net worth 50
FX 100
Govt bonds 100
Com B Res Dep 150
Currency 50
Money stock: 350
Reserve/Deposit ratio: 1/2 or 50%
Day Six: Com. Bnk makes more loans Com Bank
Assts Lib
-------------------------------
The Fed
Assts Lib
------------------------------------Reserves 150
Loan papers 100Loan papers 100Loan papers 450
Deposits 750
Net worth 50
FX 100
Govt bonds 100
Com B Res Dep 150
Currency 50
Money stock: 800 Reserve/Deposit ratio: 1/5 or 20% *Note that a total reserve of $150 lead to the creation of $750’s worth of checkable Deposits.
800800
Reserve Requirements and Money Multiplier
• The reserve requirement ratio: The required ratio between the deposits held by a commercial bank and the sum of its cash reserve and its reserve deposit with the Fed.
• Money multiplier mm= 1/rrr
M = mm(Bank Reserves) + Currency in cir.
The potential increase in the money stock (checkable deposits) resulting from one dollar increase in the com. banks’ reserves.
How does the Fed change the money
stock?
• Open Market Operation• Buying or selling bonds
• FX Market Intervention• Buying or selling FX
• Other methods
Given the currency in circulation,
Δ M = mm (Δ GB + Δ FXR)
The Money Market
• Real money versus nominal money Real Money = L = M/P
• Demand for real money • Transaction demand • Asset demand
LD = L ( Q, i)
• Money stock (supply) The stock money is (exogenously) determined
by monetary authorities.
Money Market Equilibrium
For any given level of output, Q, the money market is in equilibrium if the interest rate is at a level at which the quantity of real money, L, people want to hold is equal to the stock of real money provided by the monetary authorities (the Fed).
Money Market
L0
rMo/Po
LD =L( Q1 , i)
LD =L( Qo , i)
r2
ro
r1
Shifts in LD : Changes in Q Other exogenous changesShifts in real money stock: Changes in M Changes in P
Money Market Equilibrium and the Output Level: The LM Curve
As the out put level changes the demand for real money will change, given the money stock, resulting in changes in the interest rate:
Q LD (Given M/P) i
A positive relationship between Q and equilibrium i: The LM curve
The LM Curve
Q
i i
0 0
LD =L( Q1 , i)
LD =L( Qo , i)
Qo Q1
LMM/Po
Shifts in the LM Curve
Q
i i
0 0
LD =L( Q1 , i)
LD =L( Qo , i)
Qo Q1
LMoMo/Po
M1/Po
LM1
Factors Causing Shifts in the LM Curve • Changes in the real money stock
– Changes in the nominal money stock
• Monetary and FX policies affecting banks reserves: Buying and selling bonds and/or FX
– Changes in the price level
• The price level could be affected by both internal (domestic) and external (foreign) factors.
IS and LM Curves
Q
i
0
LMo
LM1
IS
IS’
Q’ Q
Balance of Payment EquilibriumRecall:
CAB = X (Q*, R) – Imp (Q, R)CAB = CAB ( Q*, Q, R )
KAB = K inflow – K outflowAlso recall:
At parity i = i* + (ef-e)/e or I*+ (ee-e)/e That means direction of the funds would
depend on i, i*, e, ef , ee
So we write:
KAB = KAB (i, i*, e, ef , ee)
+ - + - -
At equilibrium:
CAB ( Q*, Q, R ) = - KAB (i, i*, e, ef , ee)
+ - - + - + - -
Given i*, e, ef , ee , Q*, R
CAB (Q) = - KAB ( i )
As Q increases CAB worsens, for the BOP to be restored the interest rate must increase.
BOP EquilibriumCAB (Q)
KAB (i)
45o
BOP>o
BOP<0
BOP Equilibrium
Q
i
0
BOP
i*, e, ef , ee , Q*, R - + - - + -
Adjustments under Flexible X Rate
Q
i
0
LMo
IS(eo)
Q’ Q
BOP(eo)
BOP(e1)
IS(e1)
(eo) > (e1)
E
E’
The adjustment process:The case of a BOP surplus:
Appreciation of the home currency, e will fall
R will increase Exports will decrease
Imports will increaseIS curve will shift to the left BOP curve will shift to the left
The case of a BOP Deficit:Depreciation of the home currency, e will increase
R will decrease Exports will increase
Imports will decreaseIS curve will shift to the right BOP curve will shift to the right
Adjustments Under A Fixed X Rate Regime
The case of a BOP surplus:To keep the X rate fixed the Fed would have to buy FX. An increase in the money stock
Shift of the LM curve to the rightThe case of a BOP deficit:
To keep the X rate fixed the Fed would have to sell FX. A reduction in the money stock
Shift of the LM curve to the left
Adjustments under a Fixed X Rate
Q
i
0
LMo
IS(e)
Q Q’
BOP(e)
E
E’
LM1
i
i’
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