ECON 311 1st Edition Lecture 11 Outline of Last Lecture I. Purchasing Power ParityOutline of Current Lecture I. Factors that Affect Exchanges Rates in the Short RunII. Interest Parity ConditionIII. Short-Term Exchange Rate ModelIV. Shifting the Demand for Dollar AssetsV. Function of MoneyVI. Evolution of CashVII. Measuring MoneyCurrent LectureI. Factors that Affect Exchange Rates in the Short Runa. An exchange rate is the price of domestic assets in terms of foreign assetsb. Dollar assets – assets denominated in US $II. Interest Parity ConditioniD = domestic interest rate- The return on dollar assetsiF = foreign interest rate- The return on foreign assetsa. From US perspective:i. Expected return in $ assets = iDii. Expected return in foreign assets = iF−Et +1e−EtEtb. At equilibrium iD and iF should be:iD=iF−Et +1e− EtEtThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.c. Suppose US government bonds yield 6% and German government bonds yield 4%. Assume 10 year bondiD=iF−Et +1e−EtEtThen the expected appreciation is -2% or the US dollar would depreciate 2%III. Short-Term Exchange Rate Modela. Supply and Demand of dollar assetsi. In short-run, assume supply of dollar assets is fixedSuppose: EtEet+1A 10 pesos/$112 pesos/$1B 11 pesos/$112 pesos/$1If exchange rate today increases expected return decreasesWhen exchange rate is high expected appreciation is low (Dollar is stronger)E* = equilibrium exchange rateIV. Shifting the Demand forDollar Assetsa. If Et changesDemand curve doesNOT shiftb. changes in iD, iF andEet+1 shift thedemand curve1. If iD increases theDemand for dollarassets increases2. If iF decreases theDemand for dollarassets increasesEtE*Quantity of Dollar AssetsSDEtE2E1Quantity of Dollar AssetsSD2D13. If Eet+1 increases the Demand for dollar assets increasesChapter 7: What is Money?V. Function of Moneya. Medium of Exchange: facilitates the exchange of goods and servicesb. Store of Value: retains its value over time (not perfect because of inflation)c. Unit of Account: an agreed upon measure for stating the prices of goods and servicesVI. Evolution of Casha. Commodity money: physical commodity that has value in its own right (intrinsic value) but also serves as money (EX: bananas, gold)b. Convertible Paper Money: paper “claim” to a commodityc. Fiat Money: commodity with no intrinsic value that also serves as moneyi. Must also have general agreement among the public as well as government backingVII. Measuring Moneya. Why are we interested?i. Changes in money supply in the economy are related to changes in inflation, interest rates, and economic growthb. Monetary AggregatesM1 M2Currency M1Checking Deposits Small Savings DepositsTravelers Checks Small Time Deposits (CDs)Small Money Market Mutual Fund DepositsM1 is considered more liquid than