Intermediate Macroeconomics

Lecture 21: output, interest rates and exchange rates

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 This lecture

1- The open economy IS-LM model

2- Monetary and fiscal policy in the open economy model

3- Fixed and flexible exchange rates

4- Reading: Blanchard, chapter 19, sections 19.3-19.5

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 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?

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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: i = ī (remember real money supply adjusts to clear money market

M/P = Y L(i))

• Interest parity condition implies positive relation between domestic interest rate i and
exchange rate

(1 + i) 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, i) + 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
money demand, and (ii) 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 IS slopes down.
Given the central bank sets the interest rate, the LM curve is flat and M/P is endogenous. If i rises, the
exchange rate appreciates, so interest parity relation slopes up.
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 Effects of monetary policy in an open economy

• Monetary policy

– expansionary monetary policy: central bank lowers the interest rate

– contractionary monetary policy: central bank increases the interest rate

• Suppose the central bank decides to increase the domestic interest rate → the LM
curve shifts up

• The rise in domestic interest rate leads to a higher exchange rate (movement along the
interest-parity curve)

• Output decreases and the exchange rate appreciates, what about net exports?

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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 policy in an open economy

• Fiscal policy

– expansionary fiscal policy: increase G or decrease T

– contractionary monetary policy: decrease G or increase T

• Suppose the government pursues an expansionary fiscal policy → the IS curve shifts
to the right

• Output increases and the exchange rate stays unchanged (because the interest rate
does not change), what about net exports?

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 Effects of fiscal expansion

Increase in G increases output. Since the central bank keeps the interest rate constant, there is no effect on
E.
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 A fiscal expansion with a monetary contraction

• Suppose the increase in G happens when output is close to its potential level

• The central bank can use a contractionary monetary policy to avoid moving the
economy much above potential output

• The LM curve shifts up. Output increases by much less than without the
contractionary monetary policy

• The exchange rate will rise as domestic interest rate rises. What about net exports?

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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 versus dirty floats

• Fixed (or “pegged”) exchange rate

– government sets price – how?

– must be willing to buy/sell lots of foreign currency at set price
– collapse if run out of 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 + i) = (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∗
• Then from LM curve
M
= Y L(i∗ )
P
• 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. Either
M/P or Y has to respond

• 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

• More on exchange rate regimes

– Blanchard, chapter 20

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