Chapter14Money, Interest Rates, and Exchange Rates73

Chapter14

Money, Interest Rates, and Exchange Rates

.1

nAnswers to Textbook Problems

1.

Areductioninrealmoneydemandhasthesameeffectsasanincreaseinthenominalmoneysupply.
Infigure14.1,thereductioninmoneydemandisdepictedasabackwardshiftinthemoneydemand
schedulefromL1toL2.TheimmediateeffectofthisisadepreciationoftheexchangeratefromE 1to
E2,ifthereductioninmoneydemandistemporary,oradepreciationtoE 3ifthereductionis
permanent.Thelargerimpacteffectofapermanentreductioninmoneydemandarisesbecausethis
changealsoaffectsthefutureexchangerateexpectedintheforeignexchangemarket.Inthelongrun,
thepricelevelrisestobringtherealmoneysupplyintolinewithrealmoneydemand,leavingall
relativeprices,output,andthenominalinterestratethesameanddepreciatingthedomesticcurrency
inproportiontothefallinrealmoneydemand.Thelongrunlevelofrealbalancesis(M/P 2),alevel
wheretheinterestrateinthelongrunequalsitsinitialvalue.Thedynamicsofadjustmenttoa
permanentreductioninmoneydemandarefromtheinitialpoint1inthediagram,wherethe
exchangerateisE1,immediatelytopoint2,wheretheexchangerateisE3andthen,asthepricelevel
fallsovertime,tothenewlongrunpositionatpoint3,withanexchangerateofE 4.

2.

Afallinacountryspopulationwouldreducemoneydemand,allelseequal,sinceasmaller
populationwouldundertakefewertransactionsandthusdemandlessmoney.Thiseffectwould
probablybemorepronouncedifthefallinthepopulationwereduetoafallinthenumberof
householdsratherthanafallintheaveragesizeofahouseholdsinceafallintheaveragesizeof
householdsimpliesapopulationdeclineduetofewerchildrenwhohavearelativelysmall
transactionsdemandformoneycomparedtoadults.Theeffectontheaggregatemoneydemand
functiondependsuponnochangeinincomecommensuratewiththechangeinpopulationelse,the
changeinincomewouldserveasaproxyforthechangeinpopulationwithnoeffectonthe
aggregatemoneydemandfunction.

74Krugman/ObstfeldInternationalEconomics:TheoryandPolicy,SeventhEdition

E
2

E3

E2
E4
E1

I2
I1
R

(M/P2)
(M/P1)
L2
Figure14.1

L1

Chapter14Money, Interest Rates, and Exchange Rates75

3.

Equation144isM /PL(R,Y).Thevelocityofmoney,VY/(M/P).Thus,whenthereis
equilibriuminthemoneymarketsuchthatmoneydemandequalsmoneysupply,VY/L(R,Y).
WhenRincreases,L(R,Y)fallsandthusvelocityrises.WhenYincreases,L(R,Y)risesbyasmaller
amount(sincetheelasticityofaggregatemoneydemandwithrespecttorealoutputislessthanone)
andthefractionY/L(R,Y)rises.Thus,velocityriseswitheitheranincreaseintheinterestrateoran
increaseinincome.Sinceanincreaseininterestratesaswellasanincreaseinincomecausethe
exchangeratetoappreciate,anincreaseinvelocityisassociatedwithanappreciationoftheexchange
rate.

4.

AnincreaseindomesticrealGNPincreasesthedemandformoneyatanynominalinterestrate.This
isreflectedinfigure14.2asanoutwardshiftinthemoneydemandfunctionfromL 1toL2.Theeffect
ofthisistoraisedomesticinterestratesfromR 1toR2andtocauseanappreciationofthedomestic
currencyfromE1toE2.

5.

Justasmoneysimplifieseconomiccalculationswithinacountry,useofavehiclecurrencyfor
internationaltransactionsreducescalculationcosts.Moreimportantly,themorecurrenciesusedin
trade,thecloserthetradebecomestobarter,sincesomeonewhoreceivespaymentinacurrencyshe
doesnotneedmustthensellitforacurrencysheneeds.Thisprocessismuchlesscostlywhenthere
isareadymarketinwhichanynonvehiclecurrencycanbetradedagainstthevehiclecurrency,which
thenfulfillstheroleofagenerallyacceptedmediumofexchange.

E
E1
Interest Parity Schedule

E2
R1

R2

(M/P)

L1

L2

M/P
Figure14.2
6.

Currencyreformsareofteninstitutedinconjunctionwithotherpolicieswhichattempttobringdown
therateofinflation.Theremaybeapsychologicaleffectofintroducinganewcurrencyatthe
momentofaneconomicpolicyregimechange,aneffectthatallowsgovernmentstobeginwitha
cleanslateandmakespeoplereconsidertheirexpectationsconcerninginflation.Experienceshows,
however,thatsuchpsychologicaleffectscannotmakeastabilizationplansucceedifitisnotbacked
upbyconcretepoliciestoreducemonetarygrowth.

76Krugman/ObstfeldInternationalEconomics:TheoryandPolicy,SeventhEdition

7.

Theinterestrateatthebeginningandattheendofthisexperimentareequal.Theratioofmoneyto
prices(thelevelofrealbalances)mustbehigherwhenfullemploymentisrestoredthanintheinitial
statewherethereisunemployment:themoneymarketequilibriumconditioncanbesatisfiedonly
withahigherlevelofrealbalancesifGNPishigher.Thus,thepricelevelrises,butbylessthan
twiceitsoriginallevel.Iftheinterestratewereinitiallybelowitslongrunlevel,thefinalresultwill
beonewithhigherGNPandhigherinterestrates.Here,thefinallevelofrealbalancesmaybehigher
orlowerthantheinitiallevel,andwecannotunambiguouslystatewhetherthepricelevelhasmore
thandoubled,lessthandoubled,orexactlydoubled.

8.

The19841985moneysupplygrowthratewas12.4percentintheUnitedStates(100% *(641.0
570.3)/570.3)and334.8percentinBrazil(100%*(106.124.4)/24.4).Theinflationrateinthe
UnitedStatesduringthisperiodwas3.5percentandinBraziltheinflationratewas222.6percent.
ThechangeinrealmoneybalancesintheUnitedStateswasapproximately12.4%3.5%8.9%,
whilethechangeinrealmoneybalancesinBrazilwasapproximately334.8%222.6%112.2%.
ThesmallchangeintheU.S.pricelevelrelativetothechangeinitsmoneysupplyascomparedto
BrazilmaybeduetogreatershortrunpricestickinessintheUnitedStates;thechangeintheprice
levelintheUnitedStatesrepresents28percentofthechangeinthemoneysupply((3.5/12.4) *
100%)whileinBrazilthisfigureis66percent((222.6/334.8) *100%).Thereare,however,large
differencesbetweenthemoneysupplygrowthandthegrowthofthepricelevelinbothcountries,
whichcastsdoubtonthehypothesisofmoneyneutralityintheshortrunforbothcountries.

9.

Velocityisdefinedasrealincomedividedbyrealbalancesor,equivalently,nominalincomedivided
bynominalmoneybalances(VP*Y/M).VelocityinBrazilin1985was13.4(1418/106.1)while
velocityintheUnitedStateswas6.3(4010/641).Thesedifferencesinvelocityreflectedthedifferent
costsofholdingcruzadoscomparedtoholdingdollars.Thesedifferentcostswereduetothehigh
inflationrateinBrazilwhichquicklyerodedthevalueofidlecruzados,whiletherelativelylow
inflationrateintheUnitedStateshadamuchlessdeleteriouseffectonthevalueofdollars.

E
E3
E2
E4
E1
R3

R2

(M1/P)
(M2/P)

L1
Figure14.3

L2

R1

Chapter14Money, Interest Rates, and Exchange Rates77

10. Ifanincreaseinthemoneysupplyraisesrealoutputintheshortrun,thenthefallintheinterestrate
willbereducedbyanoutwardshiftofthemoneydemandcurvecausedbythetemporarilyhigher
transactionsdemandformoney.Infigure14.3,theincreaseinthemoneysupplylinefrom(M 1/P)to
(M2/P)iscoupledwithashiftoutinthemoneydemandschedulefromL 1toL2.Theinterestratefalls
fromitsinitialvalueofR1toR2,ratherthantothelowerlevelR3,becauseoftheincreaseinoutput
andtheresultingoutwardshiftinthemoneydemandschedule.Becausetheinterestratedoesnotfall
asmuchwhenoutputrises,theexchangeratedepreciatesbyless:fromitsinitialvalueofE 1toE2,
ratherthantoE3,inthediagram.InbothcasesweseetheexchangerateappreciatebacksometoE 4
inthelongrun.ThedifferenceistheovershootismuchsmallerifthereisatemporaryincreaseinY.
Note,thefactthattheincreaseinYistemporarymeansthatwestillmovetothesameIPcurve,as
LRpriceswillstillshiftthesameamountwhenYreturnstonormalandwestillhavethesamesize
Mincreaseinbothcases.ApermanentincreaseinYwouldinvolveasmallerexpectedpriceincrease
andasmallershiftintheIPcurve.
Undershootingoccursifthenewshortrunexchangerateisinitiallybelowitsnewlongrunlevel.
ThishappensonlyiftheinterestrateriseswhenthemoneysupplyrisesthatisifGDPgoesupso
muchthatRdoesnotfall,butincreases.Thisisunlikelybecausethereasonwetendtothinkthatan
increaseinMmayboostoutputisbecauseoftheeffectofloweringinterestrates,sowegenerally
dontthinkthattheYresponsecanbesogreatastoincreaseR.
11. WesawinChapter14thatastheinterestratefalls,peopleprefertoholdmorecashandfewer
financialassets.Ifinterestratesweretofallbelowzero,peoplewouldstrictlyprefercashtofinancial
assetsasthezeroreturnoncashwoulddominateanynegativereturn.Thus,interestratescannotfall
belowzerobecausenoonewouldholdafinancialassetwithanegativerateofreturnwhenanother
assetatazerorateofreturn(cash)exists.
12. Oneclearcomplicationthatazerointerestrateintroducesisthatthecentralbankisoutof
ammunition.Itliterallycannotreduceinterestratesanyfurtherandthusmaystruggletorespondto
additionalshocksthathittheeconomyovertime.Thecentralbankisstillnotcompletelypowerless,
itcanprintmoremoneyandtrytoincreaseinflation(increasinginflationwithaconstantzerointerest
ratewouldmeanadecliningrealinterestrate)tostimulatetheeconomy,butthestandardtoolkitis
notoperational.Asfurtherdiscussioninchapter17willshow,azerointerestratemayalsobea
symptomofalackofresponsivenessintheeconomytolowinterestrates.
13. (a) Ifmoneyadjustsautomaticallytochangesinthepricelevel,thenanynumberofcombinationsof
moneyandpricescouldsatisfythemoneysupply/moneydemandequations.Therewouldbeno
uniquesolution.
(b) Yes,arulesuchasthisonewouldhelpanchorthepricelevelandimplythereisnolongeran
infinitenumberofmoneyandpricecombinationsthatcouldsatisfymoneysupplyandmoney
demand.
(c) AonetimepermanentunexpectedfallinuwouldimplythatRwouldhavetofalluntilprices
haveachancetoriseandbalanceouttheequation.Aspricesrise,Rwouldreturntoitsinitial
level.Thestorydescribedisessentiallyidenticaltothatinfigure14.13.Theinterestratewould
dropandthenriseslowlyovertimeandthepricelevelwouldstartoutstaticandthenriseover
time.Theexchangerateshouldovershoot(assumingthatexpectationsaretiedtofuturepricesin
thesamewaytheyaredescribedinthetext).