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49:03
Transcript
0:17
Let's say let's start with the
0:19
Mundell-Fleming model. Now this is a
0:21
model that that
0:23
I think it's extremely useful.
0:26
And
0:28
in the short term it will be important
0:29
for you because it probably 70% of the
0:32
quiz will be related to things that
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0:35
to this model. Meaning, you know, we're
0:36
going to use this model for different
0:38
things.
0:39
But but but if you understand it well,
0:42
you probably have 70% of the last quiz
0:45
under control.
0:46
So I'm going to go very slowly over it
0:48
and please stop me if there's any step
0:50
you don't understand. I I put the steps
0:53
into myself so I don't
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0:54
rush because again I think it's
0:56
important.
0:57
Um
0:59
to understand things.
1:00
So here you have the exchange rate, two
1:03
exchange rates.
1:05
The the wide one is the
1:08
the the
1:10
the euro-dollar
1:12
exchange rate.
1:14
I'm quoting it the opposite of the way
1:16
it's normally quoted. There are some
1:18
conventions in effects markets but this
1:20
is as we have defined in this course is
1:22
if it goes up it means an appreciation
1:24
of the local currency.
1:26
That is the dollar.
1:27
That is you get more of the foreign
1:30
currency per unit of the domestic
1:32
currency when it goes up.
1:34
And down is a depreciation.
1:36
And you see there that the so this is
1:39
the the dollar became
1:41
uh
1:41
gained value relative to the euro
1:43
through all this period and then it has
1:45
lost quite a bit of value uh since sort
1:48
of late 2022.
1:51
For for with respect to the Japanese
1:53
yen, that's the blue line, it's was the
1:55
whole cycle is even more dramatic, no?
1:57
Big appreciation of the dollar.
1:59
Depreciation of the yen.
2:02
Uh and and a reversal
2:05
uh
2:06
since late 2022 and so on.
2:09
So what is behind this this big
2:12
fluctuations?
2:13
Many things. Effects are volatile like
2:15
almost any asset price. But one of the
2:18
main drivers of this uh
2:20
of of of these fluctuations is
2:23
perceptions about interest rate policy
2:24
in the different parts of the world.
2:26
Okay?
2:27
So
2:28
uh the reason we have seen a lot of this
2:31
decline here.
2:33
So the reason for the rise here of the
2:35
dollar is mostly because
2:37
investors in general perceived that the
2:39
US was more advanced in its business
2:42
cycle. It began to tighten interest rate
2:43
before the rest of the world.
2:45
And since interest rates were rising in
2:48
in the US, that led to an appreciation
2:50
of the dollar.
2:51
By a mechanism they described at the end
2:54
of the previous lecture but I'm going to
2:56
repeat today. Remember when I talked
2:58
about the uncovered interest rate parity
2:59
condition? Well, it's related to what
3:01
I'm talking about here.
3:03
I'm going to again go go again over
3:05
that. And a big reason for the decline
3:07
more recently is simply that there's a
3:11
sense that monetary policy is peaking in
3:13
the US in terms of tightness while the
3:15
rest of the world is catching up. Uh and
3:18
and in the case of Europe more than
3:20
catching up because they have further
3:22
supply shocks coming from energy shocks
3:24
and so on.
3:26
So if you look for example at the
3:27
expected in policy rate path in the case
3:30
of the US
3:32
nowadays
3:33
it looks like this. So the still market
3:35
expect some hike some hikes in the US
3:38
but a limited amount of hikes and then
3:40
they expect quickly the Fed to start
3:42
undoing that. Okay? That's what this
3:44
path is telling you. This is expected
3:46
policy rate path. What the market thinks
3:49
now the policy rate will be in the next
3:51
meeting, two meetings from now, three
3:53
meetings from now, four meetings
3:54
meetings of the FOMC
3:56
uh
3:57
from now. Okay? Well, if you look at the
3:59
same picture in Europe, it looks like
4:00
that. It's clear that they are they are
4:02
still there is more ahead.
4:04
And and then you see sort of that that's
4:07
what the market perceive at this point.
4:09
Whether that ends up being true or not
4:11
doesn't matter. At any point in time the
4:13
exchange rate is determined by what the
4:14
markets think. So so what actually
4:17
happens is less important for an asset
4:19
price. An asset price is a lot about
4:21
pricing today is things that you expect
4:23
to happen in the future. Uh what it
4:25
expects what you expect is what matters,
4:27
not what actually happens. And at this
4:28
moment the market expect uh
4:32
the euro area to go through a
4:34
sort of a more prolonged periods of
4:36
hiking interest rate hiking.
4:38
Japan hasn't had hikes in interest rate
4:40
for three three decades but even now you
4:43
start you begin to see some
4:45
you know,
4:46
the scale here is very small. These are
4:48
a few basis points. But even the point
4:50
I'm trying to make is that certainly
4:52
that
4:53
people expect interest rates in the US
4:55
to go down relative to interest rates in
4:57
Japan.
4:59
Not to say that the interest rate in the
5:00
US will be lower than the interest rate
5:02
in Japan but the direction of the change
5:04
is in that way. So relative to where
5:05
we're at now
5:07
the direction of the change is is is is
5:10
towards the US loosening monetary policy
5:14
uh before the rest of the world does.
5:16
Okay? And and that's what is leading to
5:18
these big swings.
5:21
As I said before you know, this is the
5:23
period in which the US had to start
5:24
tightening before the rest and and the
5:27
currency appreciated a lot especially
5:29
with respect to the yen because again
5:30
the yen has been against the zero lower
5:32
bound for a very long time. So nobody
5:34
expected the yen to move to follow the
5:36
US.
5:37
And and and while with respect to
5:39
Europe, well Europe was having
5:40
inflationary problems and so on as well.
5:42
So people expected it to follow the US
5:44
at some point. For Japan, there was
5:47
nothing like that and that's what led to
5:48
the massive depreciation of the yen.
5:51
Appreciation of the US dollar vis-a-vis
5:53
the yen.
5:54
Okay?
5:54
So what we the Mundell-Fleming model is
5:57
about is about first connecting these
6:00
things, trying to understand what moves
6:01
exchange rate, how different monetary
6:03
policies in different places or
6:05
different policies in different places
6:06
of the world affect exchange rate. And
6:09
then it's about understanding how those
6:11
exchange rate movements affect real
6:13
activity. Okay?
6:15
In the short run.
6:16
That's what the Mundell-Fleming model
6:18
is. So it is really we're going to go
6:20
back to our old IS-LM model. Very short
6:24
run. We're going to even fix nominal
6:25
prices and so on. So back to that
6:28
environment. But we're going to do it in
6:29
an open economy so we're going to have a
6:31
new variable floating around which is
6:33
the exchange rate. And and and we need
6:35
to understand how the exchange rate
6:36
moves when you different things happen
6:37
in different countries. And the and and
6:40
what is the impact of that on aggregate
6:42
demand and hence in on output. We're
6:44
talking about the very short run
6:46
in the different parts of the world.
6:48
Okay? That's the plan. That's what we
6:50
intend to
6:52
So let's start with the this
6:53
Mundell-Fleming model. Remember we we
6:56
wrote down
6:57
uh the equilibrium in the goods market
7:00
in the previous lecture and and and
7:02
that's that's I'm just reproducing what
7:04
I wrote in the previous lecture. So it
7:06
looks exactly like the closed economy.
7:08
Output is determined by aggregate
7:09
demand. But it's aggregate demand for
7:11
domestically produced goods.
7:13
Domestically produced goods is now the
7:15
is not the same as domestic demand
7:18
for goods which is this. Because now
7:20
there's a net export term. So part of
7:22
the things that the that
7:25
residents sort of demand they they
7:27
demand from the rest of the world, not
7:29
from domestic producers.
7:30
And at the same time part of the demand
7:32
perceived by domestic producers comes
7:34
from the rest of the world, from
7:35
exports, not from domestic producers. So
7:37
that's the reason we got an extra term
7:38
here which is this net exports.
7:41
And we said this net exports is a
7:43
function of three things.
7:44
It's a function of output.
7:47
Okay?
7:49
And it's a it's a decreasing function of
7:51
output. Why is that?
7:53
Of domestic output.
7:57
Domestic output, domestic income. Why
8:00
isn't that decreasing function of
8:01
domestic income?
8:08
Why do net exports decline when domestic
8:10
income rises?
8:17
They buy they import more. They consume
8:19
everything more but part of that is
8:20
imports.
8:21
And so part of that energy of the extra
8:23
demand goes to foreign goods and that's
8:26
what deteriorates net exports. Okay? And
8:28
that's the reason we said had Had we
8:30
just stopped there, made the net export
8:32
function just a function of output, we
8:34
would have not needed all this extra
8:36
apparatus that I'm about to build
8:38
because all that would have meant is
8:39
that just we have a smaller multiplier.
8:42
It would have been exactly the same as
8:43
we did in the closed economy but with a
8:45
smaller multiplier because you know,
8:47
every time an output goes up now part of
8:49
that demand goes to foreign goods rather
8:51
than domestic goods.
8:54
But it's not so.
8:56
First because we have an extra another
8:59
income that matters here which is the
9:00
income of the rest of the world.
9:03
Uh but more important because we also
9:05
have an exchange rate. But let's start
9:06
from this side. So net exports is
9:09
increasing in the income of the rest of
9:10
the world. Why is that?
9:15
That is demand for domestically produced
9:17
good rises when foreign income goes up.
9:22
Foreign output foreign income goes up.
9:23
Why is that?
9:29
It's a symmetric argument, no?
9:31
If with with imports, well
9:34
our exports are the imports of the other
9:36
country. So if the income in the other
9:39
country goes up then their their imports
9:42
will go up which is our exports that go
9:44
up. That's the reason net exports uh
9:47
goes up.
9:49
And the last term
9:51
remember
9:52
uh is that says that net exports is
9:56
declining
9:57
on the real exchange rate.
9:59
Why is that?
10:05
What happens when the real exchange rate
10:06
goes up?
10:07
Net exports are going to be more
10:08
expensive relative to foreign goods.
10:10
Exactly. Our goods become more expensive
10:12
relative to foreign goods and that
10:13
affects us from two dimensions. First,
10:15
our exports will tend to decline because
10:17
our goods are more expensive and also
10:20
our imports are going to tend to
10:21
increase because foreign goods are
10:23
cheaper. Okay? And so that's the reason
10:25
this
10:27
is decreasing with respect to the
10:28
exchange rate.
10:30
The big thing of the Mundell-Fleming
10:31
model really comes from the fact that
10:33
this guy is there. We Had we not had the
10:36
exchange rate there, again we could have
10:37
used exactly the same apparatus as we
10:39
used
10:40
earlier on.
10:41
But we're going to have an exchange rate
10:42
floating around and that will require us
10:44
that to to build more
10:47
a little more. We need an extra
10:48
equation, you know, because we have an
10:50
extra endogenous variable.
10:52
Now, what I'm going to assume here
10:54
as we did in in in the first part of the
10:56
course is that both the domestic and
10:59
foreign prices are completely fixed. So,
11:00
I'm going to ignore Phillips curve,
11:02
inflation, expected inflation and all
11:03
that. Okay? I'm going to assume all that
11:05
is zero. Expected inflation, inflation,
11:08
zero.
11:09
When I do that,
11:11
the same equation, the equilibrium in
11:12
the goods markets,
11:14
changes a little bit. I mean, it's the
11:16
same equation, but now I don't need to
11:18
differentiate between real interest rate
11:20
and nominal interest rate because
11:21
inflation is zero. So, nominal interest
11:23
rate is equal to the real interest rate.
11:25
So, I'm going to stick in here the
11:26
nominal interest rate.
11:27
Second, I really don't
11:30
need to differentiate between real
11:31
exchange rate and nominal exchange rate
11:34
because the relative prices, the prices
11:36
themselves are not changing and so all
11:38
that will move the the real exchange
11:40
rate is the nominal exchange rate. Okay?
11:42
So, that's the reason I'm going to write
11:44
here the the nominal exchange rate
11:47
is because it's the only thing that will
11:49
move this variable around given that
11:51
prices are fixed.
11:53
Okay?
11:54
So, that's my our equilibrium in the
11:56
goods market and this is the thing you
11:58
need to compare with, you know, lecture
11:59
three or something like that. And as I
12:01
said, this part here only lowers the
12:04
multiplier, so not a big change. This
12:06
one here is an extra parameter that
12:08
shifts
12:09
aggregate demand up and down, so you can
12:11
treat it almost like we treated C0.
12:13
Remember, if the consumer confidence
12:15
goes up, then aggregate demand goes up.
12:17
Well, here we have sort of the rest of
12:19
the world's output goes up. It does
12:21
exactly the same the same analysis.
12:23
The problem we have though is that we
12:24
have an extra variable here, which is
12:26
the exchange rate and that's an
12:27
endogenous variable. Okay? So, we're
12:30
going to have to come up with some other
12:32
equation
12:33
to solve for that equation here. In in
12:36
lecture three or four, what we did is,
12:39
okay, we said we have two endogenous
12:40
variables, output and the interest rate
12:43
if we output and the interest rate, we
12:45
need one more equation. Well, the other
12:47
equation was just monetary policy that
12:49
set the nominal interest rate.
12:51
Here, that's not going to be enough
12:53
because we also have an exchange rate
12:55
floating around. Okay? So, and we need
12:57
to bring another equation here
12:59
uh
13:01
to deal with this this new endogenous
13:03
variable.
13:05
What is that extra equation?
13:07
Well, is the uncovered interest parity
13:09
condition. Remember, it's the last
13:10
expression we had in in in the previous
13:13
lecture
13:14
uh
13:15
that takes this form.
13:18
Okay? It says
13:20
I Before I simplify lots of things, I
13:22
wrote this down.
13:24
And it says that the exchange rate
13:26
is uh
13:28
is equal to that. Okay?
13:31
Now, what what is this
13:33
Where does this equation come from?
13:36
What is it trying to do?
13:39
Remember, we talked we we talked about
13:41
this in the context and say, well, you
13:43
know, when you open goods markets and
13:45
you need a relative price to decide
13:46
where you're going to buy.
13:47
That's what what
13:50
the real exchange rate did.
13:52
And and and now that then then we opened
13:55
the capital account and then you need to
13:56
people need to decide where they're
13:58
going to invest their money. And that
14:00
equation was related to that.
14:03
The expected rate of return has to be
14:05
the same for like domestic Exactly. It's
14:06
what equalizes expected rate of return.
14:08
In equilibrium, that has to happen.
14:10
Okay? Again, in reality, there is risk
14:13
adjustment, there is lots of other
14:14
factors that we're removing from here.
14:16
But absent those other factors,
14:19
the the returns have to be similar in
14:20
both places because if one asset is
14:22
giving more return than the other
14:23
expected return, then then then people
14:25
are going to invest all their portfolios
14:27
in that asset. And what happens is those
14:29
flows that try to go to the worst those
14:32
assets that give the highest return and
14:33
that equalizing expected return in
14:35
equilibrium.
14:36
And that's the equation that does that.
14:39
Exactly that. How do I know that? Well,
14:42
remember,
14:43
uh I can divide this by the exchange
14:46
rate on both sides and then what you get
14:48
is one
14:50
equal to a numerator that has the
14:52
nominal exchange rate
14:54
times the expected appreciation of the
14:57
currency plus
14:59
and in the denominator you have the the
15:01
the foreign interest rate.
15:03
And so, you have to when you compare the
15:04
two, you have to compare
15:06
one
15:07
base interest rate, either the domestic
15:09
or the foreign, plus the expected
15:11
appreciation or depreciation of that
15:12
currency. And that's what this term is
15:14
doing here.
15:15
This divided by that. Okay?
15:19
Good. So, what do we get out of this? Uh
15:21
one thing we're going to do for for
15:22
quite a while because it will simplify
15:24
things a lot, but sometimes also lead to
15:26
confusion in in in in
15:31
in the way we understand why currencies
15:32
depreciate or appreciate, but we will
15:35
pause and and I'll remind you of this
15:37
repeatedly. We're going to assume for
15:39
now
15:40
that the
15:41
expected exchange rate for T plus one is
15:44
fixed.
15:45
Okay? And and until I tell you
15:47
otherwise,
15:49
we're going to make this assumption.
15:53
Now,
15:54
that's a huge simplification, completely
15:56
unrealistic, and so on. But it will help
15:59
me explain the mechanism.
16:01
I mean, one of the things that moves
16:02
exchange rates a lot is that people have
16:04
lots of expectations about future
16:05
exchange rate. We'll get to that later.
16:08
But for now, so you understand the
16:10
mechanism, how the Mundell-Fleming model
16:12
works,
16:13
I'm going to assume that we all know
16:15
what the expected exchange rate We all
16:17
We all have a common expected exchange
16:18
rate and it's fixed.
16:20
Okay?
16:22
We may move it as a parameter, but I
16:24
won't say I'm not going to endogenize
16:26
that. I'm going to take it as fixed
16:28
and I I may move it around to show you
16:31
what happens when that changes, but I'm
16:33
not going to endogenize it.
16:35
Okay?
16:38
Otherwise, I need more equations.
16:39
One more. I want to stop this this this
16:43
sequence of equations that I would have
16:45
to build, but
16:47
later we'll understand more that what I
16:49
just said, but but for now, just take
16:51
this as fixed. So, if I take this as
16:53
fixed, now I have an equation. Remember,
16:54
we was looking for an equation
16:57
here for my exchange rate.
17:00
Once I do that, then I have what I
17:01
wanted.
17:02
I have an equation for my exchange rate
17:04
today. It's just
17:06
function of
17:07
domestic interest rate, international
17:08
interest rate,
17:10
and the expected exchange rate.
17:12
Okay?
17:13
So, I know the following, for example. I
17:15
know that an increase in the domestic
17:17
interest rate,
17:18
other things equal,
17:20
appreciates exchange rate. You know, I
17:22
can see it in the equation. If I move
17:23
the domestic interest rate up, the
17:25
exchange rate goes up. That's an
17:27
appreciation. The dollar becomes
17:29
more expensive.
17:31
Even simpler. Suppose we start with a
17:33
situation in which the domestic and the
17:36
international interest rate were the
17:37
same.
17:38
And now I increase the international
17:40
interest rate. And I'm saying the
17:41
exchange rate will appreciate.
17:45
Well, first of all,
17:47
let me let me start from something even
17:48
simpler. Suppose that
17:50
suppose that that
17:52
this interest rate is equal to
17:53
international interest rate before
17:55
analyzing the change I'm about to
17:57
analyze,
17:58
then from this equation, what do I know
18:00
I know about the exchange rate? What is
18:02
it equal to?
18:03
If the domestic interest rate is equal
18:05
to international interest rate,
18:07
what is the exchange rate today equal
18:09
to?
18:12
The expected exchange rate of next year.
18:14
If I have the same interest rates, I
18:15
cannot expect a capital gain or loss on
18:17
the currency position because I have
18:19
already an equal interest rate in in the
18:21
two bonds. Okay?
18:23
So then, I'm starting from a situation
18:25
where the current exchange rate is equal
18:27
to expected exchange rate and these two
18:28
are equal. And now, I'm going to
18:30
increase the interest rate, the domestic
18:32
interest rate.
18:33
And it's very easy for you to read from
18:35
here that the exchange rate will go up.
18:38
The currency will appreciate.
18:40
Why?
18:42
This is not an easy
18:43
thing to answer unless you know
18:46
unless you have read the book or
18:47
something.
18:50
If the interest rate goes up, then like
18:53
money supply should go down, which would
18:54
generally increase the value of money.
18:56
No.
18:57
No money here.
18:59
That money is only related to the
19:00
mechanism we used to increase
19:03
interest rate, but
19:04
I'm saying just use that equation
19:07
and the logic behind that equation, the
19:09
uncovered interest parity.
19:10
Why is it that if I you know, we went to
19:13
from a situation which interest rate
19:14
were the same, now I increase the
19:16
domestic interest rate, I'm saying the
19:18
the exchange rate has to appreciate.
19:23
No, no, but that's the description of
19:25
Yeah, that's that's We know that.
19:27
The question is what? What is the logic?
19:32
Yeah,
19:33
we have We know the result, but I'm
19:35
asking is for an economic explanation
19:37
for that result.
19:40
More people will want to invest in the
19:43
currency that you are in currency, so
19:44
the demand will go up and so the value
19:46
Well, if you go to Wall Street, you want
19:48
to rate, they will explain it in those
19:49
terms.
19:50
It's not the right explanation, but they
19:52
they will explain on those terms. And
19:54
there is some logic behind that because
19:57
this equation assumes that the arbitrage
19:58
happens instantaneously. Immediately
20:00
things move. But, but before that
20:02
happens, you know, some people will
20:03
start they buy more of the one that has
20:06
more return. But, this equation already
20:08
solved all that.
20:10
And that's when this assumption
20:13
matters and and is a little annoying.
20:15
It bothers me for a logical reason. But,
20:17
but we're going to use it to understand
20:19
the mechanism.
20:20
You see, if if I keep the exchange rate
20:23
fixed, we started with a situation where
20:24
the exchange rate was equal to expected
20:26
exchange rate.
20:27
If I keep it fixed
20:29
and I appreciate the currency today,
20:32
then what do I expect
20:34
to happen to the dollar, let's talk
20:36
about the dollar, from this period to
20:38
the next one? Remember, we start from a
20:40
situation where the exchange rate was
20:42
equal to the expected exchange rate.
20:43
Now, I increase the interest rate and I
20:45
said the exchange rate appreciate.
20:48
Then what do you expect
20:50
the exchange rate to do over the next
20:51
period?
20:53
If I haven't moved expected exchange
20:54
rate and now the exchange rate move
20:55
above the expected exchange rate.
20:58
What do you expect the exchange rate to
20:59
do?
21:03
Exactly, it has to depreciate.
21:05
So, the reason depreciation happens here
21:09
is because you need to expect to
21:11
depreciate the dollar from this period
21:13
to the next one. Why do I need to expect
21:16
exchange rate to depreciate?
21:20
So, I'm appreciating the currency
21:21
because I need in equilibrium I need to
21:23
expect to depreciate. That is, I need to
21:25
expect to lose money money on the
21:27
currency part of the trade.
21:30
Why is that? Confusion is good. You you
21:32
learn from that.
21:34
And this can be very confusing, I know.
21:40
What is this equation trying to do?
21:46
We are trying to make the expected
21:47
returns the same. That's the whole idea
21:49
of this.
21:50
So, if I I'm now telling you that one
21:53
bond is paying a higher interest than
21:55
the other one,
21:56
I need to
21:57
offset that somehow.
21:59
How do I offset it? By expecting a
22:02
depreciation of the currency
22:04
of the bond
22:05
that is, you know, of of the bond that
22:08
is denominated
22:10
in the currency that is expected to
22:11
depreciate. So, what I need to do is
22:14
compensate for the interest rate
22:16
differential with an expected
22:17
depreciation of the currency that is
22:18
paying
22:20
a higher interest rate.
22:22
So, that's what in this model when I fix
22:24
the expected exchange rate, the only way
22:25
I can do that is by appreciating the
22:27
currency today so I can expect it to
22:29
depreciate in the future.
22:32
That's the logic.
22:33
Okay?
22:35
Now, how what is the connection with
22:37
what in Wall Street what they will tell
22:38
you is to say, "Well, before this may
22:40
happen not instantaneously. It happens
22:43
somewhat slowly. So, traders immediately
22:45
will go to the US dollar
22:48
bond because they see that they have a
22:50
higher return."
22:52
And it will be the case until the
22:53
currency really appreciates.
22:56
The Once the currency appreciates
22:57
enough, then that that advantage
22:59
disappear. That's what this condition is
23:01
doing. It's making the expected return
23:02
the same.
23:03
But, in the process of the exchange rate
23:05
going from the initial exchange rate to
23:07
to to the new
23:08
equilibrium exchange rate, there may be
23:10
an opportunity there. And that's when
23:11
you start seeing these flows. Okay?
23:14
That happens very very fast. But, that's
23:16
when you can see some of those flows.
23:24
I mean, in these markets that happens
23:25
very very quickly. So, what is typically
23:27
wrong is that then an analyst comes and
23:29
tells you explaining a story why the
23:30
exchange rate is going to continue to
23:31
appreciate, well, that's just way too
23:33
late. You're already in this
23:34
environment. You lost the trade.
23:36
Okay?
23:41
Okay.
23:42
What about an increase in the foreign
23:44
interest rate, I star?
23:47
So, an increase in the foreign interest
23:48
rate is Let's start from the same
23:50
situation we had before. We start from
23:51
interest rate equal to international
23:53
interest rate. Therefore, the exchange
23:55
rate is equal to expected exchange rate.
23:56
And now
23:58
the
23:59
foreign interest rate goes up.
24:01
Okay? What is going on now in the US?
24:03
The US is sort of stabilizing here and
24:05
and and Europe is beginning to hike a
24:08
little more than the US.
24:10
So,
24:12
we know from the equation that that
24:13
means the exchange rate will
24:16
fall. That is, will drop here. So, that
24:18
that means
24:19
the exchange rate is depreciating. The
24:21
dollar is depreciating.
24:23
Why is the dollar depreciating?
24:30
It's the same mechanism. Like
24:32
the exchange rate you previously said
24:34
was facing like ET with the interest
24:36
rate starting Yeah, that's correct.
24:39
I mean, the the issue here in terms of
24:41
the economics is that
24:43
remember, if we start from the same
24:44
interest rate and now
24:46
all the lines I'm giving you doesn't
24:48
need to start from the same interest
24:49
rate. It's just a lot simpler to start
24:50
from the
24:51
from the same interest. But, suppose we
24:53
start with the same interest rate and
24:54
now I increase this one,
24:56
then that means the foreign bond is
24:57
paying a higher interest rate than the
24:59
domestic bond. I need to equalize the
25:01
expected returns. The only way I can do
25:03
that is by having an expected
25:05
appreciation of the dollar.
25:08
Since the expected exchange rate we fix
25:09
it here, the only way I can give you an
25:11
expected appreciation of the dollar is
25:12
to by depreciating the dollar today.
25:16
Okay?
25:18
So, this is the same mechanism, the same
25:19
logic. It's symmetric.
25:21
That's That's the mechanism.
25:24
Now, is this true that in the very short
25:25
run
25:26
when when I star goes up and and I
25:29
doesn't move, then lots of people go and
25:31
buy foreign bonds and that produces sort
25:32
of, you know, demand for euros and blah
25:34
blah blah blah. But, that's very quick.
25:37
Machines do it for you now. So,
25:40
it happens very quickly.
25:43
So, this equation shows you what happens
25:45
after all that mess has already cleared.
25:47
Which happens in milliseconds now.
25:53
Okay.
25:56
What What if I change the expected
25:58
exchange rate? So, again, I'm fixing it,
26:00
but I can move it around. I'm treating
26:02
it as a parameter. When I say that I fix
26:04
it,
26:05
I just don't want to endogenize. I don't
26:07
want to make it another endogenous
26:08
variable.
26:10
So, what happens here if the exchange
26:11
rate we start with the same situation we
26:13
had before and now the expected exchange
26:14
rate goes up. Well, from the equation
26:16
it's very clear.
26:17
The current exchange rate immediately
26:19
rises.
26:21
One for one, in fact. Okay? If I have
26:23
the these two interest rates are the
26:24
same and now I move the expected
26:26
exchange rate up, then the current
26:28
exchange rate immediately jumps.
26:31
So, this If we expect the dollar to
26:33
appreciate in the future,
26:35
then it appreciates today.
26:37
Why is that?
26:40
Expectations are very powerful in
26:43
financial assets in general. This is the
26:44
first time you come but and we'll talk a
26:47
lot more about that in the
26:49
next week. But,
26:51
but you can see it here.
26:53
So, if I move the exchange rate today
26:55
up,
26:56
the expected exchange rate means we
26:58
expect the exchange rate to be, you
26:59
know, today the dollar is is 90 cents on
27:04
90 cents
27:05
0.9 euros per dollar.
27:07
Well, suppose I expect
27:09
1 euro per dollar in the next period.
27:12
What will happen to the exchange rate
27:13
today? Well, it jumps today to one.
27:16
Why is that?
27:24
The dollar will be more expensive to buy
27:26
there. So, people will
27:28
Okay, that's that's your friend the
27:30
trader there. Okay? But,
27:36
yes,
27:39
that's true.
27:42
That's true. What does that mean?
27:46
No.
27:48
It is true it's more expensive, but why
27:49
would Why did you want to buy it in to
27:51
start with? I mean, who cares that
27:53
something is more expensive if you are
27:54
not planning to buy it?
27:59
Um because the the current price is only
28:02
also taking into account future prices.
28:04
That's what the question says.
28:07
So, um because it gets part of its
28:09
cuz it it's value at the present moment
28:12
takes into account
28:13
some of its value in the future. I I You
28:15
know, whenever we we This is an
28:16
arbitrage type relationship. And what I
28:19
suggest is whenever you come across an
28:21
arbitrage type argument,
28:23
you ask the question, "Well, suppose
28:25
not."
28:27
Suppose this didn't happen.
28:29
What would then happen? What would look
28:31
odd?
28:32
Okay? That's Almost any arbitrage that's
28:34
a good way of thinking about this. It's
28:36
okay. The equation tells me that the
28:38
exchange rate has to jump right away.
28:40
Well, suppose not. What goes wrong?
28:44
That's I I think that's the way the
28:46
the easiest way to think about any of
28:48
these things, asset pricing in general,
28:49
by the way.
28:52
Well, suppose not. Suppose the expected
28:54
exchange rate goes up, the interest
28:55
rates haven't changed, and the exchange
28:57
rate today doesn't move. What happens
28:59
then?
29:00
Remember, we start in a situation with
29:02
both interest rates are the same.
29:05
Now, the expected exchange rate went up
29:07
by 10% say,
29:10
and uh
29:12
the current exchange rate hasn't moved.
29:16
I'm sure that between the two you can
29:17
design this trade.
29:19
What do you do?
29:25
Everyone will buy foreign bonds in like
29:27
the next period.
29:29
No one will in the first period.
29:33
Uh No, no, but what do you do today?
29:38
Suppose it's you're not a trader and and
29:40
then now you see, "Whoops, the exchange
29:43
the dollar will appreciate 10%, the
29:44
interest rates are the same, and the
29:46
exchange rate is not moving today, what
29:47
do you do?
29:58
Which bond do you buy?
30:05
Of course, because you have a 10%
30:07
expected capital gain from buying that
30:08
bond. If that doesn't happen, the both
30:10
the two bonds are paying the same
30:12
interest rate and now I tell you, well,
30:13
yeah, but one is going to appreciate by
30:15
10%.
30:16
Relative to the other, okay? So, clearly
30:19
that you go short massively the foreign
30:21
bond and you go very long the US bond.
30:23
That's what you do.
30:25
We all want to do the same, so happens
30:26
very quickly.
30:28
And the exchange is appreciated today
30:31
up to a point in which that that
30:33
incentive is no longer there.
30:35
And that in this particular case, if the
30:37
interest rate are the same, that will
30:38
happen only if the exchange rate today
30:40
jumps exactly by the same amount as
30:42
expected appreciation of the
30:44
expected value of the
30:46
dollar
30:47
changing the future. Okay?
30:50
Good.
30:51
Think about this. Play with these
30:52
things. I know it can be confusing, but
30:54
and I
30:55
always start with, let me move
30:57
something.
30:59
The equation tells me this is what it
31:00
has to happen to the exchange rate.
31:02
Well, suppose that didn't happen to the
31:03
exchange rate.
31:05
And then you say, oh, then I clearly
31:07
invest in this bond. This dominates the
31:08
other one. Well, that condition tells
31:10
you, no, no, in equilibrium, you have to
31:13
be indifferent. So, so the only thing
31:15
that can move is the exchange rate.
31:17
And the exchange has to move until you
31:18
are indifferent again.
31:20
After you have done some change to some
31:22
argument on the right hand side, okay?
31:24
That's the way you need to think about
31:26
this.
31:27
So,
31:29
I here I'm just plotting
31:33
uh this this relationship
31:35
in the space of exchange rate in the
31:37
x-axis and the domestic interest rate
31:40
here. Okay?
31:42
So, that's an upward sloping
31:44
relationship. You You can see here as I
31:45
move the interest rate up
31:47
or the other way around, but anyways, as
31:49
I move the interest rate up
31:51
the exchange rate is going up. So,
31:52
that's a positive relationship.
31:54
I can do it the other way around. As I
31:56
move the exchange rate up, then the
31:57
domestic interest rate has to go up. I'm
31:59
taking as parameters
32:01
the foreign interest rate
32:03
and and and the expected exchange rate.
32:05
So, if I take as parameter this and that
32:08
then I have a positive relationship
32:09
between the exchange rate
32:10
and the domestic interest rate, okay?
32:13
So, that's going to be the
32:14
I'm plotting the UIP uncovered interest
32:17
parity condition.
32:19
Notice this point here is interesting.
32:21
This point tells you that when the
32:23
domestic interest rate I is equal to the
32:26
international interest rate
32:28
then the exchange rate has to be equal
32:31
to the expected exchange rate, which is
32:33
the question I asked before.
32:35
Remember, I asked you a question, what
32:36
suppose that we start with an interest
32:38
rate
32:39
that is equal to the international
32:40
interest rate.
32:42
Uh uh
32:43
what the exchange rate what is the
32:45
exchange rate? And you said the answer
32:46
was, well, it has to be equal to the
32:48
expected exchange rate. That's that
32:50
point here.
32:52
Okay?
32:53
If the interest rate domestic interest
32:55
rate is above that
32:57
the international interest rate
32:59
then the exchange rate
33:01
today has to be above the expected
33:03
exchange rate because that will give you
33:05
expected depreciation of the currency,
33:07
which will compensate for the fact that
33:09
the domestic bond is paying a higher
33:11
interest rate than international bond.
33:13
Okay?
33:15
Conversely, if if the domestic bond is
33:17
paying a lower interest rate, then the
33:19
exchange rate today is very depreciated
33:21
because you have to expect it to
33:23
appreciate in order to compensate for
33:25
the interest rate differential.
33:27
Are we okay?
33:29
Probably not, but
33:32
this requires practice, I tell you.
33:34
Uh
33:40
Okay.
33:41
So, but now we have a
33:44
an equation for the exchange rate at
33:45
least.
33:46
So, I can go back to my I yes I I yes is
33:50
the IS equation in the open economy.
33:52
And now I have an equation for the
33:53
exchange rate, so I can replace it.
33:56
This is nice because I I'm I have two
33:58
new parameters, expected exchange rate
34:01
and international interest rate, but now
34:02
this is also function of the interest
34:04
rate. So, at this moment I have one
34:06
equation in two unknowns really after I
34:08
solve out for the exchange rate. I have
34:10
one equation and two unknowns. The two
34:11
unknowns are output and the domestic
34:13
interest rate.
34:15
All the rest are parameters.
34:17
So, that's the same situation we were at
34:19
in lecture three or so.
34:21
So, then we need an extra equation.
34:24
The extra equation was monetary policy,
34:27
the LM.
34:28
We're going to do exactly the same here.
34:31
Okay, the LM is the same. It's the
34:32
domestic central bank
34:34
sets the interest rate. So, now I'm set.
34:37
Now we have the IS-LM model in the open
34:40
economy. This is the Mundell-Fleming
34:42
model, okay? That's what the
34:43
Mundell-Fleming model is.
34:45
So,
34:47
just a more complicated IS
34:50
with a
34:52
UIP
34:55
uh uh um driven exchange rate
34:59
and then the LM is the same as in the
35:00
closed economy.
35:03
Okay?
35:05
So, this is the Mundell-Fleming model.
35:09
So, notice that that So, one thing we
35:12
know already, we knew from the previous
35:14
lecture that that we have a smaller
35:17
multiplier in the open economy because
35:18
we have the imports that are also
35:19
responding to output. We have a new
35:21
parameter.
35:22
But now we also know that
35:24
an increase in the interest rate, so
35:26
monetary policy in the open economy has
35:28
two effects now. It used to have only
35:30
this effect. Remember, it affected the
35:32
domestic investment. So, an increase in
35:33
the interest rate
35:35
would lead to
35:36
uh um
35:38
a reduction in aggregate demand because
35:40
investment would fall.
35:42
Remember, that's what was the role of
35:43
the interest rate.
35:44
That's the way monetary policy worked in
35:46
the closed economy. It was through this
35:48
channel here.
35:50
Now we have a second channel, which is
35:51
this one.
35:54
So, when the interest rate goes up
35:57
it's contractionary for two reasons.
35:58
One, for the reason we had before, which
36:00
is that investment falls. But there is a
36:02
second reason it's contractionary.
36:06
What is that second reason?
36:18
I mean, it's only here. It's only second
36:21
Yeah.
36:23
It's because it appreciates the exchange
36:24
rate. And when you appreciate the
36:25
exchange rate, net exports decline.
36:27
Okay? So, more of the domestic
36:28
consumption is diverted to foreign goods
36:31
and less of foreign demand is is
36:34
allocated to our exports, okay? So,
36:37
that's the second channel. So, in an
36:38
open economy and the smaller is the
36:40
economy, the more important is this
36:41
term, the more powerful is that channel.
36:45
Okay?
36:53
The US cares very little about this
36:54
effect.
36:56
Most of the economies care a lot about
36:58
this effect, okay?
37:01
Because the US is a relatively closed
37:03
economy, believe it or not.
37:05
So,
37:06
this is sort of the start diagram of the
37:08
Mundell-Fleming model.
37:11
So, this thing here is our old IS-LM
37:14
model.
37:15
It's just that this IS is a little
37:17
thicker now. It has net exports in there
37:19
and so on, but it looks exactly the
37:20
same. That is
37:22
plots equilibrium in financial and and
37:24
and and the goods market
37:27
the combinations of output and domestic
37:29
interest rate that are consistent with
37:31
equilibrium
37:32
in in both markets. That's the case
37:34
here, okay?
37:36
This is the IS, which is all the
37:37
combinations of
37:39
domestic output and domestic interest
37:40
rate that are consistent with
37:41
equilibrium in goods market.
37:44
This is the interest rate that is
37:45
consistent with equilibrium in financial
37:46
markets. That's what the Fed does in the
37:48
US.
37:49
Uh that point is where both markets are
37:53
in equilibrium.
37:54
But we can take this interest rate. So,
37:55
that's what will happen. The interest
37:57
rate will be there in the US. The
37:58
interest rate is set by the Fed, not by
38:00
the ECB. The Fed will set the interest
38:02
rate.
38:03
That will give us some equilibrium
38:04
output.
38:06
And then we can go to the UIP condition,
38:08
you see I'm plotting here, and figure
38:10
out what the exchange rate is.
38:13
Because for this interest rate here
38:15
there's going to be some point in the
38:16
UIP
38:17
and that tells you exactly what the
38:19
exchange rate is.
38:21
Okay?
38:22
So, it with this set of diagrams I can
38:25
determine the interest rate, output, and
38:26
exchange rate.
38:31
So, I can study the effects of different
38:32
policies, for example, on output, the
38:35
interest rate, of course
38:37
that's the policy itself, and exchange
38:39
rate. So, this is the the new thing I
38:41
can explain. I can do a little bit of
38:42
asset pricing here. I can explain
38:45
the
38:46
the the behavior of the exchange rate as
38:48
well.
38:49
Okay?
38:52
So, this diagram, I mean, you need to
38:53
really control very very well.
38:55
So, that's what I'm going to play with
38:56
it
38:57
quite a bit.
39:00
Monetary policy. Let's do monetary
39:01
policy. We talked about monetary policy
39:03
already.
39:04
So, suppose that for whatever reason uh
39:06
the domestic economy
39:08
the domestic central bank
39:11
uh decides to hike interest rate.
39:13
Suppose the economy was overheating,
39:15
output was too high relative to natural
39:17
rate of output,
39:18
the typical reasons why you need to
39:19
raise interest rate.
39:21
And so, suppose that the domestic
39:22
interest rate goes up.
39:24
Well, as it used to be, that's going to
39:26
be contractionary.
39:28
What happens to the exchange rate?
39:31
Well,
39:32
I know the interest rate went up.
39:35
I go I look into my UIP for the higher
39:38
interest rate and in a current exchange
39:40
rate that is above
39:42
the old they has to go up relative to
39:44
all of them. When they When they
39:46
increase interest rate from here to
39:47
there, then my exchange rate has to
39:49
appreciate.
39:50
Why is that?
39:52
So,
39:53
an expansionary domestic monetary policy
39:56
will lead to a contraction in output,
39:58
which is what we get out of
40:01
uh
40:02
monetary policy, but it will also lead
40:05
to an appreciation of the currency. Why
40:07
is that?
40:13
That's what we just discussed. It's UIP.
40:15
If If I move the domestic interest rate
40:18
and the rest and the rest of world does
40:20
not follow me, so we move interest rate,
40:22
they don't,
40:23
then now I need to compensate for this
40:25
increase in the interest rate
40:26
differential and the compensation will
40:28
come through an expected capital loss at
40:31
through the currency.
40:32
So, if I appreciate more the currencies
40:34
and since I haven't moved the expected
40:35
exchange rate, I expect a larger loss
40:38
from the point of from the country's
40:40
from the currency side. Okay?
40:43
That's what it what has happened here.
40:45
So, that's what is behind depreciation.
40:47
And of course, the depreciation is
40:48
already built in here,
40:50
which is what uh
40:53
you know,
40:55
makes monetary policy more powerful than
40:57
the closed economy. Okay? Because you
40:59
get the net export channel, but that's
41:00
built in here.
41:04
Um
41:06
Okay, here all that I did is exactly the
41:08
same as we were doing in the last 30
41:10
minutes. I just used this this UIP. For
41:13
whatever domestic reason, I need to
41:15
raise interest rate,
41:17
uh
41:18
you know, I have contractionary monetary
41:19
policy. Well, one of the effects that
41:21
you're going to get in an open economy
41:23
is that your currency will tend to
41:24
appreciate.
41:25
Okay? Good.
41:31
What about fiscal policy?
41:35
Well,
41:36
if the Fed doesn't follow, if the
41:37
central bank doesn't follow,
41:39
and you had an expansionary fiscal
41:41
policy,
41:42
then
41:43
uh that will increase output.
41:47
It has no effect on the interest rate,
41:49
therefore has absolutely no effect on
41:51
the exchange rate. So, an expansionary
41:52
fiscal policy, which is accommodated by
41:55
the Fed, that means the interest rate is
41:57
kept at the same level,
41:58
then does not lead to an appreciation of
42:00
the currency. It doesn't move the
42:01
exchange rate. It has no implication for
42:02
the exchange rate.
42:04
Okay?
42:08
Now, what about this change in output?
42:10
Is it larger or smaller than the one we
42:12
did in lecture three or four?
42:18
It's smaller. Why? Uh because part of my
42:20
increase in
42:21
like uh demand falls on the foreign
42:23
Exactly, because yeah, it goes to
42:25
import. Perfect.
42:26
Okay, good. So, this is a smaller than
42:28
it was in the closed economy and it had
42:29
but it has no impact
42:31
on uh the exchange rate.
42:35
That is, the UIP has nothing to do
42:37
with going on expenditure. It's all
42:40
about financial markets. It's about
42:42
expected returns, things like that. So,
42:44
unless the fiscal policy somehow affects
42:48
interest rate,
42:49
uh
42:50
then there's no effect. What may happen
42:53
is that, for example, is that that, you
42:55
know, Treasury becomes very expansionary
42:58
and this output becomes too large for
43:00
what is consistent with a
43:02
a zero output gap or no inflation, and
43:06
then the Fed may react and raise
43:08
interest rate, and that will lead to an
43:10
appreciation of the exchange rate and so
43:11
on. And that's the reason why in
43:12
practice,
43:14
when countries have sort of expansionary
43:16
fiscal packages, they the currency tends
43:18
to appreciate. It's because
43:20
investors expect the Fed to react to
43:23
that or the central bank to react to
43:25
that and raise interest rate. But if the
43:27
Fed says, "No, no, we needed that fiscal
43:28
expansion. I'm not going to move the
43:30
interest rate," then the exchange rate
43:31
won't move.
43:39
So, let's look at Let's use a little
43:41
more this model and and look at other
43:43
shocks within this model.
43:47
So,
43:48
let's start with Suppose that that uh
43:51
we increase the expected exchange rate.
43:53
What moves?
43:59
In this diagram.
44:04
Let's go cur- cur- Does the LM move?
44:16
No. The LM is controlled by the domestic
44:18
central bank, doesn't move.
44:20
Does the IS move?
44:25
When When I ask you whether it moves,
44:27
you you should always fix something. So,
44:29
you say, "Okay, let me fix the interest
44:30
rate." Say, pick the point like this
44:33
one, say.
44:34
And now I have to ask the question,
44:36
"What happens to output now that I have
44:38
moved the expected exchange rate?" If I
44:39
get the same output back, means the IS
44:41
hasn't moved. If I get a different
44:43
output equilibrium output, then I can
44:45
tell you that the IS did move.
44:48
So, what is the answer?
44:54
If the interest rate doesn't move, the
44:55
foreign interest doesn't move, and
44:57
expected exchange rate goes up, what
44:59
happens to the current exchange rate?
45:02
Appreciates.
45:04
What happens when when there's an
45:05
appreciation?
45:07
Net exports decline.
45:09
That means that moves the IS to the
45:10
left. Okay? So, so so this movement will
45:14
move the IS to the left as a first
45:16
effect.
45:18
What about the UIP condition? Will it
45:20
move or not? We have taken that as a
45:22
parameter.
45:23
Will it move?
45:26
I mean, remember, I gave you a clue
45:28
because I said we are taking these two
45:30
as parameters here.
45:32
So, if I move a parameter, most likely I
45:34
will move the curve.
45:36
Okay?
45:38
But in which direction will it move?
45:46
To the right. Yes, because for the same
45:49
interest rate,
45:51
now I need the exchange rate to move one
45:53
for one, the current exchange rate to
45:54
move one for one with the expected
45:56
exchange rate, you know?
45:58
So, this was the exchange rate before,
46:01
and now the expected exchange rate moved
46:02
to the right. Well, in order not to
46:04
generate expected capital gain or loss,
46:06
I have to move the current exchange rate
46:08
by the same amount. And so, that means
46:10
this curve will shift to the right.
46:13
Okay? What if I move foreign output?
46:17
Down.
46:18
What happens?
46:20
Which curve moves? Well, this is not a
46:23
parameter here, so this is not moving.
46:27
This is not a parameter here, so this
46:29
one is not moving.
46:30
Only one can move. The IS. Where?
46:34
It will move to the left because net
46:36
exports will decline.
46:38
Now, for any given level of the interest
46:39
rate, now we're going to have less net
46:41
exports and therefore the IS moves to
46:43
the left. So, output falls. But there's
46:45
no movement here.
46:47
Unless the Fed reacts to that,
46:49
the central bank reacts to that, it
46:51
won't happen.
46:53
Okay?
47:00
I mean, and and and it may well be the
47:01
case that you want to react to that. If
47:03
If the whole world goes into recession,
47:06
the US is very likely to lower interest
47:08
rates because, you know,
47:11
it's
47:11
it's very contractionary if the whole
47:13
world goes into recession.
47:15
When the US goes into recession, the
47:17
rest of the world everyone wants to cut
47:19
interest rates because the US is a big
47:21
player. So, so it really drags everyone
47:23
down.
47:24
Okay?
47:28
Good.
47:30
The last one and I'm I'm going to repeat
47:32
this in the next lecture is, well, what
47:34
happens if the if I a star moves up? The
47:37
foreign interest rate moves up.
47:39
Well, the LM doesn't move.
47:42
This one will move.
47:44
Which way?
47:45
Because that was a parameter here.
47:51
To the right?
47:54
You said to the right, that's right.
47:58
Okay. No.
47:59
So, so
48:02
Think what happened here. If the foreign
48:04
interest rate goes up,
48:05
at any given interest rate, now the
48:09
domestic bond is worse than otherwise.
48:12
So, I need to depreciate the exchange
48:14
rate
48:15
today
48:16
in order to
48:18
expect an appreciation.
48:21
Okay?
48:22
That means this curve moves to the left.
48:27
Okay?
48:30
Okay, it moves to the left because I
48:31
have to expect an appreciation
48:33
to compensate for the interest rate
48:34
differential.
48:37
So, this will move to the left.
48:38
What about this curve here?
48:43
We solve it in the next lecture.
48:49
Good.
— end of transcript —
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