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**Output, the Interest Rate, and the Exchange Rate**

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**Output, the Interest Rate, and the Exchange Rate**

In chapter 19, we treated the exchange rate as one of the policy instruments of the government. But it’s not a policy instrument: it’s a price, determined by the (foreign exchange) market. The main questions we try to solve are: What determines the exchange rate? How can policy makers affect exchange rates?

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**Output, the Interest Rate, and the Exchange Rate**

The model developed in this chapter is an extension of the open economy IS-LM model, known as the Mundell-Fleming model. It’s a combination of the goods market… The domestic financial market… And the foreign exchange market.

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**Equilibrium in the Goods Market**

20-1 Equilibrium in the goods market can be described by the following equations: defining

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**Equilibrium in the Goods Market**

In this chapter we make two simplifications: Assume both the domestic and the foreign price levels are given (i.e., fixed). Thus, the nominal and the real exchange rate move together. In chapters 3-5, we assumed the domestic price level was given (fixed).

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**Equilibrium in the Goods Market**

In this chapter we make two simplifications: There is no inflation, neither actual nor expected. This means that the real interest rate (which is what determines investment) is equal to the nominal interest rate (which is determined in the financial markets). Then, the equilibrium condition becomes:

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**Equilibrium in Financial markets**

20-2 The Demand for Domestic Money People will still demand currency for the same reasons: Higher income raises the demand for money, Higher interest rates reduce the quantity demanded of money.

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**Equilibrium in Financial markets**

Domestic Bonds Versus Foreign Bonds What combination of domestic and foreign bonds should financial investors choose in order to maximize expected returns? The domestic interest rate must be equal to the foreign interest rate plus the expected rate of depreciation of the domestic currency.

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**Equilibrium in Financial Markets**

If the expected future exchange rate is given, then: The current exchange rate is:

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**Equilibrium in Financial Markets**

An increase in the U.S. interest rate, say, after a monetary contraction, will cause the demand for U.S. bonds to rise. As investors switch from foreign currency to dollars, the dollar appreciates.

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**Equilibrium in Financial Markets**

We know that, in the medium run, monetary policy doesn’t do anything to interest rates. Monetary policy can’t change the medium run “neutral” interest rate This “neutral” interest rate is given by saving and investment (see Ch. 24 from ECON 201).

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**Equilibrium in Financial Markets**

If the interest rate is constant in the medium run, the expected exchange rate is constant in the medium run. So if today, we know that, in the medium run, This means that today’s appreciation will lead to people to expect a future depreciation.

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**Equilibrium in Financial Markets**

Assume that, until now, the one-year US interest rate and the one-year UK interest rate were both 4%. The US interest rate rises to 10%. If Ee is constant, then it must be that the dollar is expected to depreciate by 6%. That way, 10% = 4% % Expected gain in the dollar value of US asset Expected gain in the pound value of UK asset Expected gain in the value of the pound versus the dollar.

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**Equilibrium in Financial Markets**

If the dollar is expected to depreciate over the year… And Ee is constant… (so E is expected to end up at the same value in a year) Then the dollar must jump and appreciate by 6% today. 10% = 4% % Expected gain in the dollar value of US asset Expected gain in the pound value of UK asset Expected gain in the value of the pound versus the dollar.

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**Equilibrium in Financial Markets**

The more the dollar appreciates, the more investors expect it to depreciate in the future. The initial dollar appreciation must be such that the expected future depreciation exactly compensates for the increase in the U.S. interest rate. When this is the case, investors are again indifferent and equilibrium prevails.

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**Equilibrium in Financial Markets**

Ee i - i*

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**Equilibrium in Financial Markets**

Ee i - i* Here, the exchange rate appreciated too much. The expected depreciation requires a larger interest rate differential.

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**Equilibrium in Financial Markets**

Ee i - i* Here, the exchange rate appreciated too little. The expected depreciation is too small to justify the interest rate differential.

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**Equilibrium in Financial Markets**

The Relation Between the Interest Rate and the Exchange Rate Implied by Interest Parity A lower domestic interest rate leads to a higher exchange rate—to a depreciation of the domestic currency. A higher domestic interest rate leads to a lower exchange rate—to an appreciation of the domestic currency.

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**Putting Goods and Financial Markets Together**

20-3 Goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate.

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**Putting Goods and Financial Markets Together**

The interest rate is determined in the money market: The interest-parity condition implies a negative relation between the domestic interest rate and the exchange rate:

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**Putting Goods and Financial Markets Together**

Combining the interest-parity relation and the open-economy version of IS:

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**Putting Goods and Financial Markets Together**

The open-economy versions of the IS and LM relations are: Changes in the interest rate affect the economy directly through investment, and indirectly through the exchange rate.

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**Putting Goods and Financial Markets Together**

The IS-LM Model in the Open Economy An increase in the interest rate reduces output directly … (higher interest rates make investment more expensive) and indirectly. (higher i causes an exchange rate appreciation which makes exports more expensive). The IS curve is downward sloping. Given the real money stock, an increase in income increases the interest rate: The LM curve is upward sloping.

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**The Effects of Policy in an Open Economy**

20-4 The Effects of an Increase in Government Spending An increase in government spending leads to an increase in output, an increase in the interest rate, and an appreciation. The increase in government spending does not shift the LM curve nor the interest-parity curve.

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**The Effects of Policy in an Open Economy**

An expansionary fiscal policy raises both output and the interest rate. Higher interest rates lead to an appreciation. Higher Y and higher i work in opposite directions for investment. Higher Y increases imports (domestic purchases of foreign goods) while a lower E makes exports more expensive and import cheaper: NX declines.

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**The Effects of Monetary Policy in an Open Economy**

The Effects of a Monetary Contraction A monetary contraction leads to a decrease in output, an increase in the interest rate, and an appreciation. The decrease in the money supply does not shift the IS curve nor the interest-parity curve.

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**The Effects of Policy in an Open Economy**

A contractionary monetary policy lowers output and raises the interest rate. Higher interest rates lead to an appreciation. Lower Y and higher i work in the same direction on investment: I falls. Lower Y decreases imports (domestic purchases of foreign goods) but a lower E pushes NX down: the effect on NX is ambiguous.

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**The Effects of Policy in an Open Economy**

In the early eighties, the Fed pursued a very contractionary policy while fiscal policy turned very expansionary.

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**Monetary Contraction and Fiscal Policy Expansions**

Table The Emergence of Large U.S. Budget Deficits, 1980 1981 1982 1983 1984 Spending 22.0 22.8 24.0 25.0 23.7 Revenues 20.2 20.8 20.5 19.4 19.2 Personal taxes 9.4 9.6 9.9 8.8 8.2 Corporate taxes 2.6 2.3 1.6 2.0 Budget surplus 1.8 2.0 3.5 5.6 4.5 Numbers are for fiscal years, which start in October of the previous calendar year. All numbers are expressed as a percentage of GDP.

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**The Effects of Policy in an Open Economy**

Both a fiscal expansion and a monetary contraction should lead to higher interest rates and an exchange-rate appreciation. The effect on output is ambiguous. However, we know that monetary policy works more quickly than fiscal policy, so output should have fallen first and then recuperated.

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**The Effects of Policy in an Open Economy**

The E appreciation should have contracted NX. The initial recession should have improved NX, but the later boom should have contributed to a trade deficit.

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**Monetary Contraction and Fiscal Policy Expansions**

Economic policy was made by “Supply siders” a group of economists who argued that a cut in tax rates would boost economic activity. High output growth and dollar appreciation during the early 1980s resulted in an increase in the trade deficit. A higher trade deficit, combined with a large budget deficit, became know as the twin deficits of the 1980s.

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**Monetary Contraction and Fiscal Policy Expansions**

Table 20-2 Major U.S. Macroeconomic Variables, 1980 1981 1982 1983 1984 GDP Growth (%) 0.5 1.8 2.2 3.9 6.2 Unemployment rate (%) 7.1 7.6 9.7 9.6 7.5 Inflation (CPI) (%) 12.5 8.9 3.8 Interest rate (nominal) (%) 11.5 14.0 10.6 8.6 Interest rate (real) (%) 2.5 4.9 6.0 5.1 5.9 Real exchange rate 117 99 89 85 77 Trade surplus (: deficit) (% of GDP) 0.4 0.6 1.5 2.7 Inflation: Rate of change of the CPI. The nominal interest rate is the three-month T-bill rate. The real interest rate is equal to the nominal rate minus the forecast of inflation by DRI, a private forecasting firm. The real exchange rate is the trade-weighted real exchange rate, normalized so that 1973 = 100

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Fixed Exchange Rates 20-5 Central banks act under implicit and explicit exchange-rate targets and use monetary policy to achieve those targets. Some peg their currency to the US Dollar or to another strong currency, like the Deutsche Mark or the French Franc or the Euro. Alternatively, they may peg to a basket of currencies, with weights reflecting the composition of their trade.

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**Fixed Exchange Rates Some countries operate under a crawling peg.**

Suppose you know that the domestic price level rises faster than the U.S. price level, Then you know that the country faces a real appreciation that can rapidly make domestic goods noncompetitive. To avoid this effect, countries choose a predetermined depreciation rate against the dollar, a “crawl”.

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Fixed Exchange Rates The European Monetary System (EMS), determined the movements of exchange rates within the European Union from 1978 to 1998. Countries agreed to maintain their currencies within bands around a central parity. Some countries moved further, agreeing to adopt a common currency, the Euro, in effect, adopting a “fixed exchange rate.”

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**Pegging the Exchange Rate, and Monetary Control**

The interest parity condition is: Pegging the exchange rate turns the interest parity relation into:

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**Pegging the Exchange Rate, and Monetary Control**

If the exchange rate is expected to remain unchanged, the domestic interest rate must be equal to the foreign interest rate. Increases in the domestic demand for money must be matched by increases in the supply of money in order to maintain the interest rate constant, so that this condition now holds:

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**Pegging the Exchange Rate, and Monetary Control**

If the exchange rate is expected to remain unchanged, the domestic interest rate must be equal to the foreign interest rate. This means that the domestic Central Bank does not have an independent monetary policy. If it tries to lower i, it will have to give up control over E.

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**Pegging the Exchange Rate, and Monetary Control**

Under fixed exchange rates, monetary policy is not effective. But fiscal policy is very effective. Because the CB keeps i=i*, expansionary fiscal policy does not raise interest rates. There’s no “crowding out” of investment, and no E appreciation to reduce NX. The expansion of output is relatively large.

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**Fiscal Policy Under Fixed Exchange Rates**

The Effects of a Fiscal Expansion Under Fixed Exchange Rates Under flexible exchange rates, a fiscal expansion increases output, from YA to YB. Under fixed exchange rates, output increases from YA to YC. The central bank must accommodate the resulting increase in the demand for money.

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**Pegging the Exchange Rate, and Monetary Control**

But because Y expands by a lot under fixed exchange rates, expansionary fiscal policy causes a surge of imports and a trade deficit. There are two goals: Y and NX. Monetary policy is now ineffective, and fiscal policy can only shoot for one.

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McGraw-Hill/Irwin Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. INTERNATIONAL FINANCIAL POLICY INTERNATIONAL FINANCIAL POLICY.

McGraw-Hill/Irwin Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. INTERNATIONAL FINANCIAL POLICY INTERNATIONAL FINANCIAL POLICY.

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