1. Output, the Interest Rate, and the Exchange Rate

2. 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?

3. 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.

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

5. 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).

6. 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:

7. 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.

8. 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.

9. Equilibrium in Financial Markets
If the expected future exchange rate is given, then:
The current exchange rate is:

10. 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.

11. 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).

12. 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.

13. 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.

14. 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.

15. 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.

16. Equilibrium in Financial MarketsEe
i - i*

17. Equilibrium in Financial MarketsEe
i - i*
Here, the exchange rate appreciated too much.
The expected depreciation requires a larger interest rate differential.

18. Equilibrium in Financial MarketsEe
i - i*
Here, the exchange rate appreciated too little.
The expected depreciation is too small to justify the interest rate differential.

19. 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.

20. 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.

21. 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:

22. Putting Goods and Financial Markets Together
Combining the interest-parity relation and the open-economy version of IS:

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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

35. 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.

36. 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”.

37. 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.”

38. Pegging the Exchange Rate, and Monetary Control
The interest parity condition is:
Pegging the exchange rate turns the interest parity relation into:

39. 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:

40. 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.

41. 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.

42. 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.

43. 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.