CHAPTER
20 Output, the
Interest
Rate, and the
Exchange Rate
Prepared by:
Fernando Quijano and Yvonn Quijano
Output, the Interest Rate,
and the Exchange Rate
• In chapter 19, we treated the exchange
rate as one of the policy instruments of the
government.
• But it’s not a policy instrument: it’s a price,
determined by the (foreign exchange)
market.
• The main questions we try to solve are:
 What determines the exchange rate?
 How can policy makers affect exchange
rates?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Output, the Interest Rate,
and the Exchange Rate
• The model developed in this chapter is an
extension of the open economy IS-LM
model, known as the Mundell-Fleming
model.
 It’s a combination of the goods market…
 The domestic financial market…
 And the foreign exchange market.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
20-1
Equilibrium in the
Goods Market
• Equilibrium in the goods market can be
described by the following equations:
(  )
(  , )
(  , )
(  )
(  , )
(  , , )
(  , )
• defining
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Goods Market
• In this chapter we make two
simplifications:
1. Assume both the domestic and the foreign
price levels are given (i.e., fixed).
Thus, the nominal and the real exchange
rate move together.
P*
1   E
P
In chapters 3-5, we assumed the domestic
price level was given (fixed).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Goods Market
•
In this chapter we make two
simplifications:
2. There is no inflation, neither actual nor
expected.
This means that the real interest rate (which
is what determines investment) is equal to
the nominal interest rate (which is
determined in the financial markets).
• Then, the equilibrium condition becomes:
(  )
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(  , )
(  , , )
Macroeconomics, 3/e
Olivier Blanchard
20-2
Equilibrium in
Financial markets
The Demand for Domestic Money
• People will still demand currency for the
same reasons:
 Higher income raises the demand for money,
 Higher interest rates reduce the quantity
demanded of money.
M
 YL(i )
P
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Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in
Financial markets
Domestic Bonds Versus Foreign Bonds
• What combination of domestic and foreign
bonds should financial investors choose in
order to maximize expected returns?
e
E
t 1  E t
*
it  i t 
Et
 The domestic interest rate must be equal to
the foreign interest rate plus the expected rate
of depreciation of the domestic currency.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
e
E
t 1  E t
*
it  i t 
Et
• If the expected future exchange rate is
given, then:
e
E
E
*
ii 
E
 The current exchange rate is:
e
E
E
1 i  i*
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Macroeconomics, 3/e
i  E 
i  E 
Olivier Blanchard
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.
i  E 
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Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
• We know that, in the medium run,
monetary policy doesn’t do anything to
interest rates.
• Monetary policy can’t change the medium
run “neutral” interest rate i  i .
 This “neutral” interest rate is given by saving
and investment (see Ch. 24 from ECON 201).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
• If the interest rate is constant in the
medium run, the expected exchange rate
is constant in the medium run. E e  E e
• So if i  E  today, we know that, in the
medium run, i  E  .
• This means that today’s appreciation will
lead to people to expect a future
depreciation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
• Assume that, until now, the one-year US
interest rate and the one-year UK interest
rate were both 4%.
• The US interest rate rises to 10%.
• If Ee is constant, then it must be that the
dollar is expected to depreciate by 6%.
• That way,
10% = 4% +
6%
Expected
gain in the
dollar value
of US asset
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Expected gain in
Expected
the value of the
gain in the
pound versus the
pound value
of Macroeconomics,
UK asset
3/e dollar.
Olivier Blanchard
Equilibrium in Financial Markets
• If the dollar is expected to depreciate over
the year…
• And Ee is constant…
 (so E is expected to end up at the same value
in a year)
• Then the dollar must jump and appreciate
by 6% today.
10% = 4% +
6%
Expected
gain in the
dollar value
of US asset
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Expected gain in
Expected
the value of the
gain in the
pound versus the
pound value
of Macroeconomics,
UK asset
3/e dollar.
Olivier Blanchard
Equilibrium in Financial Markets
• The more the dollar appreciates, the more
investors expect it to depreciate in the
future.
• The initial dollar appreciation must be such
that the expected future depreciation
exactly compensates for the increase in
the U.S. interest rate. When this is the
case, investors are again indifferent and
equilibrium prevails.
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Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
e
E
E
*
ii 
E
E
Ee
i - i*
0
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Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
e
E
E
*
ii 
E
E
Ee
i - i*
0
Here, the exchange rate appreciated too much.
The expected depreciation requires a larger interest rate
differential.
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Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
E
Ee
i - i*
0
Here, the exchange rate appreciated too little.
The expected depreciation is too small to justify
the interest rate differential.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in Financial Markets
The Relation Between the
Interest Rate and the
Exchange Rate Implied by
Interest Parity
A lower domestic interest
rate leads to a higher
exchange rate—to a
depreciation of the
domestic currency. A
higher domestic interest
rate leads to a lower
exchange rate—to an
appreciation of the
domestic currency.
i  E  i  E 
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Macroeconomics, 3/e
Olivier Blanchard
Putting Goods and
Financial Markets Together
20-3
• Goods-market equilibrium implies that
output depends, among other factors, on
the interest rate and the exchange rate.
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Macroeconomics, 3/e
Olivier Blanchard
Putting Goods and
Financial Markets Together
• The interest rate is determined in the
money market:
M
 YL(i )
P
 The interest-parity condition implies a negative
relation between the domestic interest rate and
the exchange rate:
i  E 
i  E 
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Macroeconomics, 3/e
Olivier Blanchard
Putting Goods and
Financial Markets Together
• Combining the interest-parity relation and
the open-economy version of IS:
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Olivier Blanchard
Putting Goods and
Financial Markets Together
• The open-economy versions of the IS and
LM relations are:
 Changes in the interest rate affect the economy
directly through investment, and indirectly
through the exchange rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Putting Goods and
Financial Markets Together
The IS-LM Model in
the Open Economy
An increase in the interest rate
reduces output directly …
(higher interest rates make
investment more expensive)
and indirectly.
(higher i causes an exchange
rate appreciation which
makes exports more
expensive).
The IS curve is downward
sloping.
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Given the real money
stock, an increase in
income increases the
interest rate: The LM
curve is upward sloping.
Macroeconomics, 3/e
Olivier Blanchard
20-4
The Effects of 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
does not shift the LM
curve nor the interestparity curve.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of Policy
in an Open Economy
• An expansionary fiscal policy raises both
output and the interest rate.
 Higher interest rates lead to an appreciation.
• Higher Y and higher i work in opposite
directions for investment.
• Higher Y increases imports (domestic
purchases of foreign goods) while a lower
E makes exports more expensive and
import cheaper: NX declines.
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Macroeconomics, 3/e
Olivier Blanchard
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 does not
shift the IS curve nor
the interest-parity
curve.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of Policy
in an Open Economy
• A contractionary monetary policy lowers
output and raises the interest rate.
 Higher interest rates lead to an appreciation.
• Lower Y and higher i work in the same
direction on investment: I falls.
• Lower Y decreases imports (domestic
purchases of foreign goods) but a lower E
pushes NX down: the effect on NX is
ambiguous.
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Macroeconomics, 3/e
Olivier Blanchard
The Effects of Policy
in an Open Economy
• In the early eighties, the Fed pursued a
very contractionary policy while fiscal
policy turned very expansionary.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Contraction and
Fiscal Policy Expansions
Table 20-1 The Emergence of Large U.S.
Budget Deficits, 1980-1984
1980
1981
1982
1983
1984
Spending
22.0
22.8
24.0
25.0
23.7
Revenues
20.2
20.8
20.5
19.4
19.2
Personal taxes
9.4
9.6
9.9
8.8
8.2
Corporate taxes
2.6
2.3
1.6
1.6
2.0
Budget surplus
1.8
2.0
3.5
5.6
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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of Policy
in an Open Economy
• Both a fiscal expansion and a monetary
contraction should lead to higher interest
rates and an exchange-rate appreciation.
• The effect on output is ambiguous.
However, we know that monetary policy
works more quickly than fiscal policy, so
output should have fallen first and then
recuperated.
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The Effects of Policy
in an Open Economy
• The E appreciation should have
contracted NX.
• The initial recession should have improved
NX, but the later boom should have
contributed to a trade deficit.
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Olivier Blanchard
Monetary Contraction and
Fiscal Policy Expansions
• Economic policy was made by “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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Contraction and
Fiscal Policy Expansions
Table 20-2
Major U.S. Macroeconomic Variables, 1980-1984
1980
1981
1982
1983
1984
0.5
1.8
2.2
3.9
6.2
7.1
7.6
9.7
9.6
7.5
Inflation (CPI) (%)
12.5
8.9
3.8
3.8
3.9
Interest rate (nominal) (%)
11.5
14.0
10.6
8.6
9.6
Interest rate (real) (%)
2.5
4.9
6.0
5.1
5.9
GDP Growth (%)
Unemployment rate (%)
Real exchange rate
Trade surplus (: deficit)
(% of GDP)
117
0.5
99
89
85
77
0.4
0.6
1.5
2.7
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
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
20-5
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 US Dollar
or to another strong currency, like the
Deutsche Mark or the French Franc or the
Euro.
• Alternatively, they may peg to a basket of
currencies, with weights reflecting the
composition of their trade.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Fixed Exchange Rates
• Some countries operate under a crawling
peg.
 Suppose you know that the domestic price
level rises faster than the U.S. price level,
 Then you know that the country faces a real
appreciation that can rapidly make domestic
goods noncompetitive.
 To avoid this effect, countries choose a
predetermined depreciation rate against the
dollar, a “crawl”.
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Macroeconomics, 3/e
Olivier Blanchard
Fixed Exchange Rates
• The European Monetary System (EMS),
determined the movements of exchange
rates within the European Union from
1978 to 1998.
• Countries agreed to maintain their
currencies within bands around a central
parity.
• Some countries moved further, agreeing to
adopt a common currency, the Euro, in
effect, adopting a “fixed exchange rate.”
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Pegging the Exchange Rate,
and Monetary Control
• The interest parity condition is:
e
E
t 1  E t
*
it  i t 
Et
 Pegging the exchange rate turns the interest
parity relation into:
E E
it  i 
E
 it*
*
t
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
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 this condition now holds:

M
 YL i *
P
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Pegging the Exchange Rate,
and Monetary Control

M
 YL i *
P
• If the exchange rate is expected to remain
unchanged, the domestic interest rate
must be equal to the foreign interest rate.
• This means that the domestic Central
Bank does not have an independent
monetary policy.
 If it tries to lower i, it will have to give up
control over E.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Pegging the Exchange Rate,
and Monetary Control
• Under fixed exchange rates, monetary
policy is not effective.
• But fiscal policy is very effective.
• Because the CB keeps i=i*, expansionary
fiscal policy does not raise interest rates.
• There’s no “crowding out” of investment,
and no E appreciation to reduce NX.
• The expansion of output is relatively large.
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Macroeconomics, 3/e
Olivier Blanchard
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.
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Macroeconomics, 3/e
Olivier Blanchard
Pegging the Exchange Rate,
and Monetary Control
• But because Y expands by a lot under
fixed exchange rates, expansionary fiscal
policy causes a surge of imports and a
trade deficit.
• There are two goals: Y and NX. Monetary
policy is now ineffective, and fiscal policy
can only shoot for one.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard