Monetary Macroeconomics Midterm Summary Week 1: Chapter 14 - Financial Markets and Expectations βͺExpected present discounted values: Value today of expected sequence of payments -Used to determine whether or not an investment is a good idea. If profits today > costs today, investment is a good idea. -Computing expected present discounted values: → A general formula: π Where: $ππ‘ is present discounted value, $π§π‘ is payment this year, $ππ‘+1 is expected payment in one year, π π $ππ‘+2 is expected payment in two years, ππ‘is interest rate in one year, $ππ‘+1 is expected interest rate in two years. -In reality: as payments and interest rates in the future are not known, they are based on expectations. -An increase in today’s or expected payments → higher $ππ‘ -An increase in current or expected interest rates → lower $ππ‘ → Constant interest rates: Recap Geometric series → Infinite sum of geometric series → Finite sum of Geometric series: When interest rates are constant: → Constant interest rates and constant payments finite: (Finite Geometric series) → Constant interest rates and constant payments forever: → → Zero interest rates: When interest rate is 0, then discount factor = 1, in turn present value is just the sum of future payments (current and expected) → Nominal versus real interest rates and present values: -Nominal interest rate: Interest rate in terms of dollars (monetary currency) (what has been used thus far) -Real interest rate: Interest rate in terms of basket of goods (monetary currency) -Real PV real interest rate (ππ‘ ) and real payments (π§π‘): π Where: ππ‘ is real present discounted value, π§π‘ is real payment this year, ππ‘+1 is real expected payment in π π one year, ππ‘+2 is real expected payment in two years, ππ‘is real interest rate in one year, ππ‘+1 is expected real interest rate in two years. -To pass from nominal PV to real PV: βͺBond prices and bond yields: -Bonds differ in two dimensions: β Maturity: length of time over which the bond promises to make payments to the holder of the bond β Risk: β Default risk: possibility that issuer of the bond won’t pay the full amount β Price risk: uncertainty of which price for which you will be able to sell the bond in the future -Yield to maturity: bonds of different maturities each have a price and an associated interest rate -Short term interest rates: Yields on bonds with short maturity -Long-term interest rates: Yields on bonds with long maturity -Yield curve: the yield and associated maturity can be represented in a curve → Bond prices as present values: -Present value ($π1π‘) one year bond paying $100: -Present value ($π2π‘) two year bond paying $100: → Arbitrage and bond prices: -When given the choice between which bond to hold, we will only focus on expected return and disregard risk (known as expectation hypothesis). -In order to avoid arbitrage, two year bonds need to have a PV that in one year will equal the PV of a one year bond. → From bond prices to bond yields: -Yields to maturity on an n-year bond - constant annual interest rate that makes the bond price today equal the PV of future payments of the bond With this, the two year interest rate can be approximated to: → Reintroducing risk: -A one year bond is riskless, as it is not based on expectations, whereas a two year bond already presents a risk, and in turn its price must reflect a risk premium to compensate for the possibility of default or the lack of certainty on the price of the bond. -In turn the approximation for the interest rate of a 2 year bond becomes: βͺThe stock market and movements in prices: → Firms have 4 ways of financing themselves: β Internal finance: using own profits β External finance: bank loans β Debt finance: Loans and bonds β Equity finance: shares and stocks → Stock prices as present values: A stock price must be equal to the present value of its future expected dividends -If we hold stock for a year, in which this year’s dividend has already been paid (ex-dividend), we expect to receive in one year the one-year dividend and the price of the stock in one year. -Divided by $Qt as it one dollar buys 1/$Qt of stock. -When stock has a risk, it includes an equity premium x, in turn the price of a stock in n-years can be simplified to in nominal values In turn: β Higher expected dividends → higher PV of stock β Higher current and expected interest → lower PV of stock β Higher equity premium → lower stock price → Economic policies and stock market: -Monetary policy & stock market (LM Curve): -A change in monetary policy (interest rates) will change stock prices depending on how the changes to the monetary policies are perceived and how they affect expectations -When unexpected stock prices might go up, when expected they may remain unchanged or even go down. -Consumer spending and stock market (IS curve): -A change in consumption can lead to different movements -If a response is not expected from the central bank, output will increase and stock goes up -If central bank reacts to counteract possible inflation, there is no change in output but interest is higher, in turn stock goes down Week 2: Chapter 15 - Expectations, consumption and investment βͺConsumption: -How much people consume and how much they save depends on the permanent income and the life cycle theory of consumption: they emphasize on the fact that consumer look beyond current income and that consumer’s natural planning horizon is their entire lifetime → The very foresighted consumer (assumption): A very foresighted consumer will decide how much to spend by: 1. Valuing her non human wealth: financial and housing wealth (add value of stocks and bonds, value of checking and savings accounts, and the value of the assets -house- minus mortgage) 2. Estimate human wealth: PV of after-tax labor income over lifetime Total wealth = non human wealth + human wealth Based on total wealth, the person will decide how much to spend. To calculate the PV of human wealth we use sum of geometric series: ππ π»π’πππ π€ππππ‘β = π€(1 − π‘) 1+π π ) 1+π 1+π 1−( 1+π ) 1−( Where: w is starting salary, g is growth rate, i is interest rate, T is total number of working years and t is tax rate → Towards a more realistic description: -The very near sighted consumer is not realistics, as consumption is not consistent throughout life, consumption decisions are not taken with such forward vision, it is based on estimations that could be far from reality, etc. -We want to estimate consumption based on current after tax income and total wealth πΆπ‘ = πΆ(π‘ππ‘ππ π€ππππ‘β, ππΏπ‘ − ππ‘) (+, +) -Consumption increased with a higher total wealth and with a higher current after-tax labor income. How much each affects consumption is relative: most consumer look forward in terms of total wealth and expected income, however, especially poorer consumers, will spend based on current income. → Putting things together: current income, expectations and consumption Given πΆπ‘ = πΆ(π‘ππ‘ππ π€ππππ‘β, ππΏπ‘ − ππ‘), we can say that expectations affect consumption in two ways: -Directly: through human wealth - to know their human wealth, a person will form expectations about future labor income, future real interest rates, and taxes. -Indirectly: through non human wealth - the value of stocks, bonds and houses is calculated based on expectations -The dependence of consumption on expectations has two implications for the relation between consumption and income: → Consumption is likely to respond less than one-on-one to fluctuations on current income – unless it is a decrease that is permanent, then consumption is very likely to decrease one to one// if it is transitory, consumption will change by less than one-to-one → Consumption may move even if current income doesn’t change – with political circumstances, recessions/expansions in the long run, etc. βͺInvestment: -Expectations also play a crucial role in investment. → Investment and expectation of profit: -Depreciation: -To compute PV of profits, depreciation needs to be calculated, which determines how long the investment will last. -Depreciation rate (σ) measures how much usefulness the machine loses each year. -A machine one year from now, will be 1-σ next year, and a machine two years from now will be (1-σ)2 . -Present value of expected profits: -Where Π is the expected profit, delta is the depreciation, rt is the real interest rate. In turn, the present value of the expected profits in the following years is given by → The investment decision: π If the PV of expected profits (V(Ππ‘ ) > 1 → Invest π If the PV of expected profits (V(Ππ‘ ) < 1 → not invest -Taking this to investment as a whole in the economy: Investment is a function of the PV of the expected profits – The higher the expected profits from an investment, the higher the PV and in turn the higher the level of investment – The higher the current and expected real interest rates, the lower the PV and the lower the investment => When expected profits and future interest rates are expected to stay the same, then PV of profits is given by the ratio of expected profits divided by real interest rate + depreciation rate (rental cost). In turn investment is determined by: → Current versus expected profit: -Historical evidence shows that investment also depends tremendously on current income (which could be consistent with expected profits, if expected profits are thought to behave like current profits). -This is due to the financing of the investment: when current profits are low, financing has to be done through borrowing, which could be threatened by the current bad situation. If the current profits are high, financing could happen through retention of profits instead of borrowing. In turn, INVESTMENT DECISION BASED ON: → Profits and sales Profits per unit of capital (Ππ‘) is determined by: -Level of sales -Existing capital stock ππ‘ Ππ‘ = Π( πΎπ‘ ) Where Yt is sales and Kt is capital stock. – This implies: Current output affects profits, and expected future output affects expected future profit. Week 2: Chapter 16 - Expectations, output and policy βͺExpectations and decisions: taking stock → Expectations, consumption and investment decisions: ↑ current/ expected after-tax income ↑ human wealth ↑ consumption ↑ current/expected ↑ stock prices dividends ↑ non wealth human ↑ consumption ↓ current/expected real ↑ stock prices interest rates ↑ non wealth human ↑ consumption ↓ ↑ human ↑ consumption current/expected ↑ bond prices non nominal interest rates wealth ↑ current/expected ↑ PV profits Profits ↑ investment ↓ current/expected real ↑ PV profits interest rates ↑ investment → Expectations and IS relation -To make a model that takes into account expectations, we take into account some simplifications: – Reduction of present and future to only two periods: 1. A current period (the current year) 2. A future period (thought of as all future years lumped together) -Initially the IS relation was given by: Y= C (Y-T) + I (Y, r+x) + G To take into account expectations, we modify it in two steps: → 1). Rewrite the equation in a more compact form. For this, we define aggregate private spending as the sum of consumption and investment spending. A(Y, T, r, x) = C(Y-T) + I (Y, r+x) Where A is aggregate private spending We can rewrite the IS relation as: Y=A(Y, T, r, x) + G (+,-,-,-) → 2). We now take into account the role of expectations. (Ignore the risk premium, assuming it is constant). -We take the last IS relation, and make it dependent on the previous elements and the expected values of each. Y=A(Y, T, r, Y’e, T’e, r’e) + G (16.2) (+,-,-,+,-,-) This equation shows the goods market equilibrium. → The IS curve - The IS curve captures the relation between interest rate and output, taking all other variables as given or constant. -The IS curve is now much steeper: this indicates that a large decrease in r will lead to a small effect on output. -The effects of a change in r depend on the strength of the effects of real policy rate on spending given income and on the size of the multiplier. – A change in r without changing r’e, will not have much effect on spending (now IS curve is less affected by current changes if expectations don’t change) – The multiplier is likely to be small, if future expectations don’t change, the change in consumption given a non persistent change in income (output) is unlikely to have a large effect on consumption. -A Change in T or G: Higher G, will give a higher Y (right shift). A higher T will give a lower Y (left shift). -A change in expected future values (Y’e, T’e, r’e): -Higher Y’e → Higher Y (right shift) -Higher T’e → Lower Y (left shift) -Higher r’e → lower Y (left shift) βͺ Monetary policy, expectations and output - The interest rate affected directly by the central bank is the current real interest rate, r → LM curve is given by a horizontal line at the chosen real interest rate (π) In turn: IS: Y = A(Y, T, r, Y’e, T’e, r’e) + G LM: r = π → Monetary policy revisited: -Let’s assume the economy is in a recession and the central bank lowers r (no change to expectations) -Then the LM curve shifts down to LM’’. Equilibrium moves from Ya to Yb → However, the lower current r, means a small effect on Y (as there are no changes on expectations). What if the financial markets expect future lower interest rates? And expect higher future output? Expectation of lower interest rates and high expected output shift the IS curve to the right: meaning a large increase in current output. – The effects of any monetary policy depend on expectations, if there is a change in expectations, there is a large change in output, if there is no change in expectations, there is limited change in output. – Expectations are not arbitrary, they depend on informed decisions (rational expectations). βͺ Deficit reduction expectations and output -A budget deficit (higher Government spending than earnings - taxes -) reduction implies: → Short run: unless it is offset by monetary expansion, will lead to lower private spending and a contraction in output. → Medium run: higher savings and higher investment → Long run: higher capital and in turn higher output – due to the effects in the SR, many governments often avoid it. However, some argue that it can even have positive outcomes in SR if people knew of future outcomes. Week 3: Chapter 17 - Openness in Goods and Financial Markets βͺOpenness in goods markets -Exports and imports -Openness in goods markets allows consumers and firms to choose between domestic goods and foreign goods. -Exports > Imports = trade surplus // Exports< imports = trade deficit -The best index of openness of a market, compared to export or import ratios, is the proportion of aggregate output composed of tradable goods (goods that compete with foreign goods in either domestic markets or foreign markets). → The choice between domestic goods and foreign goods -Until now, consumer’s decisions were based on whether to consume or to save. -With an open goods market, consumers will have to decide whether to buy domestic or foreign, which will have a direct effect on domestic output. -If consumers buy more domestic → demand for domestic goods increased (domestic output increases as well) -If consumers decide to buy more foreign → foreign output increases -Buying domestic or foreign is correlated to the price of domestic goods relative to foreign goods. → Relative price is called real exchange rate (not directly observable we often make reference to nominal exchange rate of currencies). → Nominal exchange rates Can be quoted in two manners: -As the price of the domestic currency in terms of foreign currency (eg.1 USD is 0.79 GBP) -As the price of the foreign currency in terms of the domestic currency. DEFINITION FOR COURSE: Nominal exchange rate is the price of domestic currency in terms of foreign currency (Denoted E). -Exchange rates change constantly in foreign exchange markets Nominal appreciation: increase in the price of the domestic currency in terms of foreign currency (increase in exchange rate) Nominal depreciation: decrease in the price of the domestic currency in terms of foreign currency (decrease in exchange rate) → From nominal to real exchange rates To pass from nominal to real exchange rates, we use the price of products put in the same currency. -The price of products is determined by the GDP deflator ((Nominal GDP/Real GDP)x100) used as a price index. P is the GDP deflator for home and P* is the GDP deflator for foreign. -This is just a price index, which turns out to be uninformative. However, the rate of change of the real exchange rate is useful! Real appreciation: increase in relative price of domestic goods in terms of foreign goods Real depreciation: decrease in relative price of domestic goods in terms of foreign goods. βͺOpenness in financial markets -Openness in financial markets allows financial investors to hold both domestic and foreign assets, it allows them to diversify their portfolios, to speculate on movements in foreign interest rates vs domestic interest rates, movements on exchange rates, etc. -Buying or selling foreign assets implies buying or selling foreign currencies. -A country’s openness in financial markets allows a country to have a trade deficit or a trade surplus. → Trade deficit: need to borrow from other countries- they need to make it attractive for countries to hold their domestic assets. → The balance of payments -They are a set of accounts that summarize a country’s transaction with the rest of the world (both trade and financial flows). -The current account: The current account has exports and imports, summarized by trade balance. It then has the income received, which refers to the payments received from holding foreign assets. And the income paid, which refers to the payments done to foreigners holding domestic assets. This is summarized by the net income. Current account balance is then calculated based on the trade balance and the net income. Current account > 0 → Current account surplus Current account < 0 → Current account deficit (in case of a deficit, it will need to have borrowed which is reflected on the financial account) -The Financial account: -Net capital transfers: cancellation of debt to other countries -Increase in foreign holdings of home assets: foreign invests in home assets -Increase in home holdings of foreign assets: home invests in foreign assets -Financial account balance= Net capital transfers + increase in foreign holdings of home assets - increase in home holdings of foreign assets In principle: the financial account should cancel out with the current account, in practice it doesn’t happen (due to errors and discrepancies in economic data). → GNP vs GDP: -GDP: measures value added domestically -GNP: measures value added by domestic factors of production – With a closed economy: GDP=GNP – –With an open economy, to go from GDP to GNP, one must take GDP and add the income received from the rest of the world (holdings of foreign assets) and subtract the payments to the rest of the world (from foreigners holding home assets). GNP = GDP + Net payments of income (NI) → The choice between domestic and foreign assets: -Decision on whether to hold domestic or foreign interest paying assets -Foreign assets depend on their interest rates and the exchange rates. -We want to hold the bond with the highest rate of return In turn, arbitrage implies that the price of the home bond in one year must equal the price of the foreign bond in one year In turn: This is called the uncovered interest parity condition → Interest rates and exchange rates: The interest parity condition is approximated to (given that interest rates and depreciation rates aren’t too high): Reminder: If one currency appreciates relative to another currency, then the other currency is depreciating. Deciding which bond to hold depends on whether you expect foreign currency to depreciate less or more than the difference in the interest rates. - If foreign depreciates more than the difference between the interest rates, then holding foreign is not smart. -If foreign depreciates by less (or appreciates) than the difference between interest rates, then holding foreign is a good idea. Week 3 and 4: Chapter 18 - The goods market in an open economy βͺThe IS relation in the open economy Demand for domestic goods ≠ Domestic demand for goods -Domestic demand for goods can be for foreign and domestic goods -Demand for domestic goods can come from foreigners or domestic consumers → The demand for domestic goods In an open economy, demand for domestic goods (z) is given by: Z= C + I + G - IM/ε + X Where C is consumption, I is investment, G is government spending, IM/ε is imported goods in domestic currency, and exports. → The determinants of C, I and G - How much consumers decide to consume still depends on their income and wealth , in turn, the open economy doesn’t affect it overall (exchange rate does have an effect on the composition of consumption, but it doesn’t affect it as a whole). -Same happens with investment In turn, we can use the previous descriptions of consumption, investment and gov spending: Domestic demand: C + I + G = C(Y-T) + I(Y, r) + G (+) (+,-) (+) – We forget about expectations and risk for now – → The determinants of imports -They depend on domestic income (higher income, higher demand for foreign and domestic goods) -They depend on the exchange rate (higher exchange rate, higher imports) IM = IM (Y, ε) (+, +) Note: as ε goes up, IM goes up. However, 1/ε goes down. The effect is ambiguous. → The determinants of exports -They depend on foreign income (Y*): the higher the Y*, the higher the consumption of foreign and the higher the exports -They depend on the real exchange rate (ε): the higher the ε, the lower the exports X= X(Y*, ε) (+, -) →Putting the components together – We plot the various components of demand against output, keeping constant r, T, G, Y*, and ε – Line DD plots domestic demand in terms of C + I + G as a function of output Y → it has a positive relation increasing by less than one to one – Line AA plots domestic demand (DD) minus the imports, representing domestic demand for domestic goods. -AA is flatter than DD: as income increases, demand increases, and as some of the demand is for foreign goods, the curve will be flatter. – Line ZZ represents domestic demand (DD) minus imports plus exports, or AA plus exports, representing demand for domestic goods as a whole. -Exports depend on foreign income, in turn it is parallel to AA. – Net exports: from DD, AA and ZZ we can get information about the net exports (exports minus imports// NX= X- IM/ε). - Net exports is a decreasing function of output (downward sloping curve). As output increases, imports increase, but exports are unaffected, in turn NX decreases. - At Ytb imports equal exports, in turn there is trade balance, and NX intersects the x-axis. If Y is above Ytb, NX will be below 0 and there is a trade deficit (higher imports than exports). If Y is below Ytb then NX is above 0 and there is a trade surplus (higher exports than imports). βͺEquilibrium output and the trade balance -The goods market is in equilibrium when domestic output equals demand for domestic goods In turn, Y=Z, which expanded is Y= C(Y-T) + I(Y, r) + G - IM (Y,ε) /ε + X (Y*, ε) -Line zz plots the same ZZ we saw above! It is upward sloping by less than one. -Equilibrium where demand = output, in turn, where the ZZ intersects the 45º line (point A). -Where the goods market is in equilibrium, it is not necessarily where there is trade balance. -Line NX can have trade balance where the goods market has equilibrium, or it can have it below it, or above it. βͺIncreases in demand - domestic or foreign → Increases in domestic demand -We assume that the economy is in a recession and in turn the government increases government spending to increase domestic demand. -Increase in G: leads to an upward shift of ZZ to ZZ’, where output is higher increasing to Y’. The increase in Y makes Y be above the trade balance, in turn imports are higher than exports, and there is a trade deficit. -The increase in G makes Y increase through a multiplier effect, however, there is a smaller multiplier effect than in a closed economy, as higher Y will also be used for foreign goods. (In an open economy, an increase in domestic demand has a smaller effect on output than in a closed economy). → Increases in foreign demand -We assume an increase in Y* either because of higher G* or some other source. -With higher foreign output, there is a higher foreign demand, which includes a higher foreign demand for domestic goods. In turn, exports increase. -In turn, the demand for domestic goods shifts upwards to ZZ’ by delta X. There is a higher domestic output as a result. -NX will also shift up by delta X becoming NX’. This improves the trade balance, as there will be a trade surplus if the economy was initially at a trade balance, or lower trade deficit if it was in a trade deficit. → Fiscal policy revisited -We have two conclusions thus far: 1. Increase in domestic demand → increase in domestic output + deterioration of trade balance 2. Increase in foreign demand → increase in domestic output + improvement of trade balance - This in turn has two implications: 1. Shocks to demand in one country affect other countries (higher trade links-higher effects) 2. These interactions complicate the tasks of policymakers (especially in fiscal policy) → All countries want to avoid trade deficits and wait for other countries to increase output, leading to a static situation, in turn a policy coordination is necessary (extremely complicated). βͺDepreciation, trade balance and output -We assume the US takes policy measures that depreciate the dollar (lower nominal exchange) -In the short run, we assume that P and P* are given, so there is a one to one change between real exchange rate and nominal exchange rate, yielding: E=ε → Depreciation and the trade balance: Marshall lerner condition Given Net exports: NX = X - IM/ε NX = X (Y*, ε) - IM (Y, ε)/ε With a lower exchange rate: – Exports increase: lower ε, means US products are cheaper abroad, in turn, increases demand for them and exports increase. – Imports decrease: lower ε, means that foreign goods are more expensive in the US, in turn imports decrease and demand for domestic goods increases. – The relative price of foreign goods in terms of domestic goods (1/ε) increases -For trade balance to improve with depreciation, exports must increase enough and imports must decrease enough to compensate for increase in relative price of foreign goods. → Marshall lerner condition Conclusion: Depreciation → increase in net exports → Effects of a real depreciation -The real depreciation leads to a result just like the increase in foreign demand -Higher exports, shifts up NX and ZZ by delta X, increasing output. -Trade balance improves and output increases -Slight difference: It also implies foreign goods are more expensive, in turn some domestic people are worse off. → Combining exchange rate and fiscal policies -In a country running a trade deficit and output in its natural level – The government would like to reduce its trade deficit while keeping output unchanged: what should it do? – The government must combine depreciation and a fiscal contraction -It must lower the exchange rate to increase exports (shift NX up) and improve trade balance -It must then decrease government spending to return output to the initial level without having an effect on the NX. βͺSaving, investment and the current account balance -We can write the equilibrium condition in the goods market as investment equal to savings (sum of private and public savings). We get that current account (Net exports plus Net income) is equal to private savings (S) plus public savings (T-G) minus investment → When we have a current account surplus: a country is saving more than it is investing (the country is lending to the rest of the world). → When we have a current account deficit: a country is investing more than it is saving (the country is borrowing from the rest of the world). In turn: → An increase in investment is seen through either an increase in public or private savings or a deterioration of the current account. -Deterioration of the government budget (T-G) will lead to higher private spending, lower investment, and lower current account. -A higher saving rate will lead to a higher investment and a higher current account Week 4: Chapter 19 - Output, the interest rate and the exchange rate βͺEquilibrium in the goods market Given the equilibrium equation Y= C(Y-T) + I(Y, r) + G - IM (Y,ε) /ε + X (Y*, ε) The last two terms can be written as NX = X (Y*, ε) - IM (Y, ε)/ε We can rewrite equilibrium as Y= C(Y-T) + I(Y, r) + G + NX (Y, Y*, ε) (+) (+,-) (+) (-,+,-) → Effect of real interest rates and real exchange rates -Increase in r: lower investments, lower demand for domestic goods, decrease in output -Increase in ε: Lower NX, lower exports and higher imports → lower demand for domestic goods → lower output Assumptions: 1. Domestic and foreign price level are given, E and ε move together: P=P* → E=ε π 2. No inflation (current or expected) π =0 in turn, i=r nominal exchange rate and π real interest rate are equal to each other. (Normally, i = r + π ) In turn, the equilibrium becomes Y= C(Y-T) + I(Y, i) + G + NX (Y, Y*, E) (+) (+,-) (+) (-,+,-) Output depends negatively on nominal interest rate and nominal exchange rate. βͺEquilibrium in financial markets -In an open economy, investors have to decide whether to hold domestic bonds or foreign bonds → Domestic bonds vs foreign bonds Assumption: financial investors go for the highest expected rate of return, ignoring risk. → Implies that in equilibrium, both domestic and foreign bonds must have the same expected rate of return (Uncovered interest parity condition): If we multiply each side by the expected exchange rate, reorganize and assume the expected exchange rate as given, we get An increase in domestic interest rate → increase in exchange rate An increase in foreign interest rate → decrease in exchange rate An increase in expected exchange rate → increase in exchange rate → Choosing between two bonds: -Same interest rate and expected exchange rate = current exchange rate: Parity condition follows and both bonds have the same rate of return -When there is a higher expected exchange rate (future appreciation) - same interest rate: the currency that is expected to appreciate will appreciate to match the current exchange rate and return to equilibrium, this happens with higher demand for those bonds and higher demand for the currency. -Higher interest rate for home: as there is higher demand for the bonds with higher interest, there will be higher demand for the currency, but it will also be expected to depreciate to return to parity. In turn, the foreign currency will appreciate by the same amount to have the same return. βͺPutting goods and financial markets together Goods market equilibrium implies; Y= C(Y-T) + I(Y, i) + G + NX (Y, Y*, E) (+) (+,-) (+) (-,+,-) Where πΈ = 1+π 1+π* πΈ π Interest is policy set by central bank; π = π OPEN ECONOMY IS AND LM IS: Y= C(Y-T) + I(Y, i) + G + NX (Y, Y*, 1+π 1+π* π πΈ) LM: π = π → IS relation and interest rate: -Higher i → lower investment → lower demand for domestic goods →decrease in output -Higher i → higher exchange rate → Appreciation → domestic goods more expensive for foreigners and locals → decrease in net exports → lower demand for domestic goods → decrease in output βͺThe effects of policy in an open economy → Effects of monetary policy in an open economy -Central bank increases domestic interest rate → The LM curve shifts up, IS remains the same → lower output (interest parity leads to an appreciation) → higher exchange rate also decreases output indirectly (contractionary monetary policy) → Effects of fiscal policy in an open economy Higher G: (output below potential) → IS curve shifts to the right and output increases Higher G: (output close to potential) → Central bank will increase i to avoid inflation, which will offset the increase in Y with the higher G, exchange rate will also increase → consumption still increases, and NX decreases. → Monetary policy when exchange rate is fixed Monetary policy must ensure that interest rate is equal to the currency to which it is pegged Fiscal policy will not help to move interest rates.
