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1、Chapter 20:Output,the Interest Rate,and the Exchange RateOutput,the Interest Rate,and the Exchange RateThe model developed in this chapter is an extension of the open economy IS-LM model,known as the Mundell-Fleming model.The main questions we try to solve are:What determines the exchange rate?How c
2、an policy makers affect exchange rates?1Chapter 20:Output,the Interest Rate,and the Exchange RateEquilibrium in the Goods MarketEquilibrium in the goods market can be described by the following equations:20-12Chapter 20:Output,the Interest Rate,and the Exchange RateEquilibrium in the Goods MarketCon
3、sumption C depends positively on disposable income Y-T.Investment I depends positively on output Y,and negatively on the real interest rate r.Government spending G is taken as given.The quantity of imports IM depends positively on both output Y and the real exchange rate .Exports X depend positively
4、 on foreign output Y*and negatively on the real exchange rate .3Chapter 20:Output,the Interest Rate,and the Exchange RateEquilibrium in the Goods MarketThe main implication of this equation is that both the real interest rate and the real exchange rate affect demand and,in turn,equilibrium output:An
5、 increase in the real interest rate leads to a decrease in investment spending,and to a decrease in the demand for domestic goods.An increase in the real exchange rate leads to a shift in demand toward foreign goods,and to a decrease in net exports.4Chapter 20:Output,the Interest Rate,and the Exchan
6、ge RateEquilibrium in the Goods MarketIn this chapter we make two simplifications:Both the domestic and the foreign price levels are given;thus,the nominal and the real exchange rate move together:There is no inflation,neither actual nor expected.Then,the equilibrium condition becomes:5Chapter 20:Ou
7、tput,the Interest Rate,and the Exchange RateEquilibrium in Financial markets20-2Now that we look at a financially open economy,we must also take into account the fact that people have a choice between domestic bonds and foreign bonds.6Chapter 20:Output,the Interest Rate,and the Exchange RateMoney Ve
8、rsus BondsWe wrote the condition that the supply of money be equal to the demand for money as:We can use this equation to think about the determination of the nominal interest rate in an open economy.7Chapter 20:Output,the Interest Rate,and the Exchange RateDomestic Bonds Versus Foreign BondsWhat co
9、mbination of domestic and foreign bonds should financial investors choose in order to maximize expected returns?The left side gives the return,in terms of domestic currency.The right side gives the expected return,also in terms of domestic currency.In equilibrium,the two expected returns must be equ
10、al.8Chapter 20:Output,the Interest Rate,and the Exchange RateDomestic Bonds Versus Foreign BondsIf the expected future exchange rate is given,then:The current exchange rate is:9Chapter 20:Output,the Interest Rate,and the Exchange RateDomestic Bonds Versus Foreign BondsAn increase in the U.S.interest
11、 rate,say,after a monetary contraction,will cause the U.S.interest rate to increase,and the demand for U.S.bonds to rise.As investors switch from foreign currency to dollars,the dollar appreciates.The more the dollar appreciates,the more investors expect it to depreciate in the future.The initial do
12、llar appreciation must be such that the expected future depreciation compensates for the increase in the U.S.interest rate.When this is the case,investors are again indifferent and equilibrium prevails.10Chapter 20:Output,the Interest Rate,and the Exchange RateDomestic Bonds Versus Foreign BondsThe
13、Relation Between the Interest Rate and the Exchange Rate Implied by Interest ParityA higher domestic interest A higher domestic interest rate leads to a higher rate leads to a higher exchange rate an exchange rate an appreciation.appreciation.Figure 20-111Chapter 20:Output,the Interest Rate,and the
14、Exchange RatePutting Goods andFinancial Markets TogetherGoods-market equilibrium implies that output depends,among other factors,on the interest rate and the exchange rate.20-312Chapter 20:Output,the Interest Rate,and the Exchange RatePutting Goods andFinancial Markets TogetherThe interest rate is d
15、etermined by the equality of money supply and money demand:The interest-parity condition implies a negative relation between the domestic interest rate and the exchange rate:13Chapter 20:Output,the Interest Rate,and the Exchange RatePutting Goods andFinancial Markets TogetherThe open-economy version
16、s of the IS and LM relations are:Changes in the interest rate affect the economy directly through investment,indirectly through the exchange rate.14Chapter 20:Output,the Interest Rate,and the Exchange RatePutting Goods andFinancial Markets TogetherThe IS-LM Model in the Open EconomyAn increase in th
17、e An increase in the interest rate reduces interest rate reduces output both directly and output both directly and indirectly(through the indirectly(through the exchange rate).The IS exchange rate).The IS curve is downward curve is downward sloping.Given the real sloping.Given the real money stock,a
18、n money stock,an increase in output increase in output increases the interest increases the interest rate:The LM curve is rate:The LM curve is upward sloping.upward sloping.Figure 20-215Chapter 20:Output,the Interest Rate,and the Exchange RateThe Effects of Policyin an Open EconomyThe Effects of an
19、Increase in Government SpendingAn increase in An increase in government government spending leads to an spending leads to an increase in output,increase in output,an increase in the an increase in the interest rate,and an interest rate,and an appreciation.appreciation.The increase in government spen
20、ding shifts the IS curve to the right.It shifts neither the LM curve nor the interest-parity curve.20-4Figure 20-316Chapter 20:Output,the Interest Rate,and the Exchange RateThe Effects of Policyin an Open EconomyCan we tell what happens to the various components of demand for money when the governme
21、nt increases spending:Consumption and government spending both go up.The effect of government spending on investment was ambiguous in the closed economy,it remains ambiguous in the open economy.Both the increase in output and the appreciation combine to decrease net exports.17Chapter 20:Output,the I
22、nterest Rate,and the Exchange RateThe Effects of Monetary Policyin an Open EconomyThe Effects of a Monetary ContractionA monetary A monetary contraction leads to a contraction leads to a decrease in output,decrease in output,an increase in the an increase in the interest rate,and an interest rate,an
23、d an appreciation.appreciation.A monetary contraction shifts the LM curve up.It shifts neither the IS curve nor the interest-parity curve.Figure 20-418Chapter 20:Output,the Interest Rate,and the Exchange RateTable 1 The Emergence of Large U.S.Budget Deficits,1980-198419801981198219831984Spending22.0
24、22.824.025.023.7Revenues20.220.820.519.419.2 Personal taxes9.49.69.98.88.2 Corporate taxes2.62.31.61.62.0Budget surplus(-:deficit)1.8 2.0 3.5 5.6 4.5Numbers are for fiscal years,which start in October of the previous calendar year.All numbers are expressed as a percentage of GDP.Monetary Contraction
25、,and Fiscal Expansion:The United States in the Early 1980s19Chapter 20:Output,the Interest Rate,and the Exchange RateSupply sidersa 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 in
26、crease in the trade deficit.A higher trade deficit,combined with a large budget deficit,became know as the twin deficits of the 1980s.Monetary Contraction,and Fiscal Expansion:The United States in the Early 1980s20Chapter 20:Output,the Interest Rate,and the Exchange RateTable 2Major U.S.Macroeconomi
27、c Variables,1980-198419801981198219831984GDP Growth(%)0.51.8 2.23.96.2Unemployment rate(%)7.17.69.79.67.5Inflation(CPI)(%)12.58.93.83.83.9Interest rate(nominal)(%)11.514.010.68.69.6(real)(%)2.54.96.05.15.9Real exchange rate85 101111117129Trade surplus(:deficit)(%of GDP)-0.5-0.4-0.6-1.5-2.7Inflation:
28、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=100Monetary
29、 Contraction,and Fiscal Expansion:The United States in the Early 1980s21Chapter 20:Output,the Interest Rate,and the Exchange RateFixed Exchange RatesCentral banks act under implicit and explicit exchange-rate targets and use monetary policy to achieve those targets.20-522Chapter 20:Output,the Intere
30、st Rate,and the Exchange RatePegs,Crawling Pegs,Bonds,the EMS,and the EuroSome countries operate under fixed exchange rates.These countries maintain a fixed exchange rate in terms of some foreign currency.Some peg their currency to the dollar.Some countries operate under a crawling peg.These countri
31、es typically have inflation rates that exceed the U.S.inflation rate.23Chapter 20:Output,the Interest Rate,and the Exchange RatePegs,Crawling Pegs,Bonds,the EMS,and the EuroSome countries maintain their bilateral exchange rates within some bands.The most prominent example is the European Monetary Sy
32、stem(EMS).Under the EMS rules,member countries agreed to maintain their exchange rate vis-vis the other currencies in the system within narrow limits or bands around a central parity.Some countries moved further,agreeing to adopt a common currency,the Euro,in effect,adopting a“fixed exchange rate.”2
33、4Chapter 20:Output,the Interest Rate,and the Exchange RatePegging the Exchange Rate,and Monetary ControlThe interest parity condition is:Pegging the exchange rate turns the interest parity relation into:25Chapter 20:Output,the Interest Rate,and the Exchange RatePegging the Exchange Rate,and Monetary
34、 ControlIncreases 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 the following condition holds:In words:Under a fixed exchange rate and perfect capital mobility,the domestic interest rate must be equal to t
35、he foreign interest rate.26Chapter 20:Output,the Interest Rate,and the Exchange RateFiscal Policy UnderFixed Exchange RatesThe Effects of a Fiscal Expansion Under Fixed Exchange RatesUnder flexible Under flexible exchange rates,a exchange rates,a fiscal expansion fiscal expansion increases output,in
36、creases output,from Yfrom YA A to Y to YB B.Under.Under fixed exchange rates,fixed exchange rates,output increases from output increases from Y YA A to Y to YC C.The central bank must accommodate the resulting increase in the demand for money.Figure 20-527Chapter 20:Output,the Interest Rate,and the
37、Exchange RateFiscal Policy UnderFixed Exchange RatesThere 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 comm
38、itting 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.28Chapter 20:Output,the Interest Rate,and the Exchange RateFiscal Policy UnderFixed Exchange RatesThere ar
39、e a number of reasons why countries choosing to fix its interest rate appears to be a bad idea:Although the country retains control of fiscal policy,one policy instrument is not enough.A country that wants to decrease its budget deficit cannot,under fixed exchange rates,use monetary policy to offset
40、 the contractionary effect of its fiscal policy on output.29Chapter 20:Output,the Interest Rate,and the Exchange RateGerman Unification,Interest Rates,and the EMSTable 1German Unification,Interest Rates,and Output Growth:Germany,France,and Belgium,1990-1992Nominal Interest Rates(%)Inflation(%)199019
41、911992199019911992Germany8.59.29.52.73.74.7France10.39.610.32.93.02.4Belgium9.69.49.42.92.72.4Real Interest Rates(%)GDP Growth(%)199019911992199019911992Germany5.75.54.85.74.52.1France7.46.67.92.50.71.4Belgium6.76.77.03.32.10.8The nominal interest rate is the short-term nominal interest rate.The rea
42、l interest rate is the realized real interest rate over the year that is,the nominal interest rate minus actual inflation over the year.All rates are annual.30Chapter 20:Output,the Interest Rate,and the Exchange RateKey TermsMundell-Fleming modelsupply siderstwin deficitspegcrawling pegEuropean Monetary System(EMS)bandscentral parityEuro31