Mundell-Flemming
APPLICATION The Carry Trade
UIP implies that the home interest rate should equal the
foreign interest rate plus the rate of depreciation of the
home currency.
UIP rules out the naive strategy of borrowing in a low
interest rate currency and investing in a high interest rate
currency, an investment referred to as a carry trade. UIP
implies that the expected profit from such a trade is zero:
Expected profit 
iF

Interest rate
on foreign currency

EHe / F
EH / F

Expected rate of depreciation
of the home currency


iH

.
Interest rate
on home currency

Cost of carry
Expected home currency rate of return on foreign deposits
(22-3)
APPLICATION The Carry Trade
The Long and Short of It Recently, low interest rate
currencies in the world economy have been the Japanese
yen and the Swiss franc. Carry traders have often borrowed
(“gone short”) in these currencies and made an investment
(“gone long”) in higher interest rate major currencies, and
the profits have been substantial.
In the Yen carry trade with the Australian dollar, the strategy
was subject to a good deal of volatility, and over the decade
from the start of 1992 to the end of 2001, the highs and
lows canceled each other out in the long run.
From 2002 to 2007, the yen persistently weakened against
the Australian dollar over this five-year period (by about 6%
to 7% per year), reinforcing the interest differential (about
6% to 7% also) rather than offsetting it (see Figure 22-4).
FIGURE 22-4
Stylized OCA
Criteria In the 1990s
and 2000s, the yen
had a lower interest
rate than many other
currencies. Carry
trades borrow in
low-yield yen to
invest in higheryield currencies like
the Australian dollar.
Such trades can be
profitable for long
periods, but
dramatic reversals,
though rare, can
quickly undermine
profits.
APPLICATION Peso Problems
Actual returns from interest arbitrage may be nonzero for a
pair of currencies that are floating, but also for two
currencies that are fixed.
The U.S. dollar pegs of two emerging market countries,
Hong Kong and Argentina illustrate this case.
For a credible peg with no risks premiums, the UIP condition
states that the home and foreign interest rates should be
equal. Investors treat domestic and foreign currency as
perfect substitutes and interchangeable at a fixed rate.
There is no desire for arbitrage (e.g., via the carry trade).
But when pegs are not credible, risk premiums can cause
large interest differentials—and cause investors to smell a
profit (see Figure 22-5).
APPLICATION
Peso Problems
FIGURE 22-5
Peso Problems
If exchange rates are
fixed (and credible),
then the interest rate
on the home
currency and the
base currency
should be the same.
As seen here,
however, the Hong
Kong dollar and
Argentina peso
often had large
currency premiums.
Hong Kong’s peg
held, and carry trade
profits were made.
Argentina’s peg
broke, and losses
were massive.
Chapter 22: Topics in International Macroeconomics
FIGURE 22-7
(1 of 2)
Risk versus Reward in the Carry This chart shows details of returns for carry trades between the
British pound and selected foreign currencies (and an equally weighted portfolio of all such trades).
The strategy supposes that each month an investor borrowed in the low interest rate currency and
invested in the high interest rate currency, and transaction costs are assumed to be negligible.
Panel (a) shows that there have been predictable excess returns to the carry trade based on data from
1976 to 2005, on average, about 4% per year.
Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e
9 of 123
Chapter 22: Topics in International Macroeconomics
FIGURE 22-7
(2 of 2)
Risk versus Reward in the Carry (continued) The average Sharpe ratio for this strategy has been about
0.4, as shown in panel (b). The diversified portfolio does a little better with a Sharpe ratio of 0.6.
Copyright © 2011 Worth Publishers· International Economics· Feenstra/Taylor, 2/e
10 of 123
Supply and Demand
• The total aggregate supply of final goods and
services is equal to total output, and (as we have
assumed) GDP = Y:
Supply = GDP = Y
• The total aggregate demand for goods and
services is given by the components defined
above:
Demand = D = C + I + G + TB
Supply and Demand
• Since GDP=Y, the GDP identity shows supply of
output is equal to demand for final goods and
services:
Equilibrium in Two Markets
• The IS curve shows combinations of output Y and
interest rate i such that the goods and forex
markets are in equilibrium.
• Bring together what we know of goods market
equilibrium (this chapter) and forex market
equilibrium.
• The IS curve is plotted with interest rate i on the
vertical axis and output Y on the horizontal axis.
 The goods market shares the same horizontal axis.
 The forex market shares the interest rate i as its vertical
axis.
Forex Market Recap
• Recap: Forex market equilibrium is given by the
uncovered interest parity condition (UIP).
 Arbitrage
 Return on domestic deposits equals expected return on foreign
deposits (in home currency terms).
 Forex market equilibrium determines the nominal exchange
rate, E given all the other variables.
Deriving the IS Curve
• Initial equilibrium
 Equilibrium output and interest rate are given from the
goods market and forex market.
 Goods market: the level of output (Y) is where demand
and supply are equal in the Keynesian Cross, where
D=Y.
 Forex market: the equilibrium interest rate (i) and
exchange rate (E) insure the UIP condition is met,
where DR = FR.
 This combination of i and Y must be a point on the IS
curve. Call this point 1.
Goods and Forex Market Equilibria: The IS Curve
• A fall in the
interest rate
 A decrease in
the interest
rate leads to
an increase in
demand
Factors that Shift the IS Curve
• Example:
exogenous
increase in
demand.
Summing Up the IS Curve
• IS curve is downward sloping
 A decrease in the interest rate leads to an increase in
investment demand and the trade balance.
 This increases the demand for goods and therefore
output, in the short run.
• Shifts in the IS curve are driven by shifts in
demand for a given level of the home interest
rate.
 Many potential sources of demand shifts.
Fig. 17-4:
Deriving the
DD Schedule
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1-19
Short-Run Equilibrium and the
Exchange Rate: DD Schedule (cont.)
DD schedule
• shows combinations of output and the exchange
rate at which the output market is in short-run
equilibrium (such that aggregate demand =
aggregate output).
• slopes upward because a rise in the exchange rate
causes aggregate demand and aggregate output to
rise.
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1-20
Shifting the DD Curve
•
Changes in the exchange rate cause movements
along a DD curve. Other changes cause it to shift:
1. Changes in G: more government purchases
cause higher aggregate demand and output in
equilibrium. Output increases for every exchange
rate: the DD curve shifts right.
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1-21
Fig. 17-5:
Government
Demand and the
Position of the DD
Schedule
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1-22
Money Market Recap
• The LM curve shows combinations of output and
the nominal interest rate such that the money
market is in equilibrium.
 Real money demand (MD) varies inversely with the nominal
interest rate, so the demand for real money balances is
downward sloping.
 Real money supply (MS) is fixed, with the price level fixed and
the supply of money chosen by the central bank.
Deriving the LM Curve
• The money market and the LM diagram share a
vertical axis (the interest rate).
• Example: Increase in output.




When output increases, money demand increases.
MD shifts to the right, MS fixed.
The interest rate rises.
Hence, we observe a positive relationship between the
interest rate and output in the money market.
 This implies the LM curve is upward sloping.
Deriving the LM Curve
• Example: Increase in output.
Factors that Shift the LM Curve
• Main factor that can shift LM is money supply.
 Example: Increase in the money supply.
Factors that Shift the LM Curve
• LM curve can be expressed as:
Short-Run Equilibrium in Asset
Markets (cont.)
• When income and production increase,
– demand of real monetary assets increases,
– leading to an increase in domestic interest rates,
– leading to an appreciation of the domestic
currency.
• Recall that an appreciation of the domestic
currency is represented by a fall in E.
• When income and production decrease, the
domestic currency depreciates and E rises.
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1-28
Short-Run Equilibrium in Asset
Markets: AA Curve
• The inverse relationship between output and
exchange rates needed to keep the foreign
exchange markets and the money market in
equilibrium is summarized as the AA curve.
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1-29
Fig. 17-7: The AA Schedule
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1-30
Short-Run IS-LM-FX Model of an Open Economy
• Overview
 Combine the IS-LM diagram with the forex market
diagram to study how changes in the economy affect
key macroeconomic variables.
Macroeconomic Policies in the Short Run
• Two policy actions
 Monetary policy: central bank changes in the money
supply.
 Fiscal policy: government changes in taxes and
government spending.
• The effects of these policies depend critically on
the nation’s exchange rate regime.
Macroeconomic Policies in the Short Run
• Assumptions
 Economy begins at long-run equilibrium.
 Sticky prices at home and abroad.
 We will specify either a floating or fixed exchange rate
regime.
• Temporary Policies, Unchanged Expectations
 To examine temporary shocks to the economy, we
assume investors do not change exchange rate
expectations (a nominal anchor).
 Simplifies the study how temporary policies (designed
to affect output in the short run) affect the economy.
Monetary Policy under Floating Exchange Rates
• Example: Monetary expansion
 A monetary contraction will have the reverse effects.
Monetary Policy under Fixed Exchange Rates
• Consider possible monetary changes.
 Monetary expansion: ↑M/P→ LM shifts right → LM
must shift back to keep the exchange rate fixed.
 Monetary contraction: same basic result.
• If committed to a fixed exchange rate regime,
central bank cannot change real money supply.
 Changing the real money supply affects the interest
rate, and therefore exchange rate through affecting
the return on domestic deposits.
 Therefore, a fixed exchange rate regime implies that
autonomous monetary policy is not an option.
Monetary Policy under Fixed Exchange Rates
• Example: Monetary expansion
Fiscal Policy under Floating Exchange Rates
• Fiscal expansion: ↑G→ IS shifts right
 Direct effect
 ↑G→↑Y
 ↑G→↑i
 Indirect effects




↑Y→ ↑C
↑Y→ ↑IM → ↓TB
↑i→ ↓I
↑i → ↓E→ ↓TB
 A fiscal expansion leads to crowding out because it
leads to an increase in the interest rate.
 Investment demand decreases.
 Appreciation, decreasing trade balance.
Fiscal Policy under Floating Exchange Rates
• Fiscal expansion
 A fiscal contraction will have the reverse effects.
Fiscal Policy under Fixed Exchange Rates
• Mechanics of a fixed exchange rate regime.
 Real money supply must adjust to keep the E fixed.
 This implies that any fiscal policy action will require a
central bank action, shifting the LM curve.
• Fiscal expansion: ↑G → IS shifts right → LM must
shift right to keep i and E unchanged.
 Effects
 ↑G→↑Y.
 ↑M/P→ i and E unchanged.
 Notice, in this case, a fiscal expansion does not lead to
crowding out.
Fiscal Policy under Fixed Exchange Rates
• Fiscal expansion
 A fiscal contraction will have the reverse effects.