Interest rate determination
This chapter aims to elucidate various aspects of money, specifically how a country’s central bank controls the quantity of money in a nation. Additionally, it explains how the money volume in the economy influences the interest rate and inflation.
A country’s money supply is the quantity of money in circulation and the entire value of checking accounts in the banks. The central bank regulates the quantity of money in the distribution in several ways, for example, by utilizing open market operations (OMO). This involves the sale or purchase of the government’s T-bills. One of the factors affecting interest rates is money demand. The volume of money that people and institutions want to hold in liquid affects the quantity of money available for loans, consequently changes interest rates. The money demand might be influenced by interest rates; banks offering high-interest rates, people deposit more money, which increases the number of funds available for lending.
The formal definition of money defers the common usage of the term. While currency and coin form the usual interpretation of money, the formal definition includes checking accounts deposits, which are neither coins nor currency. The interest rate discussed in this chapter points to the mean interest rates on deposits. Money stock refers to the stock of assets that are available in a nation and can be used for purchasing purposes.
These comprise currency, checking account balances, stocks, bonds, and whole life insurance policies. Money has some distinctive qualities, for example, as a unit of account and a means of trade. As a unit of account, it serves as a gauge of the value of goods.
There are several money-supply measures symbolized by an M followed by a numerical subscript. With increasing numbers, the definitions include assets with reducing liquidity; M1, on the other hand, comprises currency, travelers check, checking-account balances, and other checkable deposits. The currency mentioned here must be outside banks; otherwise, it is out of circulation. Other checkable accounts include NOW and ATS accounts. The first refers to checking accounts that earn interest, while the second refers to accounts used to cover overdrafts in checkable accounts.
The controlling of the money supply is the role of the Federal Reserve Bank (fed) in the US. There are several key levels that the fed uses to regulate the money distribution. These are the open market operations, reserve requirement changes (RRC), and changes in the discount rates. The RRC is the money depository institutions need to keep in reserve at the fed. Since this amount is a percentage of all deposits in the institution, then a higher RRC reduces the amount of money in supply, while a lower RRC increases the money supply. The discount rates refer to the rate the fed levies on overnight loans to banks. These loans serve to maintain reserve obligations. When the fed increases this rate, the monetary guidelines become contractionary.
The demand for money and the desire to hold liquid assets is either transactional or speculative. Apart from personal spending levels, the GDP also affects transactional demand. The economy needs money to transact in the extra goods and services produced when there is amplification in apparent GDP (GDP at current prices). This increases the monetary demand. The speculative desire relates to the opportunity price of holding money.
If people lose money through holding it, for example, when the interest rates on deposits are high, then the claim for money reduces. This connotes that money requirement depends linearly on the level of actual GDP and the price level due to their effect on the demand for transactions. The dependence on the average interest rates is diminutive; the supply is only dependent on the actions of the fed. The equilibrium interest rate, therefore, equalizes the actual money need and the real supply. An expansionary guideline reduces the interest rate, while a contraction guideline increases the average interest rates in an economy.
Price level elevations or inflation have various effects. Most significantly, the increase in prices increases the transactions demand money since more money is necessary for the transactions. The increase in ostensible demand exceeds ostensible supply, leading to an upward adjustment of the equilibrium interest rate. An increase in real GDP signifies economic development and has its outcomes. An increase in the GDP means that people will use additional money in transacting in the excess products produced in the economy. This increase in money demand fails to match with the original supply, which remains low. The current interest rate is lesser than the equilibrium rate and has to be adjusted upwards.
Integrating the money market and the forex market requires consideration of the different variables. Since the Rate of Return on the dollars is comparable to the interest rate of the dollar, it is possible to integrate the graphical representations of the two markets by using the same axis for the interest rate and ROR. The level of interest rate establishes the level of ROR in the forex market.
National output determination
The G&S market model determines how the supply and demand for the national output for G&S combine to determine the equilibrium level of national output. The aggregate demand (AD) for goods and services is the demand for households, businesses, and the government for the products in the economy. AD, the aggregate demand for GNP, is the sum demand in consumption, investment, government, and the difference between export demand and import demand. In equilibrium, the economy meets the demand, but this is not constantly the case. However, the supply, Y, corresponds to the actual GNP. The main contributor to utilization demand is expendable income.
The disposable income is the total income of the people and the money given out by the government minus the taxes. The G&S model assumes a positive correlation between disposable income and consumer demand. Thus, CD (Yd+) = CD (Y−T+TR+), where the left side is the consumer demand function, and the right side is the disposable income as defined above. A linear presentation of the equation gives rise to other variables, for example, autonomous consumption (compulsory consumption with income or not) and the marginal propensity to consume (additional demand to consume or save given an extra dollar).
Investment demand is the demand for physical capital G&S by businesses to maintain and amplify their operations. This definition bars financial investments by individuals from deferred consumption. Within this model, investment demand is dependent on external factors, a weakness of this model. GNP and the interest rate affect the investment rate, but within the G&S model, the assumption is that these aspects are external. A similar assumption exists for government demand.
Export demand refers to the demand of foreign countries for G&S produced in the country. The inverse is import demand. The imports are deducted from the GDP since they are not locally produced. The difference between the export demand and the import demand is the current account demand, whose determinants are the domestic real currency value and disposable income. The real exchange rate is the measure of a set of goods in a foreign country compared to the price of the same in the local market. It features variances in prices and the exchange rate. This variable affects the export demand since people would rather buy G&S from countries where they are relatively cheap.
Previous postulates indicate that elevations in expendable income give rise to increasing consumption demand but lead to reductions in the current account demand. This is so because the propensity to spend on foreign G&S must be lower than the consumption demand. Consequently, a $1 dollar increase in expendable income would result in a higher positive impact on consumer demand than a negative impact on the imports. Therefore, AD (Y−T+TR+, E$/£P£P$+, I0+, G0+) = C D (Y−T+TR+) +I0+G0+C A D (E$/£P£P$+, Y−T+TR). This includes the spot exchange rate in the resolution of aggregate demand.
In the G&S model, the equilibrium level of national income appears on a Keynesian cross diagram. On a plot of aggregate demand against real GNP, the AD function results. This has a positive slant. The positive slant indicates the positive relationship between the rise in expendable income and the rise in expenditure demand. The y-intercept is positive, and the gradient is less than unity. This connotes that a $1 increase in GNP results in a less-than-one increase in AD.
The 45 degrees line in the graph crosses the AD function once; this point determines the equilibrium value of GNP. If the GNP is higher than the equilibrium rate, excess supply leads to increases in inventories. Consequently, companies seek to diminish their inventories by reducing production until GNP equals aggregate demand. When the GNP is lower, the reverse occurs. Additionally, an increase in the dollar value causes an increase in GNP, and a decrease in the dollar value reduces GNP.
According to the G&S model, depreciation in the currency results in enlarged exports and diminishing imports. The two consequences increase the actual current account balance. In reality, however, diminution in currency value does not result in the projections of the G&S model. Reduction in the actual balance accounts occurs, at least for a time. This gives the AD curve a j-shape. The associated explanation is the j-curve theory. Since CA = EX – IM, and the exchange rate =E$/£, when depreciation of the dollar occurs, the E$/£ increases. The model suggests an increase in CA since the two variables share a positive correlation. However, when the dollar drops, the CA falls for a period before recovering, causing the j-curve.
The AA-DD model
By transferring data derived from the G&S model onto a DD curve, the relationship between the exchange rate and equilibrium GNP can be established. The AD aggregate function is plotted as a curve of aggregate demand against aggregate supply. However, the function is dependent on several external variables, especially E$/£. Other variables include government demand, taxes, transfer payments, and price levels. The endogenous variable is the GNP.
To plot a function including E$/£ and AD, a plot of an AD (E$/£ and other variables) against GNP is required. In such a curve, the 45 degrees line intersects at a point (G), indicating the equilibrium GNP ($Y). These two points determine one point in the DD curve. A change in E$/£ gives a different pair of points since this affects the whole AD curve. Joining the duo pairs of points results in the DD curve. The curve is the set of aggregate demand equilibriums in the G&S model.
In an economic representation, equilibrium corresponds to a point towards which the internal variable will converge on the basis of the assumed behavior of other variables in the model. In contrast, equilibrium is not a single point in the DD curve. Every point is an equilibrium point. The curve has a positive slope because an elevation in the exchange rate (depreciation of US dollar) raises equilibrium GNP in the G&S model.
The DD curve comes from the two functions of a curve of AD (E$/£ and added variables) against GNP, where the two functions result from variations in only one external variable, E$/£. An alteration in any of the various external variables would result in a shift of the DD curve. For example, a decrease in the investment demand, maintaining other variables constant, would result in a reduction of the aggregate demand. The reduction of AD results in the shifting of the DD curve to the left.
This effect follows any action that may change AD, apart from variations in the exchange rate. Swells in government demand (G), investment demand (I), transfer rates (TR), foreign price levels (P£), and decreases in domestic price levels (P$) and taxes (T) cause the curve to shift to the right. Decreases in G, I, TR, and (P£), and increases in T and P$ cause the curve to shift to the left. Alternatively, all actions leading to reductions in the AD cause the curve to shift to the left, and all actions leading to an increase in AD cause the curve to shift to the right.
The information obtained from the G&S model may be transcribed to another diagram. In this diagram, the GDP replaces GNP. Since E$/£ is equivalent to the RoR on the domestic US market, it’s possible to have two plots sharing an axis. In these curves, changes in the positions of equilibrium exchange rate occur from changes in GNP. Joining two sets of equilibrium points results in an AA curve. It consists of all possible equilibrium exchange level for every possible GNP value, other factors remaining constant.
The curve has a negative gradient since an elevation in the real GNP reduces the equilibrium exchange rate. Increasing the money supply, foreign interest rates, or expected exchange rate shift the curve upward. Declines in the money supply and predicted exchange rate shifts the curve downward.
The DD curve represents all equilibrium points in the G&S market, while the AA curve represents the set of equilibriums in the asset market. The intersection of the AA and DD curve indicate the point of equilibrium in both markets. This point represents superequilibrium. This describes the GNP level and the exchange rate value that provide equilibrium in both markets. The asset market changes rapidly, resulting in changes to the superequilibrium point. Depending on the magnitude of the change, the adjustment process may take some time. In the process, other changes may take place before the adjustment. Therefore, superequilibrium point changes often.
Works Cited
Suranovic, Steve. International Trade: Theory and Policy. Saylor Foundation, 2010.