Money, Interest Rates, and Exchange Rates

Money, Interest Rates,
and Exchange Rates
Chapter 14 showed how the exchange rate between currencies depends on
two factors, the interest that can be earned on deposits of those currencies
and the expected future exchange rate. To understand fully the
determination of exchange rates, however, we have to learn how interest rates
themselves are determined and how expectations of future exchange rates are
formed. In this and the next two chapters we examine these topics by building an
economic model that links exchange rates, interest rates, and other important
macroeconomic variables such as the inflation rate and output.
The first step in building the model is to explain the effects of a country’s
money supply and of the demand for its money on its interest rate and exchange
rate. Because exchange rates are the relative prices of national monies, factors
that affect a country’s money supply or demand are among the most powerful
determinants of its currency’s exchange rate against foreign currencies. It is
therefore natural to begin a deeper study of exchange rate determination with a
discussion of money supply and money demand.
Monetary developments influence the exchange rate by changing both interest
rates and people’s expectations about future exchange rates. Expectations
about future exchange rates are closely connected with expectations about the
future money prices of countries’ products; these price movements, in turn,
depend on changes in money supply and demand. In examining monetary
influences on the exchange rate, we therefore look at how monetary factors
influence output prices along with interest rates. Expectations of future exchange
rates depend on many factors other than money, however, and these
nonmonetary factors are taken up in the next chapter.
Once the theories and determinants of money supply and demand are laid
out, we use them to examine how equilibrium interest rates are determined by
the equality of money supply and money demand. Then we combine our model
of interest rate determination with the interest parity condition to study the
effects of monetary shifts on the exchange rate, given the prices of goods and
services, the level of output, and market expectations about the future. Finally,
we take a first look at the long-term effects of monetary changes on output
prices and expected future exchange rates.
CHAPTER 15 Money, Interest Rates, and Exchange Rates 355
LEARNING GOALS
After reading this chapter, you will be able to:
• Describe and discuss the national money markets in which interest rates are
determined.
• Show how monetary policy and interest rates feed into the foreign exchange
market.
• Distinguish between the economy’s long-run position and the short run, in
which money prices and wages are sticky.
• Explain how price levels and exchange rates respond to monetary factors
in the long run.
• Outline the relationship between the short-run and the long-run effects
of monetary policy, and explain the concept of short-run exchange rate
overshooting.