Output, The Interest Rate, and The Exchange Rate: Prepared By: Fernando Quijano and Yvonn Quijano
Output, The Interest Rate, and The Exchange Rate: Prepared By: Fernando Quijano and Yvonn Quijano
Output, The Interest Rate, and The Exchange Rate: Prepared By: Fernando Quijano and Yvonn Quijano
CHAPTER 20
CHAPTER20
Prepared by:
Fernando Quijano and Yvonn Quijano
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 * , )
( ) ( , ) ( , , )
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
Y L (i)
P
We can use this equation to think about the
determination of the nominal interest rate in an
open economy.
E t
(1 it ) (1 i t ) e
*
E t1
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.
E
(1 it ) (1 i t )
*
e
t
E t 1
and the Exchange Rate
Figure 20 - 1
The Relation Between
the Interest Rate and the
Exchange Rate Implied
and the Exchange Rate
by Interest Parity
Y C (Y T ) I (Y ,i) G N X (Y ,Y * , E )
Y L (i)
P
The interest-parity condition implies a negative
relation between the domestic interest rate and
the exchange rate:
1i i E
E *E e
1i i E
* 1 i e
I S : Y C ( Y T ) I ( Y ,i ) G N X Y ,Y , * E
1i
M
LM : Y L (i)
P
Changes in the interest rate affect the economy
directly through investment,
indirectly through the exchange rate.
Figure 20 - 2
The IS-LM Model in
the Open Economy
An increase in the
and the Exchange 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.
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.
targets.
Et
(1 it ) (1 i t ) e
*
and the Exchange Rate
E t1
Pegging the exchange rate turns the interest
parity relation into:
(1 it ) (1 i * t ) it i * t
M
Y L (i * )
P
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,
peg
Euro
crawling peg