Output, The Interest Rate, and The Exchange Rate: Prepared By: Fernando Quijano and Yvonn Quijano

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Output, the Interest

Rate, and the


Exchange Rate

CHAPTER 20
CHAPTER20
Prepared by:
Fernando Quijano and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard


Output, the Interest Rate,
and the Exchange Rate
Chapter 20: Output, the Interest Rate,

The model developed in this chapter is an


extension of the open economy IS-LM model,
known as the Mundell-Fleming model.
and the Exchange Rate

The main questions we try to solve are:


What determines the exchange rate?
How can policy makers affect exchange
rates?

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 2 of 32


Equilibrium in the
20-1
Goods Market
Chapter 20: Output, the Interest Rate,

Equilibrium in the goods market can be described


by the following equations:
and the Exchange Rate

Y  C ( Y  T )  I ( Y ,r )  G  I M ( Y , ) /   X ( Y * , )
(  ) (  , ) (  , ) (  , )

N X ( Y ,Y * ,  )  X ( Y * ,  )  I M ( Y ,  ) / 

Y  C (Y  T )  I (Y ,r )  G  N X (Y ,Y * , )
(  ) (  , ) (  , , )

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 3 of 32


Equilibrium in the
Goods Market
Chapter 20: Output, the Interest Rate,

 Consumption C depends positively on


disposable income Y-T.
 Investment I depends positively on output Y,
and the Exchange Rate

and negatively on the real interest rate r.


 Government spending G is taken as given.
 The quantity of imports IM depends positively on
both output Y and the real exchange rate  .
 Exports X depend positively on foreign output Y*
and negatively on the real exchange rate  .

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 4 of 32


Equilibrium in the
Goods Market
Chapter 20: Output, the Interest Rate,

Y  C (Y  T )  I (Y ,r )  G  N X (Y ,Y * , )
(  ) (  , ) (  , , )
The main implication of this equation is that both
and the Exchange Rate

the real interest rate and the real exchange rate


affect demand and, in turn, equilibrium output:
 An increase in the real interest rate leads to a
decrease in investment spending, and to a
decrease in the demand for domestic goods.
 An increase in the real exchange rate leads to
a shift in demand toward foreign goods, and
to a decrease in net exports.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 5 of 32


Equilibrium in the
Goods Market
Chapter 20: Output, the Interest Rate,

In this chapter we make two simplifications:


 Both the domestic and the foreign price levels
are given; thus, the nominal and the real
and the Exchange Rate

exchange rate move together:


P *
 1    E
P
 There is no inflation, neither actual nor
expected.
 e
 0, so r  i
Then, the equilibrium condition becomes:
Y  C (Y  T )  I (Y ,r )  G  N X (Y ,Y * , E )
(  ) (  , ) (  , , )
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 6 of 32
Equilibrium in
20-2
Financial markets
Chapter 20: Output, the Interest Rate,

Now that we look at a financially open


economy, we must also take into
account the fact that people have a
and the Exchange Rate

choice between domestic bonds and


foreign bonds.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 7 of 32


Money Versus Bonds
Chapter 20: Output, the Interest Rate,

We wrote the condition that the supply of money


be equal to the demand for money as:
M
and the Exchange Rate

 Y L (i)
P
We can use this equation to think about the
determination of the nominal interest rate in an
open economy.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 8 of 32


Domestic Bonds Versus
Foreign Bonds
Chapter 20: Output, the Interest Rate,

What combination of domestic and foreign bonds


should financial investors choose in order to
maximize expected returns?
and the Exchange Rate

 E t 
(1  it )  (1  i t )   e 
*
 E t1 
The left side gives the return, in terms of
domestic currency. The right side gives the
expected return, also in terms of domestic
currency. In equilibrium, the two expected
returns must be equal.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 9 of 32


Domestic Bonds Versus
Foreign Bonds
Chapter 20: Output, the Interest Rate,

E
(1 it ) (1 i t )
*
e
t
E t 1
and the Exchange Rate

If the expected future exchange rate is given,


then:
1 it
E t * E
e
t1
1 it

The current exchange rate is:


1i
E  *E e
1i

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 10 of 32


Domestic Bonds Versus
Foreign Bonds
Chapter 20: Output, the Interest Rate,

An increase in the U.S. interest rate, say, after a


monetary contraction, will cause the U.S. interest
rate to increase, and the demand for U.S. bonds
and the Exchange Rate

to rise. As investors switch from foreign currency


to dollars, the dollar appreciates.
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 compensates
for the increase in the U.S. interest rate. When
this is the case, investors are again indifferent
and equilibrium prevails.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 11 of 32


Domestic Bonds Versus
Foreign Bonds
Chapter 20: Output, the Interest Rate,

Figure 20 - 1
The Relation Between
the Interest Rate and the
Exchange Rate Implied
and the Exchange Rate

by Interest Parity

A higher domestic interest


rate leads to a higher
exchange rate – an
appreciation.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 12 of 32


Putting Goods and
20-3
Financial Markets Together
Chapter 20: Output, the Interest Rate,

Goods-market equilibrium implies that output


depends, among other factors, on the interest
rate and the exchange rate.
and the Exchange Rate

Y  C (Y  T )  I (Y ,i)  G  N X (Y ,Y * , E )

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 13 of 32


Putting Goods and
Financial Markets Together
Chapter 20: Output, the Interest Rate,

The interest rate is determined by the equality of


money supply and money demand:
M
and the Exchange Rate

 Y L (i)
P
The interest-parity condition implies a negative
relation between the domestic interest rate and
the exchange rate:

1i i  E 
E  *E e
1i i  E 

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 14 of 32


Putting Goods and
Financial Markets Together
Chapter 20: Output, the Interest Rate,

The open-economy versions of the IS and LM


relations are:
and the Exchange Rate

 * 1 i e 
I S : Y  C ( Y  T )  I ( Y ,i )  G  N X  Y ,Y , * E 
 1i 
M
LM :  Y L (i)
P
 Changes in the interest rate affect the economy
directly through investment,
 indirectly through the exchange rate.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 15 of 32


Putting Goods and
Financial Markets Together
Chapter 20: Output, the Interest Rate,

Figure 20 - 2
The IS-LM Model in
the Open Economy

An increase in the
and the Exchange Rate

interest rate reduces


output both directly and
indirectly (through the
exchange rate). The IS
curve is downward
sloping. Given the real
money stock, an
increase in output
increases the interest
rate: The LM curve is
upward sloping.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 16 of 32


The Effects of Policy
20-4
in an Open Economy
Chapter 20: Output, the Interest Rate,

Figure 20 - 3
The Effects of an
Increase in
Government
and the Exchange Rate

Spending
An increase in
government
spending leads to an
increase in output,
an increase in the
interest rate, and an The increase in government spending
appreciation.
shifts the IS curve to the right. It shifts
neither the LM curve nor the interest-
parity curve.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 17 of 32


The Effects of Policy
in an Open Economy
Chapter 20: Output, the Interest Rate,

Can we tell what happens to the various


components of demand for money when the
government increases spending:
and the Exchange Rate

 Consumption and government spending both


go up.
 The effect of government spending on
investment was ambiguous in the closed
economy, it remains ambiguous in the open
economy.
 Both the increase in output and the
appreciation combine to decrease net
exports.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 18 of 32
The Effects of Monetary Policy
in an Open Economy
Chapter 20: Output, the Interest Rate,

Figure 20 - 4
The Effects of a
Monetary
Contraction
and the Exchange Rate

A monetary
contraction leads to a
decrease in output,
an increase in the
interest rate, and an
appreciation.
A monetary contraction shifts the LM
curve up. It shifts neither the IS curve
nor the interest-parity curve.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 19 of 32


Monetary Contraction, and Fiscal
Expansion: The United States in
the Early 1980s
Chapter 20: Output, the Interest Rate,

Table 1 The Emergence of Large U.S. Budget Deficits, 1980-1984


1980 1981 1982 1983 1984
Spending 22.0 22.8 24.0 25.0 23.7
and the Exchange Rate

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 1.6 2.0
Budget surplus (-:deficit) 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.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 20 of 32


Monetary Contraction, and Fiscal
Expansion: The United States in
the Early 1980s
Chapter 20: Output, the Interest Rate,

Supply siders—a group of economists who


argued that a cut in tax rates would boost
economic activity.
and the Exchange Rate

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.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 21 of 32


Monetary Contraction, and Fiscal
Expansion: The United States
in the Early 1980s
Chapter 20: Output, the Interest Rate,

Table 2 Major U.S. Macroeconomic Variables, 1980-1984


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
and the Exchange Rate

Inflation (CPI) (%) 12.5 8.9 3.8 3.8 3.9


Interest rate (nominal) (%) 11.5 14.0 10.6 8.6 9.6
(real) (%) 2.5 4.9 6.0 5.1 5.9
117
Real exchange rate 99 89 85 77
Trade surplus (: deficit)
(% of GDP) 0.5 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

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 22 of 32


20-5 Fixed Exchange Rates
Chapter 20: Output, the Interest Rate,

Central banks act under implicit and


explicit exchange-rate targets and use
monetary policy to achieve those
and the Exchange Rate

targets.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 23 of 32


Pegs, Crawling Pegs, Bonds,
the EMS, and the Euro
Chapter 20: Output, the Interest Rate,

Some countries operate under fixed exchange


rates. These countries maintain a fixed exchange
rate in terms of some foreign currency. Some peg
and the Exchange Rate

their currency to the dollar.


Some countries operate under a crawling peg.
These countries typically have inflation rates that
exceed the U.S. inflation rate.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 24 of 32


Pegs, Crawling Pegs, Bonds,
the EMS, and the Euro
Chapter 20: Output, the Interest Rate,

Some countries maintain their bilateral exchange


rates within some bands. The most prominent
example is the European Monetary System
and the Exchange Rate

(EMS). Under the EMS rules, member countries


agreed to maintain their exchange rate vis-á-vis the
other currencies in the system within narrow limits
or bands around a central parity.
Some countries moved further, agreeing to adopt a
common currency, the Euro, in effect, adopting a
“fixed exchange rate.”

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 25 of 32


Pegging the Exchange Rate,
and Monetary Control
Chapter 20: Output, the Interest Rate,

The interest parity condition is:

 Et 
(1 it ) (1 i t )  e 
*
and the Exchange Rate

 E t1 
Pegging the exchange rate turns the interest
parity relation into:

(1  it )  (1  i * t ) it  i * t

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 26 of 32


Pegging the Exchange Rate,
and Monetary Control
Chapter 20: Output, the Interest Rate,

In words: Under a fixed exchange rate and


perfect capital mobility, the domestic interest rate
must be equal to the foreign interest rate.
and the Exchange 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 the following condition holds:

M
 Y L (i * )
P

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 27 of 32


Fiscal Policy Under
Fixed Exchange Rates
Chapter 20: Output, the Interest Rate,

Figure 20 - 5
The Effects of a
Fiscal Expansion
Under Fixed
and the Exchange Rate

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.
© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 28 of 32
Fiscal Policy Under
Fixed Exchange Rates
Chapter 20: Output, the Interest Rate,

There are a number of reasons why countries


choosing to fix its interest rate appears to be a bad
idea:
and the Exchange Rate

 By fixing the exchange rate, a country gives up a


powerful tool for correcting trade imbalances or
changing the level of economic activity.
 By committing to a particular exchange rate, a
country also gives up control of its interest rate,
and they must match movements in the foreign
interest rate risking unwanted effects on its own
activity.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 29 of 32


Fiscal Policy Under
Fixed Exchange Rates
Chapter 20: Output, the Interest Rate,

There are a number of reasons why countries


choosing to fix its interest rate appears to be a bad
idea:
and the Exchange Rate

 Although the country retains control of fiscal


policy, one policy instrument is not enough. A
country that wants to decrease its budget deficit
cannot, under fixed exchange rates, use
monetary policy to offset the contractionary effect
of its fiscal policy on output.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 30 of 32


German Unification,
Interest Rates, and the EMS
Chapter 20: Output, the Interest Rate,

Table 1 German Unification, Interest Rates, and Output Growth: Germany,


France, and Belgium, 1990-1992
Nominal Interest Rates (%) Inflation (%)
1990 1991 1992 1990 1991 1992
and the Exchange Rate

Germany 8.5 9.2 9.5 2.7 3.7 4.7

France 10.3 9.6 10.3 2.9 3.0 2.4

Belgium 9.6 9.4 9.4 2.9 2.7 2.4

Real Interest Rates (%) GDP Growth (%)


1990 1991 1992 1990 1991 1992
Germany 5.7 5.5 4.8 5.7 4.5 2.1

France 7.4 6.6 7.9 2.5 0.7 1.4

Belgium 6.7 6.7 7.0 3.3 2.1 0.8


The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realized real interest rate
over the year – that is, the nominal interest rate minus actual inflation over the year. All rates are annual.

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 31 of 32


Key Terms
Chapter 20: Output, the Interest Rate,

 Mundell-Fleming model  European Monetary System


(EMS)
 supply siders
 bands
 twin deficits
 central parity

and the Exchange Rate

peg
 Euro
 crawling peg

© 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 32 of 32

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