© 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 20 C H A P T E R Output, the.

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

2020C H A P T E RC H A P T E R

Output, the InterestOutput, the InterestRate, and theRate, and theExchange RateExchange Rate

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Output, the Interest Rate,Output, the Interest Rate,and the Exchange Rateand the Exchange Rate

The model developed in this chapter is an The model developed in this chapter is an extension of the open economy IS-LM model, extension of the open economy IS-LM model, known as the known as the Mundell-Fleming modelMundell-Fleming model..

The main questions we try to solve are:The main questions we try to solve are: What determines the exchange rate?What determines the exchange rate? How can policy makers affect exchange rates?How can policy makers affect exchange rates?


Equilibrium in theEquilibrium in theGoods MarketGoods Market

Equilibrium in the goods market can be Equilibrium in the goods market can be described by the following equations:described by the following equations:

20-1

Y C Y T I Y r G IM Y X Y ( ) ( , ) ( , ) ( , )* ( ) ( , ) ( , ) ( , )

N X Y Y IM Y( , , ) ( , )*

Y C Y T I Y r G N X Y Y ( ) ( , ) ( , , )* ( ) ( , ) ( , , )


Equilibrium in the Goods MarketEquilibrium in the Goods Market

In this chapter we make two simplifications:In this chapter we make two simplifications:1.1. Both the domestic and the foreign price levels are Both the domestic and the foreign price levels are

given; thus, the nominal and the real exchange given; thus, the nominal and the real exchange rate move together:rate move together:

P

PE

*

1

2.2. There is no inflation, neither actual nor expected.There is no inflation, neither actual nor expected. e i 0, so r

Then, the equilibrium condition becomes:Then, the equilibrium condition becomes:Y C Y T I Y r G N X Y Y E ( ) ( , ) ( , , )*

( ) ( , ) ( , , )


Equilibrium inEquilibrium inFinancial marketsFinancial markets

Domestic Bonds Versus Foreign BondsDomestic Bonds Versus Foreign Bonds What combination of domestic and foreign What combination of domestic and foreign

bonds should financial investors choose in bonds should financial investors choose in order to maximize expected returns?order to maximize expected returns?

20-2

i iE E

Et t

et t

t

* 1

The domestic interest rate must be equal to The domestic interest rate must be equal to the foreign interest rate plus the expected rate the foreign interest rate plus the expected rate of depreciation of the domestic currency.of depreciation of the domestic currency.


Equilibrium in Financial MarketsEquilibrium in Financial Markets

If the expected future exchange rate is given, If the expected future exchange rate is given, then:then:

i iE E

Et t

et t

t

* 1

i iE E

E

e

*

The current exchange rate is:The current exchange rate is:

EE

i i

e

1 *

i E

i E



An increase in the U.S. interest rate, say, after An increase in the U.S. interest rate, say, after a monetary contraction, will cause the U.S. a monetary contraction, will cause the U.S. interest rate to increase, and the demand for interest rate to increase, and the demand for U.S. bonds to rise. As investors switch from U.S. bonds to rise. As investors switch from foreign currency to dollars, the dollar foreign currency to dollars, the dollar appreciates.appreciates.



The more the dollar appreciates, the more The more the dollar appreciates, the more investors expect it to depreciate in the future.investors expect it to depreciate in the future.

The initial dollar appreciation must be such that The initial dollar appreciation must be such that the expected future depreciation compensates the expected future depreciation compensates for the increase in the U.S. interest rate. When for the increase in the U.S. interest rate. When this is the case, investors are again indifferent this is the case, investors are again indifferent and equilibrium prevails.and equilibrium prevails.



The Relation Between The Relation Between the Interest Rate and the the Interest Rate and the Exchange Rate Implied Exchange Rate Implied by Interest Parityby Interest Parity

A lower domestic interest A lower domestic interest rate leads to a higher rate leads to a higher exchange rate—to a exchange rate—to a depreciation of the depreciation of the domestic currency. A domestic currency. A higher domestic interest higher domestic interest rate leads to a lower rate leads to a lower exchange rate—to an exchange rate—to an appreciation of the appreciation of the domestic currency.domestic currency.


Putting Goods andPutting Goods andFinancial Markets TogetherFinancial Markets Together

Goods-market equilibrium implies that output Goods-market equilibrium implies that output depends, among other factors, on the interest depends, among other factors, on the interest rate and the exchange rate.rate and the exchange rate.

20-3

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



The interest rate is determined in the money The interest rate is determined in the money market: market:

M

PY L i ( )

The interest-parity condition implies a negative The interest-parity condition implies a negative relation between the domestic interest rate and relation between the domestic interest rate and the exchange rate:the exchange rate:

EE

i i

e

1 *

i E

i E



The open-economy versions of the The open-economy versions of the ISIS and and LMLM relations are:relations are:

Changes in the interest rate affect the economy Changes in the interest rate affect the economy directly through investment, and indirectly directly through investment, and indirectly through the exchange rate.through the exchange rate.

IS C Y T I Y i G N X Y YE

i i

e

: ( ) ( , ) , ,* * Y

1

L MM

PY L i: ( )



The IS-LM Model in the The IS-LM Model in the Open EconomyOpen Economy

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


The Effects of PolicyThe Effects of Policyin an Open Economyin an Open Economy

The Effects of an The Effects of an Increase in Increase in Government SpendingGovernment Spending

An increase in An increase in government spending government spending leads to an increase in leads to an increase in output, an increase in output, an increase in the interest rate, and the interest rate, and an appreciation.an appreciation.

20-4

The increase in The increase in government spending government spending affects neither the affects neither the LMLM curve nor the interest-curve nor the interest-parity curve.parity curve.


The Effects of Monetary PolicyThe Effects of Monetary Policyin an Open Economyin an Open Economy

The Effects of a The Effects of a Monetary ContractionMonetary Contraction

A monetary contraction A monetary contraction leads to a decrease in leads to a decrease in output, an increase in output, an increase in the interest rate, and the interest rate, and an appreciation.an appreciation.

The decrease in the The decrease in the money supply affects money supply affects neither the neither the ISIS curve curve nor the interest-parity nor the interest-parity curve.curve.


Monetary Contraction andMonetary Contraction andFiscal Policy ExpansionsFiscal Policy Expansions

Table 20-1 The Emergence of Large U.S. Budget Deficits, 1980-1984

19801980 19811981 19821982 19831983 19841984

SpendingSpending 22.022.0 22.822.8 24.024.0 25.025.0 23.723.7

RevenuesRevenues 20.220.2 20.820.8 20.520.5 19.419.4 19.219.2

Personal taxesPersonal taxes 9.49.4 9.69.6 9.99.9 8.88.8 8.28.2

Corporate taxesCorporate taxes 2.62.6 2.32.3 1.61.6 1.61.6 2.02.0

Budget surplusBudget surplus 1.81.8 2.02.0 3.53.5 5.65.6 4.54.5

Numbers are for fiscal years, which start in October of the previous calendar year. All numbers are expressed as a percentage of GDP.



Supply sidersSupply siders—a group of economists who —a group of economists who argued that a cut in tax rates would boost argued that a cut in tax rates would boost economic activity.economic activity.

High output growth and dollar appreciation High output growth and dollar appreciation during the early 1980s resulted in an increase during the early 1980s resulted in an increase in the trade deficit. A higher trade deficit, in the trade deficit. A higher trade deficit, combined with a large budget deficit, became combined with a large budget deficit, became know as the know as the twin deficitstwin deficits of the 1980s. of the 1980s.



Table 20-2 Major U.S. Macroeconomic Variables, 1980-1984

1980 1981 1982 1983 1984

GDP Growth (%)GDP Growth (%) 0.50.5 1.81.8 2.22.2 3.93.9 6.26.2

Unemployment rate (%)Unemployment rate (%) 7.17.1 7.67.6 9.79.7 9.69.6 7.57.5

Inflation (CPI) (%)Inflation (CPI) (%) 12.512.5 8.98.9 3.83.8 3.83.8 3.93.9

Interest rate (nominal) (%)Interest rate (nominal) (%) 11.511.5 14.014.0 10.610.6 8.68.6 9.69.6

(real) (%)(real) (%) 2.52.5 4.94.9 6.06.0 5.15.1 5.95.9

Real exchange rateReal exchange rate 117117 9999 8989 8585 7777

Trade surplus (Trade surplus (: deficit) : deficit) (% of GDP)(% of GDP) 0.50.5 0.40.4 0.60.6 1.51.5 2.72.7

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


Fixed Exchange RatesFixed Exchange Rates20-5

Central banks act under implicit and explicit Central banks act under implicit and explicit exchange-rate targets and use monetary exchange-rate targets and use monetary policy to achieve those targets.policy to achieve those targets.

Some Some pegpeg their currency to the dollar, to other their currency to the dollar, to other currencies, or to a basket of currencies, with currencies, or to a basket of currencies, with weights reflecting the composition of their weights reflecting the composition of their trade.trade.


Fixed Exchange RatesFixed Exchange Rates

Some countries operate under a Some countries operate under a crawling crawling pegpeg. If the domestic price level rises faster . If the domestic price level rises faster than the U.S. price level, the country faces a than the U.S. price level, the country faces a real appreciation that can rapidly make real appreciation that can rapidly make domestic goods noncompetitive. To avoid this domestic goods noncompetitive. To avoid this effect, countries choose a predetermined effect, countries choose a predetermined depreciation rate against the dollar.depreciation rate against the dollar.


Fixed Exchange RatesFixed Exchange Rates

The The European Monetary System (EMS),European Monetary System (EMS), determined the movements of exchange rates determined the movements of exchange rates within the European Union from 1978 to 1998.within the European Union from 1978 to 1998.

Countries agreed to maintain their currencies Countries agreed to maintain their currencies within within bandsbands around a around a central paritycentral parity..

Some countries moved further, agreeing to Some countries moved further, agreeing to adopt a common currency, the adopt a common currency, the EuroEuro, in effect, , in effect, adopting a “fixed exchange rate.”adopting a “fixed exchange rate.”


Pegging the Exchange Rate,Pegging the Exchange Rate,and Monetary Controland Monetary Control

The interest parity condition is:The interest parity condition is:

i iE E

Et t

et t

t

* 1

Pegging the exchange rate turns the interest Pegging the exchange rate turns the interest parity relation into:parity relation into:

i iE E

Eit t t

* *


Pegging the Exchange Rate,Pegging the Exchange Rate,and Monetary Controland Monetary Control

Increases in the domestic demand for money Increases in the domestic demand for money must be matched by increases in the supply of must be matched by increases in the supply of money in order to maintain the interest rate money in order to maintain the interest rate constant, so that the following condition holds:constant, so that the following condition holds:

If the exchange rate is expected to remain If the exchange rate is expected to remain unchanged, the domestic interest rate must be unchanged, the domestic interest rate must be equal to the foreign interest rate.equal to the foreign interest rate.

M

PY L i ( )


Fiscal Policy UnderFiscal Policy UnderFixed Exchange RatesFixed Exchange Rates

The Effects of a Fiscal The Effects of a Fiscal Expansion Under Expansion Under Fixed Exchange RatesFixed Exchange Rates

Under flexible Under flexible exchange rates, a exchange rates, a fiscal expansion fiscal expansion increases output, from increases output, from YYAA to Y to YBB. Under fixed . Under fixed

exchange rates, output exchange rates, output increases from Yincreases from YAA to to

YYCC..

The central bank must accommodate the resulting increase in the The central bank must accommodate the resulting increase in the demand for money.demand for money.


Key TermsKey Terms

Mundell-Fleming model,Mundell-Fleming model, supply siders,supply siders, twin deficits,twin deficits, peg,peg, crawling peg,crawling peg,

European Monetary System (EMS),

bands, central parity, Euro,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/eOlivier Blanchard Prepared by: Fernando Quijano and Yvonn Quijano 20 C H A P T E R Output, the.

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