Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9781292094182

11th Edition

614 Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

The foreign exchange market determines the prices at which currencies are exchanged, and these rates affect the cost of domestic and international goods. Long-run exchange rate movements are influenced by changes in relative price levels, trade barriers, export and import demands, and productivity differences, as explained by the law of one price and purchasing power parity. In the short run, asset market models highlight the importance of expected returns on domestic assets, where shifts in interest rates and changing expectations about future exchange rates lead to volatility. A critical aspect is the distinction between real and nominal interest rates, as they have different implications for exchange rate movements.

Learning Objectives

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Key Concepts

CONCEPT

DEFINITION

Definition: The study of how equilibrium levels of output and inflation are determined by the interaction of aggregate demand (planned spending) and aggregate supply (the economy’s capacity).

The study of how equilibrium levels of output and inflation are determined by the interaction of aggregate demand (planned spending) and aggregate supply (the economy’s capacity). •

Example Problems

Example 1

When the euro appreciates, are you more likely to drink California wine or French wine?

Example 2

"A country is always worse off when its currency is weak (falls in value)." Is this statement true, false, or uncertain? Explain your answer.

Example 3

When the U.S. dollar depreciates, what happens to exports and imports in the United States?

Example 4

If the Japanese price level rises by $5 \%$ relative to the price level in the United States, what does the theory of purchasing power parity predict will happen to the value of the Japanese yen in terms of dollars?

Example 5

If the demand for a country's exports falls at the same time that tariffs on imports are raised, will the country's currency tend to appreciate or depreciate in the long run?
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Step-by-Step Explanations

QUESTION

How does an increase in the domestic interest rate (iD) affect the equilibrium exchange rate in the short run?\nStep-by-step Answer:\nStep 1: Recognize that when domestic interest rates rise, the return on domestic assets increases relative to foreign assets.\nStep 2: This higher expected return makes domestic assets more attractive, increasing the quantity demanded at every exchange rate.\nStep 3: The demand curve for domestic assets shifts to the right, as depicted by a rightward movement (from D1 to D2) in the supply and demand diagram.\nStep 4: With a fixed supply of domestic assets (vertical supply curve), the higher demand results in an increased equilibrium exchange rate (an appreciation of the domestic currency).\nFinal Answer: An increase in the domestic interest rate shifts the demand curve rightward, leading to an appreciation of the domestic currency.\n\n- Topic: Short-Run Determination Using the Asset Market Approach \nQuestion: How are short-run exchange rates determined using the asset market approach?\nStep-by-step Answer:\nStep 1: Understand that in the asset market approach, the exchange rate is seen as the price of domestic assets (e.g., bank deposits, bonds) in terms of foreign assets.\nStep 2: Note that the supply of domestic assets is fixed (vertical supply curve), while the demand for these assets depends on the relative expected return, which in turn depends on factors like domestic versus foreign interest rates and expectations about future exchange rates.\nStep 3: When factors such as increased domestic interest rates or improved export prospects occur, the demand for domestic assets shifts rightward, causing an appreciation of the domestic currency.\nStep 4: Conversely, if factors such as higher expected inflation undermine the expected return on domestic assets, the demand curve shifts leftward, resulting in a depreciation of the domestic currency.\nFinal Answer: Short-run exchange rates are determined through shifts in the demand for domestic assets based on the relative expected returns influenced by interest rates and future expectations, while the fixed supply of domestic assets anchors the analysis.\n\n"

STEP-BY-STEP ANSWER:

Step 1: Recognize that when domestic interest rates rise, the return on domestic assets increases relative to foreign assets.\nStep 2: This higher expected return makes domestic assets more attractive, increasing the quantity demanded at every exchange rate.\nStep 3: The demand curve for domestic assets shifts to the right, as depicted by a rightward movement (from D1 to D2) in the supply and demand diagram.\nStep 4: With a fixed supply of domestic assets (vertical supply curve), the higher demand results in an increased equilibrium exchange rate (an appreciation of the domestic currency).\nFinal Answer: An increase in the domestic interest rate shifts the demand curve rightward, leading to an appreciation of the domestic currency.\n\n- Topic: Short-Run Determination Using the Asset Market Approach \nQuestion: How are short-run exchange rates determined using the asset market approach?\nStep-by-step Answer:\nStep 1: Understand that in the asset market approach, the exchange rate is seen as the price of domestic assets (e.g., bank deposits, bonds) in terms of foreign assets.\nStep 2: Note that the supply of domestic assets is fixed (vertical supply curve), while the demand for these assets depends on the relative expected return, which in turn depends on factors like domestic versus foreign interest rates and expectations about future exchange rates.\nStep 3: When factors such as increased domestic interest rates or improved export prospects occur, the demand for domestic assets shifts rightward, causing an appreciation of the domestic currency.\nStep 4: Conversely, if factors such as higher expected inflation undermine the expected return on domestic assets, the demand curve shifts leftward, resulting in a depreciation of the domestic currency.\nFinal Answer: Short-run exchange rates are determined through shifts in the demand for domestic assets based on the relative expected returns influenced by interest rates and future expectations, while the fixed supply of domestic assets anchors the analysis.\n\n"
Final Answer: An increase in the domestic interest rate shifts the demand curve rightward, leading to an appreciation of the domestic currency.\n\n- Topic: Short-Run Determination Using the Asset Market Approach \nQuestion: How are short-run exchange rates determined using the asset market approach?\nStep-by-step Answer:\nStep 1: Understand that in the asset market approach, the exchange rate is seen as the price of domestic assets (e.g., bank deposits, bonds) in terms of foreign assets.\nStep 2: Note that the supply of domestic assets is fixed (vertical supply curve), while the demand for these assets depends on the relative expected return, which in turn depends on factors like domestic versus foreign interest rates and expectations about future exchange rates.\nStep 3: When factors such as increased domestic interest rates or improved export prospects occur, the demand for domestic assets shifts rightward, causing an appreciation of the domestic currency.\nStep 4: Conversely, if factors such as higher expected inflation undermine the expected return on domestic assets, the demand curve shifts leftward, resulting in a depreciation of the domestic currency.\nFinal Answer: Short-run exchange rates are determined through shifts in the demand for domestic assets based on the relative expected returns influenced by interest rates and future expectations, while the fixed supply of domestic assets anchors the analysis.\n\n"

"- Topic: Impact of an Increase in Domestic Interest Rates on Exchange Rates \nQuestion: How does an increase in the domestic interest rate (iD) affect the equilibrium exchange rate in the short run?\nStep-by-step Answer:\nStep 1: Recognize that when domestic interest rates rise, the return on domestic assets increases relative to foreign assets.\nStep 2: This higher expected return makes domestic assets more attractive, increasing the quantity demanded at every exchange rate.\nStep 3: The demand curve for domestic assets shifts to the right, as depicted by a rightward movement (from D1 to D2) in the supply and demand diagram.\nStep 4: With a fixed supply of domestic assets (vertical supply curve), the higher demand results in an increased equilibrium exchange rate (an appreciation of the domestic currency).\nFinal Answer: An increase in the domestic interest rate shifts the demand curve rightward, leading to an appreciation of the domestic currency.\n\n- Topic: Short-Run Determination Using the Asset Market Approach \nQuestion: How are short-run exchange rates determined using the asset market approach?\nStep-by-step Answer:\nStep 1: Understand that in the asset market approach, the exchange rate is seen as the price of domestic assets (e.g., bank deposits, bonds) in terms of foreign assets.\nStep 2: Note that the supply of domestic assets is fixed (vertical supply curve), while the demand for these assets depends on the relative expected return, which in turn depends on factors like domestic versus foreign interest rates and expectations about future exchange rates.\nStep 3: When factors such as increased domestic interest rates or improved export prospects occur, the demand for domestic assets shifts rightward, causing an appreciation of the domestic currency.\nStep 4: Conversely, if factors such as higher expected inflation undermine the expected return on domestic assets, the demand curve shifts leftward, resulting in a depreciation of the domestic currency.\nFinal Answer: Short-run exchange rates are determined through shifts in the demand for domestic assets based on the relative expected returns influenced by interest rates and future expectations, while the fixed supply of domestic assets anchors the analysis.\n\n"

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