Output, the Interest Rate, and the Exchange Rate

Output, the Interest Rate, and the Exchange Rate Output, the Interest Rate, and the Exchange Rate An extension of the open economy ISLM model - the Mundell-Fleming model.  The main questions we try to solve are:  What determines the exchange rate?  How can policy makers affect the exchange rate?  Robert Mundell (1932- ) Equilibrium in the Goods Market  Equilibrium in the goods market is described by the following equation: Y = C(Y - T ) + I(Y ,r ) + G + NX (Y ,Y , ε ) * (  ) (  , ) (, , ) Equilibrium in the Goods Market  Two simplifying assumptions: 1. The domestic and the foreign price levels are given;  The nominal and the real exchange rate move together. 2. There is no inflation, neither actual nor expected.  The nominal interest rate is equal to the real interest rate Y  C(Y  T )  I (Y , r )  G  NX (Y , Y * , E ) (  , ) (  ) (, , ) Equilibrium in Financial markets Domestic Bonds Versus Foreign Bonds  What interest rates on domestic and foreign bonds should financial investors demand? Et (1  it )  (1  i t ) e E t 1 *  The domestic interest rate must be equal to the foreign interest rate plus the expected rate of depreciation of the domestic currency (UIP). 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. Equilibrium in Financial Markets The Relation Between the Interest Rate and the Exchange Rate Implied by Interest Parity Putting Goods and Financial Markets Together  Goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate. Y  C(Y  T )  I (Y , i )  G  NX (Y , Y * , E ) Putting Goods and Financial Markets Together  The interest rate is determined in the money market: M P  YL(i )  The interest-parity condition implies a positive relation between the domestic interest rate and the exchange rate: 1 i e E * E 1 i Putting Goods and Financial Markets Together   e  * 1 i IS: Y  C(Y  T ) I (Y ,i ) G NX  Y ,Y , * E    1 i The open-economy versions of the IS and LM relations are: M LM:  YL(i ) P Changes in the interest rate affect the economy directly through investment, and indirectly through the exchange rate. Putting Goods and Financial Markets Together The IS-LM Model in the Open Economy An increase in the 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 income increases the interest rate: The LM curve is upward sloping. The Effects of Fiscal Policy in an Open Economy 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 affects neither the LM curve nor the interest-parity curve. 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 affects neither the IS curve nor the interest-parity curve. Monetary Contraction and Fiscal Policy Expansions The Emergence of Large U.S. Budget Deficits, 1980-1984 1980 Spending Revenues Personal taxes Corporate taxes Budget surplus 22.0 20.2 9.4 2.6 1.8 1981 22.8 20.8 9.6 2.3 2.0 1982 24.0 20.5 9.9 1.6 3.5 1983 25.0 19.4 8.8 1.6 5.6 1984 23.7 19.2 8.2 2.0 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. Monetary Contraction and Fiscal Policy Expansions   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. Monetary Contraction and Fiscal Policy Expansions Major U.S. Macroeconomic Variables, 1980-1984 1980 GDP Growth (%) Unemployment rate (%) Inflation (CPI) (%) 0.5 7.1 12.5 1981 1.8 7.6 8.9 1982 2.2 9.7 3.8 1983 3.9 9.6 3.8 1984 6.2 7.5 3.9 Interest rate (nominal) (%) (real) (%) Real exchange rate Trade surplus (% of GDP) 11.5 2.5 117 0.5 14.0 4.9 99 0.4 10.6 6.0 89 0.6 8.6 5.1 85 1.5 9.6 5.9 77 2.7 The Twins Today Fixed Exchange Rates Central banks act under implicit and explicit exchange-rate targets and use monetary policy to achieve those targets.  Some peg their currency to the dollar, to other currencies, or to a basket of currencies, with weights reflecting the composition of their trade.  Pegging the Exchange Rate, and Monetary Control  The UIP condition is:  Et  (1  it )  (1  i t )  e   E t 1  *  Pegging the exchange rate turns the interest parity relation into: (1 it ) (1 i * t ) it  i * t 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 the following condition holds: M  YL(i ) P 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. Policy in the Mundell-Fleming Model with Fixed Exchange Rates Real Interest Rate (%) 1. Expansionary monetary policy pressures the domestic interest rate to fall. LM0 LM1 A rw BP 2. The policy is reversed to keep the exchange rate fixed. IS0 Y0 Aggregate Output Real Interest Rate (%) Policy in the Mundell-Fleming Model 1. Expansionary fiscal with Flexible policy shifts the IS curve to the right. Exchange Rates LM 2. Currency appreciation shifts the IS curves somewhat back. r1 rw A B IS0 IS1 Y0 Y1 Aggregate Output Real Interest Rate (%) Policy in the Mundell-Fleming Model 1. Expansionary monetary with Flexible policy shifts the LM curve to the right. Exchange Rates LM0 LM1 A rw B 2. Currency depreciation shifts the IS curve to the right. IS0 IS1 Y0 Y1 Aggregate Output