Download Fixed exchange rates

Chapter 20: Output, the Interest Rate,
and the Exchange Rate
ECONOMIC POLICY
Part. II
Unit 5
Monetary and Fiscal Policies in the Open
Economy
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Output, the Interest Rate,
and the Exchange Rate
The model presented in this chapter is known as
the Mundell-Fleming model. It is an extension
to the open economy of the IS-LM model
The main question we are trying to solve is:
What effect monetary and fiscal policies will
have on output, interest rates and
exchange rates?
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Nominal Exchange Rates
Reminder:
Nominal exchange rate is the relative price of
two currencies
Nominal exchange rates between two currencies
can be quoted in one of two ways:
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
1) As the price of the domestic currency in
terms of the foreign currency (the amount
of foreign currency which is needed to buy
one unit of domestic currency)
E.g.: the price of 1 euro in terms of dollars
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
2) As the price of the foreign currency in terms of
the domestic currency (the amount of
domestic currency which is needed to buy one
unit of foreign currency)
E.g.: exchange rate $/£ = 1.9
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Nominal Exchange Rates
We adopt definition 1 (nominal exchange rate
as the price of the domestic currency in terms of
the foreign currency)
An appreciation of the domestic currency is an
increase in the price of the domestic currency
in terms of the foreign currency, which
corresponds to a increase in the exchange
rate.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Domestic Bonds Versus
Foreign Bonds
We assume that an increase in the domestic
interest rate, e.g. after a monetary contraction,
will cause the demand for domestic bonds to
rise. As investors switch from foreign to national
currency, the national currency appreciates
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Domestic Bonds Versus
Foreign Bonds
Figure 20 - 1
The Relation Between
the Interest Rate and the
Exchange Rate Implied
by Interest Parity
A higher domestic interest
rate leads to a higher
exchange rate – an
appreciation.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Putting Goods and
20-3
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 )
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
The interest-parity condition implies a positive
relation between the domestic interest rate
and the exchange rate:
If i  E
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Putting Goods and
Financial Markets Together
The open-economy versions of the IS and LM
relations are:

* 1 i
e
IS: Y  C(Y  T ) I (Y ,i ) G NX  Y ,Y , * E 


1 i
M
LM :
 YL(i )
P
 changes in the interest rate affect the economy
directly through investment
 indirectly through the exchange rate
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Let’s examine the IS relation. A reduction in the
interest rate has now two effects:
i) It determines an increase in investment
demand  Y
ii) It leads to a decrease of E  NX 
demand  Y
Both effects work in the same direction
In the open economy, as in a closed economy, IS
is downward sloping (inverse relation between
Y and i )
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
The LM relation: is the same as in the closed
economy (upward sloping)
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Putting Goods and
Financial Markets Together
Figure 20 - 2
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 output
increases the interest
rate: The LM curve is
upward sloping.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Alternative exchange rate regimes:
i) Flexible exchange rates: the exchange rates
are determined on a daily basis by the market
transactions
ii) Fixed exchange rates: central banks are
committed to buy any amount of domestic
currency and to sell any amount of foreign
currency at a given exchange rate
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Some Central banks act under implicit and
explicit exchange-rate targets
These targets are usually bands or ranges,
rather than specific values
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Some countries maintain a fixed exchange rate
in terms of the dollar or other currencies some
foreign currency (they peg their currency to
the dollar or the euro)
Some countries operate under a crawling peg.
These countries typically have inflation rates
that exceed the U.S. or the Eurozone inflation
rate
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Some countries maintain their bilateral exchange
rates within some bands. The most prominent
example was the European Monetary
System (EMS)
Under the EMS rules, member countries agreed
to maintain their exchange rate vis-á-vis the
other currencies in the system within narrow
limits or bands around a central parity.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Fiscal and monetary policies under flexible
exchange rates
1) Fiscal policy  flexible exchange rates
Let’s suppose that the government increases G
without increasing T
As a consequence, IS shifts to the right. Y and i
increase, E
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
20-4
The Effects of Policy
in an Open Economy
Figure 20 - 3
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 The increase in government spending
appreciation.
shifts the IS curve to the right. It shifts
neither the LM curve nor the interestparity curve.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
The Effects of Policy
in an Open Economy
Let’s analyse what happens to the various
components of demand when the government
increases spending:
 Consumption and government spending both
go up
 The effect of government spending on
investment, which was ambiguous in the
closed economy, remains ambiguous in the
open economy
 Both the increase in output and the
appreciation combine to decrease net exports
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
When the exchange rate is flexible, movements
of the exchange rates tend to dampen the
output effects of IS shocks
The currency depreciates when IS shifts to the
left and appreciates when IS shifts to right
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Suppose that a particular country has a flexible
exchange rate. Show the short run effect of a
fall in business confidence on output, the
interest rate and the exchange rate
Answer: Y, i ; the currency depreciates. As a
consequence, NX
The exchange rate movement dampens the
effect of the fall in business confidence
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
2) Monetary policy  flexible exchange rates
Hypothesis: an expansionary monetary policy
LM shifts down: i , Y. As a consequence:
i) Investment increases;
ii) E depreciates. Provided that the MarshallLerner condition holds, NX
Let’s assume on the contrary a restrictionary
monetary policy:
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
The Effects of Monetary Policy
in an Open Economy
Figure 20 - 4
The Effects of a
Monetary
Contraction
A monetary
contraction leads to a
decrease in output,
an increase in the
interest rate, and an
appreciation.
A monetary contraction shifts the LM
curve up. It shifts neither the IS curve
nor the interest-parity curve.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Fiscal and monetary policies under fixed
exchange rates
Pegging the exchange rate turns the interest
parity relation into:
1+ it = 1+ it*  it = it*
In words: Under fixed exchange rates and perfect
capital mobility, the domestic interest rate
must be equal to the foreign interest rate.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
1) Monetary policy  fixed exchange rates
The central bank is bound to adjust domestic
money supply in order to maintain it = it*
Domestic monetary policy is totally ineffective
The impossible trinity: a country cannot have
simultaneously monetary independence,
exchange rate stability and perfect capital
mobility
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
2) Fiscal policy  fixed exchange rates
Under a fixed exchange rate system, fiscal
policy is more effective than under a flexible
exchange system
Let’s assume a fiscal expansion: the central bank
must accommodate the increased demand for
money by increasing money supply
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Fiscal Policy Under
Fixed Exchange Rates
Figure 20 - 5
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, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Fiscal Policy Under
Fixed Exchange Rates
There are a number of reasons why countries
choosing to fix its interest rate appears to be a bad
idea:
 By fixing the exchange rate, a country gives up a
powerful tool for correcting trade imbalances or
changing the level of economic activity
 By committing to a particular exchange rate, a
country also gives up control of its interest rate,
and they must match movements in the foreign
interest rate risking unwanted effects on its own
activity
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Exchange Rate Crises
Under Fixed Exchange Rates
German unification and the EMS
Under a fixed exchange rate system no individual
country can change its interest rate if the
other countries do not change theirs as well
Two possible arrangements:
i) all the member countries coordinate changes in
their interest rates
ii) one country takes the lead and the other follow
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Exchange Rate Crises
Under Fixed Exchange Rates
Case ii) is what happened in the EMS with
Germany as the leader
During the 1980s European countries shared
similar goals and were happy to let the
Bundesbank take the lead
In 1990 however, German unification led to a
sharp divergence in goals between the
Bundesbank and other European central
banks
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Exchange Rate Crises
Under Fixed Exchange Rates
Large budget deficits, triggered by transfers to
people and public investments in Eastern
Germany led to a large increase in demand
and in the price level in Germany
The Bundesbank reacted by adopting a
restrictionary monetary policy. The result was
a large increase in interest rates
This was probably the right policy mix for
Germany. For the other European countries,
however, it was totally inappropriate
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 20: Output, the Interest Rate,
and the Exchange Rate
Exchange Rate Crises
Under Fixed Exchange Rates
To stay in the EMS, however, they had to adopt
German interest rates
The net result was a sharp decrease in demand
and in output in the other countries (France,
Italy, UK, the Netherlands, etc)
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Macroeconomics, 4/e
Olivier Blanchard
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