Macroeconomics

Lecture 20: output, interest rates, and exchange

rates

Yunho Cho

Spring, 2024
This lecture

• More open economy macro

• Output, interest rates and exchange rates

– Blanchard, Chapter 19

1
This lecture

1- Interest parity and the open economy IS-LM model

– links between interest rates and exchange rates

2- Monetary and fiscal policy in the open economy model

3- Fixed and flexible exchange rates

2
Output, interest rates and exchange rates

• An open economy IS-LM model (the Mundell-Fleming model)

• Main questions

– what determines the exchange rate?

– how does policy affect exchange rates?

3
Equilibrium in the goods market

• Goods market

Y = C(Y, T ) + I(Y, i) + G + X(Y ∗ , ε) − IM (Y, ε)/ε

• Define net exports

N X(Y, Y ∗ , ε) ≡ X(Y ∗ , ε) − IM (Y, ε)/ε

• Net exports decreasing in domestic Y , increasing in foreign Y ∗ ,

decreasing in real exchange rate ε (the Marshall-Lenrner condition)

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Key simplifications

(i) Actual and expected inflation constant (and zero, for simplicity).
Since inflation is zero, domestic price P is constant

(ii) Similarly, foreign actual and expected inflation is zero so that P ∗ is

constant (and equal to P , again for simplicity). Implies nominal and
real exchange rates are the same

P
=1 ⇔ E=ε
P∗
So equilibrium condition is

Y = C(Y, T ) + I(Y, i) + G + N X(Y, Y ∗ , E)

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Equilibrium in financial markets

• Domestic or foreign bonds? What portfolio of domestic and foreign

bonds should investors hold?

• If domestic and foreign bonds are perfect substitutes (apart form

the currency in which they are denominated), then there is perfect
capital mobility

• Gives rise to the interest parity condition

Et
(1 + it ) = (1 + i∗t ) e
Et+1

Rates it and i∗t equalized up to expected exchange rate changes

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Equilibrium in financial markets

• Interest parity condition

Et
(1 + it ) = (1 + i∗t ) e
Et+1

• If expected future exchange rate is Ē e , then

E
i = (1 + i∗ ) −1
Ē e
• Also if interest rates are i and i∗ then exchange rate is

(1 + i) e
E= Ē
1 + i∗

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Equilibrium in financial markets
• Exchange rate in terms of interest rates

(1 + i) e
E= Ē
1 + i∗
• Domestic monetary policy contraction (i.e., i increases) will
increase demand for domestic bonds

– domestic currency appreciates

• Foreign monetary policy contraction (i.e., i∗ increases) will increase

demand for foreign bonds

– domestic currency depreciates

• If expected future value of domestic currency Ē e increases,

demand for domestic bonds increases

– domestic currency appreciates

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Equilibrium in financial markets

• So far we take expected exchange rate as given

• The more the dollar appreciates now, the more investors expect it
to depreciate over time in the future

• If i rises, initial $US appreciation must be such that expected future

depreciation compensates for increase in domestic interest rate

Ē e − E (1 + i∗ )
= − 1 ≈ i∗ − i
E (1 + i)
• Mundell-Fleming model focuses on short run for which expected
exchange rate is given

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Exchange rates and interest rates

Interest parity: i = (1 + i∗ )(E/Ē e ) − 1. Lower domestic interest rate leads to

lower exchange rate, a depreciation of the domestic currency. Higher domestic
interest rate leads to higher exchange rate, an appreciation of the domestic
currency.
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Putting goods and financial markets together

• IS curve: goods market equilibrium implies that output Y depends

on interest rate i and exchange rate E

Y = C(Y, T ) + I(Y, i) + G + N X(Y, Y ∗ , E)

• LM curve: interest rate set exogenously

i = ī

• Interest parity condition implies positive relation between domestic

interest rate i and exchange rate

(1 + ī) e
E= Ē
(1 + i∗ )

Substitute this into IS curve

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Putting goods and financial markets together

• Open-economy IS curve
 
∗ (1 + i) e
Y = C(Y, T ) + I(Y, ī) + G + N X Y, Y , Ē
(1 + i∗ )
• LM curve

i = ī

• Changes in domestic interest rate i affect economy (i) directly

through investment and (2) indirectly through the exchange rate
effect on net exports

• Changes in foreign interest rates i∗ or expected exchange rates Ē e

also affect domestic economy through net exports

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IS-LM in the open economy

Higher interest rate reduces output directly and indirectly (through the
exchange rate), so the IS curve slopes down. As in the closed economy, the
LM curve is horizontal at the level of the interest rate ī set by the central bank.
Given the foreign interest rate and the expected future exchange rate, the
equilibrium interest rate determines the equilibrium exchange rate.
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Effects of a monetary contraction

A monetary policy contraction leads to a decrease in output and an exchange

rate appreciation. The increase in the interest rate does not shift either the IS
curve or the interest-parity curve.

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Effects of fiscal expansion

An increase in government spending leads to an increase in output. If the

central bank keeps the interest rate unchanged, the exchange rate also
remains unchanged.

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Effects of fiscal expansion

An increase in government spending leads to an increase in output. If the

central bank responds by raising the interest rate, the exchange rate will
appreciate.

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Exchange rate regimes: basics

• Flexible (or “floating”) exchange rate

– market conditions determine exchange rate

– so far we have been presuming a floating exchange rate
– clean vs. dirty floats

• Fixed (or “pegged”) exchange rate

– government sets price

– must be willing to buy/sell lots of foreign currency at set price
– collapse if run out reserves

• Also intermediate cases (“crawling peg”)

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Monetary unification

• European Monetary System determined 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 in 2002, agreeing to adopt a

common currency, the euro, a strong form of a fixed exchange rate

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Pegging the exchange rate and monetary control

• Interest parity condition

E
(1 + ī) = (1 + i∗ )
Ē e
• If credible exchange rate peg so that Ē e = E then

i = i∗

Domestic interest rate same as foreign rate

• If domestic economy is “small” (a price-taker on international

markets), then domestic rate i is determined by foreign rate i∗

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Pegging the exchange rate and monetary control
• If domestic interest rate same as foreign rate

i = i∗

• The from LM curve

i = ī = i∗

• For small open economies that take i∗ as given, changes in foreign

interest rates pass through to changes in domestic rates and hence
to domestic money market. The central bank needs to respond by
changing ī

• Mundell-Fleming trilemma: difficult (impossible?) to maintain

(i) perfect international capital mobility

(ii) independent domestic monetary policy
(iii) fixed exchange rate
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Next Lecture

• Multiple choice questions

• Review of the course

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