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

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

• 20-1 Equilibrium in the Goods Market
• 20-2 Equilibrium in Financial Markets
• 20-3 Putting Goods and Financial Markets
  Together
• 20-4 The Effects of Policy in an Open Economy
• 20-5 Fixed Exchange Rates
• Appendix Fixed Exchange Rates, Interest Rates,
  and Capital Mobility

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20-1 Equilibrium in the Goods Market

• In Chapter 19, we had rewritten the IS curve as
• Y C(Y-T) I(Y,r) G-eQ(Y,e) X(Y,e)
• In this chapter, we assume that the
  Marshall-Lerner condition always holds
• That is, the positive effect of depreciation on
  exports is stronger than its negative effect on
  imports
• So, now we lump the two trade terms together
• Y C(Y-T) I(Y,r) G NX(Y,Y,e)
• In the short-run, prices are more-or-less
  constant, so we can replace with E
• The (net) effects of the last three arguments are
  -,,

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20-2 Equilibrium in Financial Markets

• Money versus Bonds
• Domestic Bonds versus Foreign Bonds

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Money versus Bonds

• The LM function doesnt change at all when we
  introduce international trade
• M/P YL(i)

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Domestic Bonds versus Foreign Bonds

• In Chapter 18, we introduced the idea of
  (uncovered) interest parity
• (1i) Et1(1i)/Et
• Here, we rewrite this as
• i i (Et1 - Et)/Et
• Assuming that we know the future exchange rate,
  and denote it as Ee
• Then we can rearrange this into
• E Ee/(1 i i)

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Domestic Bonds versus Foreign Bonds Contd

• This relationship indicates that domestic
  interest rates and exchange rates will move in
  opposite directions
• If our interest rates go up, this makes foreign
  investors want to sell their bonds, and buy ours
• They must have dollars in order to buy our bonds
• So, foreign investors are willing to trade more
  of their currency for less dollars pushing the
  exchange rate up

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Digression Derivation of the New Expression for
(Uncovered Interest Parity) from p. 383

• Recall that ln(1x) ? x (see p. A7)
• Note that Et1/Et 1 e
• Where e (Et1 Et)/Et
• Now, rewrite the (uncovered) interest parity
  equation
• (1i) Et1(1i)/Et (1i)(1e)
• ln(1i) ln(1i) ln(1e)
• i i e i (Et1 Et)/Et

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20-3 Putting Goods and Financial Markets Together

• Again, the LM does not change
• We now substitute the simplified (uncovered)
  interest parity condition into the net exports
  part of the IS function
• Y C(Y-T) I(Y,r) G NX(Y,Y,E)
• Y C(Y-T) I(Y,r) G NX(Y,Y, Ee/1 i
  i)
• Interest rates now affect the economy through two
  channels, but it turns out that both lead to an
  inverse relationship with output
• For example, when interest rates drop, investment
  rises and so do net exports since the exchange
  rate depreciates making exports cheaper and
  imports more expensive

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20-4 The Effects of Policy in an Open Economy

• The Effects of Fiscal Policy in an Open Economy
• The Effects of Monetary Policy in an Open Economy

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The Effects of Fiscal Policy in an Open Economy

• Expansionary fiscal policy pushes the IS to the
  right increasing GDP by a lot
• This increases domestic interest rates
• This will make the domestic currency appreciate
• So, exports will go down, and imports will go up
  which pushes us towards a trade deficit, and
  tends to mitigate the GDP increase noted above

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The Effects of Monetary Policy in an Open Economy

• Contractionary monetary pushes the LM to the left
  decreasing GDP by a lot, however the rest of
  the effects are similar to an expansionary fiscal
  policy
• This increases domestic interest rates
• This will make the domestic currency appreciate
• So, exports will go down, and imports will go up
  which pushes us towards a trade deficit, and
  tends to mitigate the GDP increase noted above

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Digression Reagan and Volkers Monetary and
Fiscal Policy Mix

• Policies
• Reagan pursued marginal tax rate reductions
  which raise issues beyond this digression
• Reagan and Congress pursued an expansionary
  fiscal policy by cutting tax revenue
• Volker and the Federal Reserve pursued a
  contractionary monetary policy at the same time
• Effects
• Interest rates rose (relative to the rest of the
  world), the dollar appreciated and the trade
  deficit ballooned

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20-5 Fixed Exchange Rates

• Pegs, Crawling Pegs, Bands, the EMS, and the Euro
• Pegging the Exchange Rate, and Monetary Control
• Fiscal Policy under Fixed Exchange Rates

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Pegs, Crawling Pegs, Bands, the EMS, and the Euro

• A currency whose exchange rate is fixed is
  pegged to the value of some asset
• Some countries choose to have a crawling peg
• Occasional adjustments are made
• There is no plan to surprise anyone
• Some countries choose to let their currency
  fluctuate freely between upper and lower bands

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Pegging the Exchange Rate, and Monetary Control

• Capital moves quicker than goods, so (uncovered)
  interest parity dictates the pressures on
  exchange rates
• Capital will move to the country with the highest
  interest rate
• Under a flexible system, exchange rates will
  adjust to this
• Under a fixed system, exchange rates are not free
  to adjust
• So, the only way a central bank can maintain
  fixed exchange rates is to peg the domestic
  interest rate to that of the country you peg your
  currency to

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Pegging the Exchange Rate, and Monetary Control
Contd

• Essentially, if you choose to peg the value of
  your currency to the value of some other
  countries currency, you
• Lose the ability to conduct your own monetary
  policy
• Adopt or mimic the monetary policy choices of the
  other country
• If you dont, you wont be able to maintain the
  peg

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Fiscal Policy under Fixed Exchange Rates

• Fortunately, fiscal policy is more powerful under
  fixed exchange rates
• Suppose the government pursues an expansionary
  fiscal policy under fixed exchange
• IS shifts to the right
• Output rises
• There is upward pressure on interest rates

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Fiscal Policy under Fixed Exchange Rates Contd

• The central bank cant permit this pressure raise
  interest rates
• Otherwise capital will flow in, and the central
  bank will have to abandon its pegged exchange
  rate
• So, the central bank must accommodate the
  expansionary fiscal policy with an expansionary
  monetary policy
• The LM shifts to the right
• This puts downward pressure on interest rates
• This increases output even further

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Appendix Fixed Exchange Rates, Interest Rates,
and Capital Mobility

• Not required