The Money Supply and the Exchange
Rate in the Short Run
In Chapter 14 we learned about the interest parity condition, which predicts how interest
rate movements influence the exchange rate, given expectations about the exchange rate’s
future level. Now that we know how shifts in a country’s money supply affect the interest
rate on nonmoney assets denominated in its currency, we can see how monetary changes
affect the exchange rate. We will discover that an increase in a country’s money supply
causes its currency to depreciate in the foreign exchange market, while a reduction in the
money supply causes its currency to appreciate.
In this section we continue to take the price level (along with real output) as given, and
for that reason we label the analysis of this section short run. The long-run analysis of an
economic event allows for the complete adjustment of the price level (which may take a
long time) and for full employment of all factors of production. Later in this chapter we
examine the long-run effects of money supply changes on the price level, the exchange rate,
R2
Q2 - Q1 1oe
R1
Y2
Y1
Real money
supply
Increase in
real income
2
1 1'
L(R, Y 2)
L(R, Y 1)
Interest
rate, R
Q2
Real money
holdings
R2
R1
Ms
P
(= Q1)
Figure 15-5
Effect on the Interest Rate
of a Rise in Real Income
Given the real money supply,
MS/P ( = Q1), a rise in real income
from Y1 to Y2 raises the interest
rate from R1 (point 1) to R2
(point 2).
364 PART THREE Exchange Rates and Open-Economy Macroeconomics
and other macroeconomic variables. Our long-run analysis will show how the money supply
influences exchange rate expectations, which we also continue to take as given for now.
Linking Money, the Interest Rate, and the Exchange Rate
To analyze the relationship between money and the exchange rate in the short run in
Figure 15-6, we combine two diagrams that we have already studied separately. Let’s assume
once again that we are looking at the dollar/euro exchange rate, that is, the price of
euros in terms of dollars.
US
Dollar/euro
exchange
rate, E$/€
U.S. real
money
holdings
(increasing)
0
1
1'
Return on
dollar deposits
Expected
return on
euro deposits
Rates of return
(in dollar terms)
U.S. real
money
supply
L(R$,YUS)
E$/€
1
R$
1
Ms
PUS
Foreign
exchange
market
Money
market
Figure 15-6
Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market
Both asset markets are in equilibrium at the interest rate and exchange rate ; at
these values, money supply equals money demand (point 1) and the interest parity
condition holds (point 1oe).
E$/€
R 1 $
1
CHAPTER 15 Money, Interest Rates, and Exchange Rates 365
The first diagram (introduced as Figure 14-4) shows equilibrium in the foreign
exchange market and how it is determined given interest rates and expectations about future
exchange rates. This diagram appears as the top part of Figure 15-6. The dollar interest
rate, which is determined in the money market, defines the vertical schedule.
As you will remember from Chapter 14, the downward-sloping expected euro return
schedule shows the expected return on euro deposits, measured in dollars. The schedule
slopes downward because of the effect of current exchange rate changes on expectations
of future depreciation: A strengthening of the dollar today (a fall in ) relative to its
given expected future level makes euro deposits more attractive by leading people to anticipate
a sharper dollar depreciation in the future.
At the intersection of the two schedules (point ), the expected rates of return on dollar
and euro deposits are equal, and therefore interest parity holds. is the equilibrium
exchange rate.
The second diagram we need to examine the relationship between money and the
exchange rate was introduced as Figure 15-3. This figure shows how a country’s equilibrium
interest rate is determined in its money market, and it appears as the bottom part of
Figure 15-6. For convenience, however, the figure has been rotated clockwise by 90 degrees
so that dollar interest rates are measured from 0 on the horizontal axis and the U.S. real
money supply is measured from 0 on the descending vertical axis. Money market equilibrium
is shown at point 1, where the dollar interest rate induces people to demand real
balances equal to the U.S. real money supply, .
Figure 15-6 emphasizes the link between the U.S. money market (bottom) and the foreign
exchange market (top)—the U.S. money market determines the dollar interest rate,
which in turn affects the exchange rate that maintains interest parity. (Of course, there is a
similar link between the European money market and the foreign exchange market that
operates through changes in the euro interest rate.)
Figure 15-7 illustrates these linkages. The U.S. and European central banks, the Federal
Reserve System and the European System of Central Banks (ESCB), respectively, determine
the U.S. and European money supplies, and Given the price levels and
national incomes of the two countries, equilibrium in national money markets leads to the
dollar and euro interest rates and . These interest rates feed into the foreign exchange
market, where, given expectations about the future dollar/euro exchange rate, the current
rate is determined by the interest parity condition.
U.S. Money Supply and the Dollar/Euro Exchange Rate
We now use our model of asset market linkages (the links between the money and foreign
exchange markets) to ask how the dollar/euro exchange rate changes when the Federal
Reserve changes the U.S. money supply The effects of this change are summarized
in Figure 15-8.
At the initial money supply , the money market is in equilibrium at point 1 with an
interest rate . Given the euro interest rate and the expected future exchange rate, a dollar
interest rate of implies that foreign exchange market equilibrium occurs at point , with
an exchange rate equal to
What happens when the Federal Reserve, perhaps fearing the onset of a recession,
raises the U.S. money supply to This increase sets in motion the following sequence
of events: (1) At the initial interest rate , there is an excess supply of money in the U.S.
money market, so the dollar interest rate falls to as the money market reaches its new
equilibrium position (point 2). (2) Given the initial exchange rate and the new, lower
interest rate on dollars, the expected return on euro deposits is greater than that on
dollar deposits. Holders of dollar deposits therefore try to sell them for euro deposits,
R$
2,
E$/€
1
R$
2
R$
1
MUS
2 ?
E$/€
1 .
R$ 1oe
1
R$
1
MUS
1
MUS
s .
E$/€
R€ R$
ME s MUS .
s
MUS
s /PUS
R$
1
E$/€
1
1oe
E$/€
R$
1,
366 PART THREE Exchange Rates and Open-Economy Macroeconomics
which are momentarily more attractive. (3) The dollar depreciates to as holders of
dollar deposits bid for euro deposits. The foreign exchange market is once again in equilibrium
at point because the exchange rate’s move to causes a fall in the dollar’s
expected future depreciation rate sufficient to offset the fall in the dollar interest rate.
We conclude that an increase in a country’s money supply causes its currency to depreciate
in the foreign exchange market. By running Figure 15-8 in reverse, you can see that a
reduction in a country’s money supply causes its currency to appreciate in the foreign
exchange market.
Europe’s Money Supply and the Dollar/Euro Exchange Rate
The conclusions we have reached also apply when the ESCB changes Europe’s money
supply. Suppose that the ESCB fears a recession in Europe and hopes to head it off
through a looser monetary policy. An increase in causes a depreciation of the euro
(that is, an appreciation of the dollar, or a fall in ), while a reduction in causes an
appreciation of the euro (that is, a depreciation of the dollar, or a rise in ).
The mechanism at work, which runs from the European interest rate to the exchange
rate, is the same as the one we just analyzed. It is good exercise to verify these assertions
by drawing figures similar to Figures 15-6 and 15-8 that illustrate the linkage between the
European money market and the foreign exchange market.
Here we use a different approach to show how changes in Europe’s money supply
affect the dollar/euro exchange rate. In Chapter 14 we learned that a fall in the euro interest
rate, shifts the downward-sloping schedule in the upper part of Figure 15-6 to the
left. The reason is that for any level of the exchange rate, a fall in lowers the expected
rate of return on euro deposits. Since a rise in the European money supply lowers
we can see the effect on the exchange rate by shifting the expected euro return schedule in
the top part of Figure 15-6 to the left.
R€, ME s
R€,
R€,
E$/€
ME s E$/€
ME s
E$/€
2oe 2
E$/€
2
U.S.
money market
(European
money
supply)
R€
(Euro
interest rate)
Foreign
exchange
market
E$/€
(Dollar/euro exchange rate)
European
money market
Europe
European System
of Central Banks
United States
Federal Reserve System
(United States
money supply)
R$
(Dollar
interest rate)
US E Ms Ms
Figure 15-7
Money Market/Exchange Rate
Linkages
Monetary policy actions by the
Fed affect the U.S. interest rate,
changing the dollar/euro exchange
rate that clears the foreign
exchange market. The ESCB can
affect the exchange rate by changing
the European money supply
and interest rate.
CHAPTER 15 Money, Interest Rates, and Exchange Rates 367
E$/€
1
R$
1
MUS
PUS
Dollar/euro
exchange
rate, E$/
U.S. real
money
holdings
0
1
1'
Dollar return
Rates of return
(in dollar terms)
Expected
euro return
L(R$,YUS)
2'
2
E$/€
2
1
MUS
PUS
2
R$
2
Increase in U.S.
real money supply
Figure 15-8
Effect on the Dollar/Euro
Exchange Rate and Dollar
Interest Rate of an Increase in the
U.S. Money Supply
Given PUS and YUS when the
money supply rises from to
the dollar interest rate
declines (as money market
equilibrium is reestablished at
point 2) and the dollar depreciates
against the euro (as foreign
exchange market equilibrium
is reestablished at point 2’).
MUS
2
MUS
1
The result of an increase in the European money supply is shown in Figure 15-9. Initially
the U.S. money market is in equilibrium at point 1 and the foreign exchange market is in
equilibrium at point with an exchange rate . An increase in Europe’s money supply
lowers and therefore shifts to the left the schedule linking the expected return on euro
deposits to the exchange rate. Foreign exchange market equilibrium is restored at point
with an exchange rate of . We see that the increase in European money causes the euro to
depreciate against the dollar (that is, causes a fall in the dollar price of euros). Similarly, a fall
in Europe’s money supply would cause the euro to appreciate against the dollar (that is,
would rise). The change in the European money supply does not disturb the U.S. money
market equilibrium, which remains at point 1.5
E$/€
E$/€
2
2oe,
R€
E$/€
1oe, 1
5The U.S. money market equilibrium remains at point 1 because the price adjustments that equilibrate the
European money market and the foreign exchange market after the increase in Europe’s money supply do not
change either the money supply or the money demand in the United States, given YUS and PUS.
368 PART THREE Exchange Rates and Open-Economy Macroeconomics
E$/€
1
R$
1
MUS
PUS
E$/€
2
s
Dollar/euro
exchange
rate, E$/€
U.S. real
money
holdings
0
1
1'
Dollar return
Rates of return
(in dollar terms)
Expected
euro return
L(R$,YUS)
2'
U.S. real
money supply
Increase in European
money supply (fall in
euro interest rate)
Figure 15-9
Effect of an Increase in the
European Money Supply on the
Dollar/Euro Exchange Rate
By lowering the dollar return on
euro deposits (shown as a leftward
shift in the expected euro return
curve), an increase in Europe’s
money supply causes the dollar to
appreciate against the euro.
Equilibrium in the foreign exchange
market shifts from point
to point but equilibrium in the
U.S. money market remains at
point 1.
2oe,
1oe
Rate in the Short Run
In Chapter 14 we learned about the interest parity condition, which predicts how interest
rate movements influence the exchange rate, given expectations about the exchange rate’s
future level. Now that we know how shifts in a country’s money supply affect the interest
rate on nonmoney assets denominated in its currency, we can see how monetary changes
affect the exchange rate. We will discover that an increase in a country’s money supply
causes its currency to depreciate in the foreign exchange market, while a reduction in the
money supply causes its currency to appreciate.
In this section we continue to take the price level (along with real output) as given, and
for that reason we label the analysis of this section short run. The long-run analysis of an
economic event allows for the complete adjustment of the price level (which may take a
long time) and for full employment of all factors of production. Later in this chapter we
examine the long-run effects of money supply changes on the price level, the exchange rate,
R2
Q2 - Q1 1oe
R1
Y2
Y1
Real money
supply
Increase in
real income
2
1 1'
L(R, Y 2)
L(R, Y 1)
Interest
rate, R
Q2
Real money
holdings
R2
R1
Ms
P
(= Q1)
Figure 15-5
Effect on the Interest Rate
of a Rise in Real Income
Given the real money supply,
MS/P ( = Q1), a rise in real income
from Y1 to Y2 raises the interest
rate from R1 (point 1) to R2
(point 2).
364 PART THREE Exchange Rates and Open-Economy Macroeconomics
and other macroeconomic variables. Our long-run analysis will show how the money supply
influences exchange rate expectations, which we also continue to take as given for now.
Linking Money, the Interest Rate, and the Exchange Rate
To analyze the relationship between money and the exchange rate in the short run in
Figure 15-6, we combine two diagrams that we have already studied separately. Let’s assume
once again that we are looking at the dollar/euro exchange rate, that is, the price of
euros in terms of dollars.
US
Dollar/euro
exchange
rate, E$/€
U.S. real
money
holdings
(increasing)
0
1
1'
Return on
dollar deposits
Expected
return on
euro deposits
Rates of return
(in dollar terms)
U.S. real
money
supply
L(R$,YUS)
E$/€
1
R$
1
Ms
PUS
Foreign
exchange
market
Money
market
Figure 15-6
Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market
Both asset markets are in equilibrium at the interest rate and exchange rate ; at
these values, money supply equals money demand (point 1) and the interest parity
condition holds (point 1oe).
E$/€
R 1 $
1
CHAPTER 15 Money, Interest Rates, and Exchange Rates 365
The first diagram (introduced as Figure 14-4) shows equilibrium in the foreign
exchange market and how it is determined given interest rates and expectations about future
exchange rates. This diagram appears as the top part of Figure 15-6. The dollar interest
rate, which is determined in the money market, defines the vertical schedule.
As you will remember from Chapter 14, the downward-sloping expected euro return
schedule shows the expected return on euro deposits, measured in dollars. The schedule
slopes downward because of the effect of current exchange rate changes on expectations
of future depreciation: A strengthening of the dollar today (a fall in ) relative to its
given expected future level makes euro deposits more attractive by leading people to anticipate
a sharper dollar depreciation in the future.
At the intersection of the two schedules (point ), the expected rates of return on dollar
and euro deposits are equal, and therefore interest parity holds. is the equilibrium
exchange rate.
The second diagram we need to examine the relationship between money and the
exchange rate was introduced as Figure 15-3. This figure shows how a country’s equilibrium
interest rate is determined in its money market, and it appears as the bottom part of
Figure 15-6. For convenience, however, the figure has been rotated clockwise by 90 degrees
so that dollar interest rates are measured from 0 on the horizontal axis and the U.S. real
money supply is measured from 0 on the descending vertical axis. Money market equilibrium
is shown at point 1, where the dollar interest rate induces people to demand real
balances equal to the U.S. real money supply, .
Figure 15-6 emphasizes the link between the U.S. money market (bottom) and the foreign
exchange market (top)—the U.S. money market determines the dollar interest rate,
which in turn affects the exchange rate that maintains interest parity. (Of course, there is a
similar link between the European money market and the foreign exchange market that
operates through changes in the euro interest rate.)
Figure 15-7 illustrates these linkages. The U.S. and European central banks, the Federal
Reserve System and the European System of Central Banks (ESCB), respectively, determine
the U.S. and European money supplies, and Given the price levels and
national incomes of the two countries, equilibrium in national money markets leads to the
dollar and euro interest rates and . These interest rates feed into the foreign exchange
market, where, given expectations about the future dollar/euro exchange rate, the current
rate is determined by the interest parity condition.
U.S. Money Supply and the Dollar/Euro Exchange Rate
We now use our model of asset market linkages (the links between the money and foreign
exchange markets) to ask how the dollar/euro exchange rate changes when the Federal
Reserve changes the U.S. money supply The effects of this change are summarized
in Figure 15-8.
At the initial money supply , the money market is in equilibrium at point 1 with an
interest rate . Given the euro interest rate and the expected future exchange rate, a dollar
interest rate of implies that foreign exchange market equilibrium occurs at point , with
an exchange rate equal to
What happens when the Federal Reserve, perhaps fearing the onset of a recession,
raises the U.S. money supply to This increase sets in motion the following sequence
of events: (1) At the initial interest rate , there is an excess supply of money in the U.S.
money market, so the dollar interest rate falls to as the money market reaches its new
equilibrium position (point 2). (2) Given the initial exchange rate and the new, lower
interest rate on dollars, the expected return on euro deposits is greater than that on
dollar deposits. Holders of dollar deposits therefore try to sell them for euro deposits,
R$
2,
E$/€
1
R$
2
R$
1
MUS
2 ?
E$/€
1 .
R$ 1oe
1
R$
1
MUS
1
MUS
s .
E$/€
R€ R$
ME s MUS .
s
MUS
s /PUS
R$
1
E$/€
1
1oe
E$/€
R$
1,
366 PART THREE Exchange Rates and Open-Economy Macroeconomics
which are momentarily more attractive. (3) The dollar depreciates to as holders of
dollar deposits bid for euro deposits. The foreign exchange market is once again in equilibrium
at point because the exchange rate’s move to causes a fall in the dollar’s
expected future depreciation rate sufficient to offset the fall in the dollar interest rate.
We conclude that an increase in a country’s money supply causes its currency to depreciate
in the foreign exchange market. By running Figure 15-8 in reverse, you can see that a
reduction in a country’s money supply causes its currency to appreciate in the foreign
exchange market.
Europe’s Money Supply and the Dollar/Euro Exchange Rate
The conclusions we have reached also apply when the ESCB changes Europe’s money
supply. Suppose that the ESCB fears a recession in Europe and hopes to head it off
through a looser monetary policy. An increase in causes a depreciation of the euro
(that is, an appreciation of the dollar, or a fall in ), while a reduction in causes an
appreciation of the euro (that is, a depreciation of the dollar, or a rise in ).
The mechanism at work, which runs from the European interest rate to the exchange
rate, is the same as the one we just analyzed. It is good exercise to verify these assertions
by drawing figures similar to Figures 15-6 and 15-8 that illustrate the linkage between the
European money market and the foreign exchange market.
Here we use a different approach to show how changes in Europe’s money supply
affect the dollar/euro exchange rate. In Chapter 14 we learned that a fall in the euro interest
rate, shifts the downward-sloping schedule in the upper part of Figure 15-6 to the
left. The reason is that for any level of the exchange rate, a fall in lowers the expected
rate of return on euro deposits. Since a rise in the European money supply lowers
we can see the effect on the exchange rate by shifting the expected euro return schedule in
the top part of Figure 15-6 to the left.
R€, ME s
R€,
R€,
E$/€
ME s E$/€
ME s
E$/€
2oe 2
E$/€
2
U.S.
money market
(European
money
supply)
R€
(Euro
interest rate)
Foreign
exchange
market
E$/€
(Dollar/euro exchange rate)
European
money market
Europe
European System
of Central Banks
United States
Federal Reserve System
(United States
money supply)
R$
(Dollar
interest rate)
US E Ms Ms
Figure 15-7
Money Market/Exchange Rate
Linkages
Monetary policy actions by the
Fed affect the U.S. interest rate,
changing the dollar/euro exchange
rate that clears the foreign
exchange market. The ESCB can
affect the exchange rate by changing
the European money supply
and interest rate.
CHAPTER 15 Money, Interest Rates, and Exchange Rates 367
E$/€
1
R$
1
MUS
PUS
Dollar/euro
exchange
rate, E$/
U.S. real
money
holdings
0
1
1'
Dollar return
Rates of return
(in dollar terms)
Expected
euro return
L(R$,YUS)
2'
2
E$/€
2
1
MUS
PUS
2
R$
2
Increase in U.S.
real money supply
Figure 15-8
Effect on the Dollar/Euro
Exchange Rate and Dollar
Interest Rate of an Increase in the
U.S. Money Supply
Given PUS and YUS when the
money supply rises from to
the dollar interest rate
declines (as money market
equilibrium is reestablished at
point 2) and the dollar depreciates
against the euro (as foreign
exchange market equilibrium
is reestablished at point 2’).
MUS
2
MUS
1
The result of an increase in the European money supply is shown in Figure 15-9. Initially
the U.S. money market is in equilibrium at point 1 and the foreign exchange market is in
equilibrium at point with an exchange rate . An increase in Europe’s money supply
lowers and therefore shifts to the left the schedule linking the expected return on euro
deposits to the exchange rate. Foreign exchange market equilibrium is restored at point
with an exchange rate of . We see that the increase in European money causes the euro to
depreciate against the dollar (that is, causes a fall in the dollar price of euros). Similarly, a fall
in Europe’s money supply would cause the euro to appreciate against the dollar (that is,
would rise). The change in the European money supply does not disturb the U.S. money
market equilibrium, which remains at point 1.5
E$/€
E$/€
2
2oe,
R€
E$/€
1oe, 1
5The U.S. money market equilibrium remains at point 1 because the price adjustments that equilibrate the
European money market and the foreign exchange market after the increase in Europe’s money supply do not
change either the money supply or the money demand in the United States, given YUS and PUS.
368 PART THREE Exchange Rates and Open-Economy Macroeconomics
E$/€
1
R$
1
MUS
PUS
E$/€
2
s
Dollar/euro
exchange
rate, E$/€
U.S. real
money
holdings
0
1
1'
Dollar return
Rates of return
(in dollar terms)
Expected
euro return
L(R$,YUS)
2'
U.S. real
money supply
Increase in European
money supply (fall in
euro interest rate)
Figure 15-9
Effect of an Increase in the
European Money Supply on the
Dollar/Euro Exchange Rate
By lowering the dollar return on
euro deposits (shown as a leftward
shift in the expected euro return
curve), an increase in Europe’s
money supply causes the dollar to
appreciate against the euro.
Equilibrium in the foreign exchange
market shifts from point
to point but equilibrium in the
U.S. money market remains at
point 1.
2oe,
1oe
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