1 00:00:17,199 --> 00:00:21,439 Let's say let's start with the 2 00:00:19,800 --> 00:00:23,199 Mundell-Fleming model. Now this is a 3 00:00:21,440 --> 00:00:26,640 model that that 4 00:00:23,199 --> 00:00:28,239 I think it's extremely useful. 5 00:00:26,640 --> 00:00:29,800 And 6 00:00:28,239 --> 00:00:32,320 in the short term it will be important 7 00:00:29,800 --> 00:00:35,000 for you because it probably 70% of the 8 00:00:32,320 --> 00:00:36,880 quiz will be related to things that 9 00:00:35,000 --> 00:00:38,159 to this model. Meaning, you know, we're 10 00:00:36,880 --> 00:00:39,120 going to use this model for different 11 00:00:38,159 --> 00:00:42,519 things. 12 00:00:39,119 --> 00:00:45,199 But but but if you understand it well, 13 00:00:42,520 --> 00:00:46,800 you probably have 70% of the last quiz 14 00:00:45,200 --> 00:00:48,560 under control. 15 00:00:46,799 --> 00:00:50,359 So I'm going to go very slowly over it 16 00:00:48,560 --> 00:00:53,000 and please stop me if there's any step 17 00:00:50,359 --> 00:00:54,799 you don't understand. I I put the steps 18 00:00:53,000 --> 00:00:56,399 into myself so I don't 19 00:00:54,799 --> 00:00:57,839 rush because again I think it's 20 00:00:56,399 --> 00:00:59,159 important. 21 00:00:57,840 --> 00:01:00,640 Um 22 00:00:59,159 --> 00:01:03,679 to understand things. 23 00:01:00,640 --> 00:01:05,439 So here you have the exchange rate, two 24 00:01:03,679 --> 00:01:08,719 exchange rates. 25 00:01:05,439 --> 00:01:10,679 The the wide one is the 26 00:01:08,719 --> 00:01:12,519 the the 27 00:01:10,680 --> 00:01:14,440 the euro-dollar 28 00:01:12,519 --> 00:01:16,439 exchange rate. 29 00:01:14,439 --> 00:01:18,000 I'm quoting it the opposite of the way 30 00:01:16,439 --> 00:01:20,560 it's normally quoted. There are some 31 00:01:18,000 --> 00:01:22,840 conventions in effects markets but this 32 00:01:20,560 --> 00:01:24,600 is as we have defined in this course is 33 00:01:22,840 --> 00:01:26,280 if it goes up it means an appreciation 34 00:01:24,599 --> 00:01:27,919 of the local currency. 35 00:01:26,280 --> 00:01:30,560 That is the dollar. 36 00:01:27,920 --> 00:01:32,480 That is you get more of the foreign 37 00:01:30,560 --> 00:01:34,400 currency per unit of the domestic 38 00:01:32,480 --> 00:01:36,600 currency when it goes up. 39 00:01:34,400 --> 00:01:39,200 And down is a depreciation. 40 00:01:36,599 --> 00:01:41,280 And you see there that the so this is 41 00:01:39,200 --> 00:01:41,840 the the dollar became 42 00:01:41,280 --> 00:01:43,680 uh 43 00:01:41,840 --> 00:01:45,640 gained value relative to the euro 44 00:01:43,680 --> 00:01:48,720 through all this period and then it has 45 00:01:45,640 --> 00:01:51,159 lost quite a bit of value uh since sort 46 00:01:48,719 --> 00:01:53,120 of late 2022. 47 00:01:51,159 --> 00:01:55,519 For for with respect to the Japanese 48 00:01:53,120 --> 00:01:57,680 yen, that's the blue line, it's was the 49 00:01:55,519 --> 00:01:59,879 whole cycle is even more dramatic, no? 50 00:01:57,680 --> 00:02:02,080 Big appreciation of the dollar. 51 00:01:59,879 --> 00:02:05,399 Depreciation of the yen. 52 00:02:02,079 --> 00:02:06,120 Uh and and a reversal 53 00:02:05,400 --> 00:02:09,520 uh 54 00:02:06,120 --> 00:02:12,159 since late 2022 and so on. 55 00:02:09,520 --> 00:02:13,680 So what is behind this this big 56 00:02:12,159 --> 00:02:15,840 fluctuations? 57 00:02:13,680 --> 00:02:18,159 Many things. Effects are volatile like 58 00:02:15,840 --> 00:02:20,560 almost any asset price. But one of the 59 00:02:18,159 --> 00:02:23,039 main drivers of this uh 60 00:02:20,560 --> 00:02:24,960 of of of these fluctuations is 61 00:02:23,039 --> 00:02:26,599 perceptions about interest rate policy 62 00:02:24,960 --> 00:02:27,520 in the different parts of the world. 63 00:02:26,599 --> 00:02:28,639 Okay? 64 00:02:27,520 --> 00:02:31,360 So 65 00:02:28,639 --> 00:02:33,039 uh the reason we have seen a lot of this 66 00:02:31,360 --> 00:02:35,240 decline here. 67 00:02:33,039 --> 00:02:37,959 So the reason for the rise here of the 68 00:02:35,240 --> 00:02:39,760 dollar is mostly because 69 00:02:37,960 --> 00:02:42,080 investors in general perceived that the 70 00:02:39,759 --> 00:02:43,959 US was more advanced in its business 71 00:02:42,080 --> 00:02:45,960 cycle. It began to tighten interest rate 72 00:02:43,960 --> 00:02:48,240 before the rest of the world. 73 00:02:45,960 --> 00:02:50,599 And since interest rates were rising in 74 00:02:48,240 --> 00:02:51,800 in the US, that led to an appreciation 75 00:02:50,599 --> 00:02:54,560 of the dollar. 76 00:02:51,800 --> 00:02:56,640 By a mechanism they described at the end 77 00:02:54,560 --> 00:02:58,560 of the previous lecture but I'm going to 78 00:02:56,639 --> 00:02:59,959 repeat today. Remember when I talked 79 00:02:58,560 --> 00:03:01,680 about the uncovered interest rate parity 80 00:02:59,960 --> 00:03:03,360 condition? Well, it's related to what 81 00:03:01,680 --> 00:03:05,159 I'm talking about here. 82 00:03:03,360 --> 00:03:07,840 I'm going to again go go again over 83 00:03:05,159 --> 00:03:11,199 that. And a big reason for the decline 84 00:03:07,840 --> 00:03:13,200 more recently is simply that there's a 85 00:03:11,199 --> 00:03:15,479 sense that monetary policy is peaking in 86 00:03:13,199 --> 00:03:18,719 the US in terms of tightness while the 87 00:03:15,479 --> 00:03:20,679 rest of the world is catching up. Uh and 88 00:03:18,719 --> 00:03:22,759 and in the case of Europe more than 89 00:03:20,680 --> 00:03:24,719 catching up because they have further 90 00:03:22,759 --> 00:03:26,000 supply shocks coming from energy shocks 91 00:03:24,719 --> 00:03:27,879 and so on. 92 00:03:26,000 --> 00:03:30,919 So if you look for example at the 93 00:03:27,879 --> 00:03:32,079 expected in policy rate path in the case 94 00:03:30,919 --> 00:03:33,280 of the US 95 00:03:32,080 --> 00:03:35,600 nowadays 96 00:03:33,280 --> 00:03:38,439 it looks like this. So the still market 97 00:03:35,599 --> 00:03:40,479 expect some hike some hikes in the US 98 00:03:38,439 --> 00:03:42,599 but a limited amount of hikes and then 99 00:03:40,479 --> 00:03:44,439 they expect quickly the Fed to start 100 00:03:42,599 --> 00:03:46,680 undoing that. Okay? That's what this 101 00:03:44,439 --> 00:03:49,000 path is telling you. This is expected 102 00:03:46,680 --> 00:03:51,360 policy rate path. What the market thinks 103 00:03:49,000 --> 00:03:53,039 now the policy rate will be in the next 104 00:03:51,360 --> 00:03:54,600 meeting, two meetings from now, three 105 00:03:53,039 --> 00:03:56,560 meetings from now, four meetings 106 00:03:54,599 --> 00:03:57,359 meetings of the FOMC 107 00:03:56,560 --> 00:03:59,199 uh 108 00:03:57,360 --> 00:04:00,840 from now. Okay? Well, if you look at the 109 00:03:59,199 --> 00:04:02,399 same picture in Europe, it looks like 110 00:04:00,840 --> 00:04:04,920 that. It's clear that they are they are 111 00:04:02,400 --> 00:04:07,120 still there is more ahead. 112 00:04:04,919 --> 00:04:09,759 And and then you see sort of that that's 113 00:04:07,120 --> 00:04:11,640 what the market perceive at this point. 114 00:04:09,759 --> 00:04:13,239 Whether that ends up being true or not 115 00:04:11,639 --> 00:04:14,399 doesn't matter. At any point in time the 116 00:04:13,240 --> 00:04:17,079 exchange rate is determined by what the 117 00:04:14,400 --> 00:04:19,480 markets think. So so what actually 118 00:04:17,079 --> 00:04:21,840 happens is less important for an asset 119 00:04:19,480 --> 00:04:23,640 price. An asset price is a lot about 120 00:04:21,839 --> 00:04:25,719 pricing today is things that you expect 121 00:04:23,639 --> 00:04:27,439 to happen in the future. Uh what it 122 00:04:25,720 --> 00:04:28,760 expects what you expect is what matters, 123 00:04:27,439 --> 00:04:32,480 not what actually happens. And at this 124 00:04:28,759 --> 00:04:34,599 moment the market expect uh 125 00:04:32,480 --> 00:04:36,319 the euro area to go through a 126 00:04:34,600 --> 00:04:38,560 sort of a more prolonged periods of 127 00:04:36,319 --> 00:04:40,439 hiking interest rate hiking. 128 00:04:38,560 --> 00:04:43,079 Japan hasn't had hikes in interest rate 129 00:04:40,439 --> 00:04:45,439 for three three decades but even now you 130 00:04:43,079 --> 00:04:46,560 start you begin to see some 131 00:04:45,439 --> 00:04:48,160 you know, 132 00:04:46,560 --> 00:04:50,839 the scale here is very small. These are 133 00:04:48,160 --> 00:04:52,960 a few basis points. But even the point 134 00:04:50,839 --> 00:04:53,799 I'm trying to make is that certainly 135 00:04:52,959 --> 00:04:55,680 that 136 00:04:53,800 --> 00:04:57,920 people expect interest rates in the US 137 00:04:55,680 --> 00:04:59,000 to go down relative to interest rates in 138 00:04:57,920 --> 00:05:00,720 Japan. 139 00:04:59,000 --> 00:05:02,279 Not to say that the interest rate in the 140 00:05:00,720 --> 00:05:04,320 US will be lower than the interest rate 141 00:05:02,279 --> 00:05:05,759 in Japan but the direction of the change 142 00:05:04,319 --> 00:05:07,279 is in that way. So relative to where 143 00:05:05,759 --> 00:05:10,759 we're at now 144 00:05:07,279 --> 00:05:14,039 the direction of the change is is is is 145 00:05:10,759 --> 00:05:16,399 towards the US loosening monetary policy 146 00:05:14,040 --> 00:05:18,520 uh before the rest of the world does. 147 00:05:16,399 --> 00:05:21,319 Okay? And and that's what is leading to 148 00:05:18,519 --> 00:05:21,319 these big swings. 149 00:05:21,439 --> 00:05:24,719 As I said before you know, this is the 150 00:05:23,160 --> 00:05:27,000 period in which the US had to start 151 00:05:24,720 --> 00:05:29,200 tightening before the rest and and the 152 00:05:27,000 --> 00:05:30,800 currency appreciated a lot especially 153 00:05:29,199 --> 00:05:32,479 with respect to the yen because again 154 00:05:30,800 --> 00:05:34,720 the yen has been against the zero lower 155 00:05:32,480 --> 00:05:36,560 bound for a very long time. So nobody 156 00:05:34,720 --> 00:05:37,680 expected the yen to move to follow the 157 00:05:36,560 --> 00:05:39,399 US. 158 00:05:37,680 --> 00:05:40,879 And and and while with respect to 159 00:05:39,399 --> 00:05:42,919 Europe, well Europe was having 160 00:05:40,879 --> 00:05:44,879 inflationary problems and so on as well. 161 00:05:42,920 --> 00:05:47,160 So people expected it to follow the US 162 00:05:44,879 --> 00:05:48,639 at some point. For Japan, there was 163 00:05:47,160 --> 00:05:51,160 nothing like that and that's what led to 164 00:05:48,639 --> 00:05:53,079 the massive depreciation of the yen. 165 00:05:51,160 --> 00:05:54,120 Appreciation of the US dollar vis-a-vis 166 00:05:53,079 --> 00:05:54,919 the yen. 167 00:05:54,120 --> 00:05:57,560 Okay? 168 00:05:54,920 --> 00:06:00,600 So what we the Mundell-Fleming model is 169 00:05:57,560 --> 00:06:01,759 about is about first connecting these 170 00:06:00,600 --> 00:06:03,360 things, trying to understand what moves 171 00:06:01,759 --> 00:06:05,159 exchange rate, how different monetary 172 00:06:03,360 --> 00:06:06,800 policies in different places or 173 00:06:05,160 --> 00:06:09,439 different policies in different places 174 00:06:06,800 --> 00:06:11,759 of the world affect exchange rate. And 175 00:06:09,439 --> 00:06:13,719 then it's about understanding how those 176 00:06:11,759 --> 00:06:15,560 exchange rate movements affect real 177 00:06:13,720 --> 00:06:16,960 activity. Okay? 178 00:06:15,560 --> 00:06:18,720 In the short run. 179 00:06:16,959 --> 00:06:20,879 That's what the Mundell-Fleming model 180 00:06:18,720 --> 00:06:24,280 is. So it is really we're going to go 181 00:06:20,879 --> 00:06:25,759 back to our old IS-LM model. Very short 182 00:06:24,279 --> 00:06:28,000 run. We're going to even fix nominal 183 00:06:25,759 --> 00:06:29,680 prices and so on. So back to that 184 00:06:28,000 --> 00:06:31,160 environment. But we're going to do it in 185 00:06:29,680 --> 00:06:33,000 an open economy so we're going to have a 186 00:06:31,160 --> 00:06:35,160 new variable floating around which is 187 00:06:33,000 --> 00:06:36,160 the exchange rate. And and and we need 188 00:06:35,160 --> 00:06:37,720 to understand how the exchange rate 189 00:06:36,160 --> 00:06:40,400 moves when you different things happen 190 00:06:37,720 --> 00:06:42,520 in different countries. And the and and 191 00:06:40,399 --> 00:06:44,799 what is the impact of that on aggregate 192 00:06:42,519 --> 00:06:46,919 demand and hence in on output. We're 193 00:06:44,800 --> 00:06:48,560 talking about the very short run 194 00:06:46,920 --> 00:06:50,280 in the different parts of the world. 195 00:06:48,560 --> 00:06:52,160 Okay? That's the plan. That's what we 196 00:06:50,279 --> 00:06:53,279 intend to 197 00:06:52,160 --> 00:06:56,320 So let's start with the this 198 00:06:53,279 --> 00:06:57,839 Mundell-Fleming model. Remember we we 199 00:06:56,319 --> 00:07:00,319 wrote down 200 00:06:57,839 --> 00:07:02,599 uh the equilibrium in the goods market 201 00:07:00,319 --> 00:07:04,639 in the previous lecture and and and 202 00:07:02,600 --> 00:07:06,360 that's that's I'm just reproducing what 203 00:07:04,639 --> 00:07:08,039 I wrote in the previous lecture. So it 204 00:07:06,360 --> 00:07:09,600 looks exactly like the closed economy. 205 00:07:08,040 --> 00:07:11,600 Output is determined by aggregate 206 00:07:09,600 --> 00:07:13,400 demand. But it's aggregate demand for 207 00:07:11,600 --> 00:07:15,879 domestically produced goods. 208 00:07:13,399 --> 00:07:18,439 Domestically produced goods is now the 209 00:07:15,879 --> 00:07:20,759 is not the same as domestic demand 210 00:07:18,439 --> 00:07:22,639 for goods which is this. Because now 211 00:07:20,759 --> 00:07:25,319 there's a net export term. So part of 212 00:07:22,639 --> 00:07:27,759 the things that the that 213 00:07:25,319 --> 00:07:29,159 residents sort of demand they they 214 00:07:27,759 --> 00:07:30,680 demand from the rest of the world, not 215 00:07:29,160 --> 00:07:32,439 from domestic producers. 216 00:07:30,680 --> 00:07:34,040 And at the same time part of the demand 217 00:07:32,439 --> 00:07:35,199 perceived by domestic producers comes 218 00:07:34,040 --> 00:07:37,520 from the rest of the world, from 219 00:07:35,199 --> 00:07:38,879 exports, not from domestic producers. So 220 00:07:37,519 --> 00:07:41,719 that's the reason we got an extra term 221 00:07:38,879 --> 00:07:43,000 here which is this net exports. 222 00:07:41,720 --> 00:07:44,840 And we said this net exports is a 223 00:07:43,000 --> 00:07:47,079 function of three things. 224 00:07:44,839 --> 00:07:49,519 It's a function of output. 225 00:07:47,079 --> 00:07:51,279 Okay? 226 00:07:49,519 --> 00:07:53,479 And it's a it's a decreasing function of 227 00:07:51,279 --> 00:07:56,599 output. Why is that? 228 00:07:53,480 --> 00:07:56,600 Of domestic output. 229 00:07:57,439 --> 00:08:01,600 Domestic output, domestic income. Why 230 00:08:00,199 --> 00:08:04,479 isn't that decreasing function of 231 00:08:01,600 --> 00:08:04,480 domestic income? 232 00:08:08,439 --> 00:08:13,439 Why do net exports decline when domestic 233 00:08:10,639 --> 00:08:13,439 income rises? 234 00:08:17,480 --> 00:08:20,680 They buy they import more. They consume 235 00:08:19,000 --> 00:08:21,639 everything more but part of that is 236 00:08:20,680 --> 00:08:23,879 imports. 237 00:08:21,639 --> 00:08:26,000 And so part of that energy of the extra 238 00:08:23,879 --> 00:08:28,560 demand goes to foreign goods and that's 239 00:08:26,000 --> 00:08:30,240 what deteriorates net exports. Okay? And 240 00:08:28,560 --> 00:08:32,158 that's the reason we said had Had we 241 00:08:30,240 --> 00:08:34,399 just stopped there, made the net export 242 00:08:32,158 --> 00:08:36,519 function just a function of output, we 243 00:08:34,399 --> 00:08:38,199 would have not needed all this extra 244 00:08:36,519 --> 00:08:39,799 apparatus that I'm about to build 245 00:08:38,200 --> 00:08:42,400 because all that would have meant is 246 00:08:39,799 --> 00:08:43,679 that just we have a smaller multiplier. 247 00:08:42,399 --> 00:08:45,720 It would have been exactly the same as 248 00:08:43,679 --> 00:08:47,639 we did in the closed economy but with a 249 00:08:45,720 --> 00:08:49,279 smaller multiplier because you know, 250 00:08:47,639 --> 00:08:51,559 every time an output goes up now part of 251 00:08:49,279 --> 00:08:54,159 that demand goes to foreign goods rather 252 00:08:51,559 --> 00:08:56,839 than domestic goods. 253 00:08:54,159 --> 00:08:59,159 But it's not so. 254 00:08:56,840 --> 00:09:00,720 First because we have an extra another 255 00:08:59,159 --> 00:09:03,360 income that matters here which is the 256 00:09:00,720 --> 00:09:05,480 income of the rest of the world. 257 00:09:03,360 --> 00:09:06,720 Uh but more important because we also 258 00:09:05,480 --> 00:09:09,080 have an exchange rate. But let's start 259 00:09:06,720 --> 00:09:10,680 from this side. So net exports is 260 00:09:09,080 --> 00:09:13,639 increasing in the income of the rest of 261 00:09:10,679 --> 00:09:13,639 the world. Why is that? 262 00:09:15,240 --> 00:09:22,039 That is demand for domestically produced 263 00:09:17,080 --> 00:09:23,720 good rises when foreign income goes up. 264 00:09:22,039 --> 00:09:26,360 Foreign output foreign income goes up. 265 00:09:23,720 --> 00:09:26,360 Why is that? 266 00:09:29,360 --> 00:09:34,480 It's a symmetric argument, no? 267 00:09:31,320 --> 00:09:36,520 If with with imports, well 268 00:09:34,480 --> 00:09:39,039 our exports are the imports of the other 269 00:09:36,519 --> 00:09:42,360 country. So if the income in the other 270 00:09:39,039 --> 00:09:44,959 country goes up then their their imports 271 00:09:42,360 --> 00:09:47,800 will go up which is our exports that go 272 00:09:44,960 --> 00:09:49,840 up. That's the reason net exports uh 273 00:09:47,799 --> 00:09:51,479 goes up. 274 00:09:49,840 --> 00:09:52,879 And the last term 275 00:09:51,480 --> 00:09:56,240 remember 276 00:09:52,879 --> 00:09:57,759 uh is that says that net exports is 277 00:09:56,240 --> 00:09:59,960 declining 278 00:09:57,759 --> 00:10:02,679 on the real exchange rate. 279 00:09:59,960 --> 00:10:02,680 Why is that? 280 00:10:05,039 --> 00:10:07,959 What happens when the real exchange rate 281 00:10:06,279 --> 00:10:08,879 goes up? 282 00:10:07,960 --> 00:10:10,400 Net exports are going to be more 283 00:10:08,879 --> 00:10:12,120 expensive relative to foreign goods. 284 00:10:10,399 --> 00:10:13,759 Exactly. Our goods become more expensive 285 00:10:12,120 --> 00:10:15,759 relative to foreign goods and that 286 00:10:13,759 --> 00:10:17,919 affects us from two dimensions. First, 287 00:10:15,759 --> 00:10:20,439 our exports will tend to decline because 288 00:10:17,919 --> 00:10:21,799 our goods are more expensive and also 289 00:10:20,440 --> 00:10:23,160 our imports are going to tend to 290 00:10:21,799 --> 00:10:25,879 increase because foreign goods are 291 00:10:23,159 --> 00:10:27,399 cheaper. Okay? And so that's the reason 292 00:10:25,879 --> 00:10:28,799 this 293 00:10:27,399 --> 00:10:30,360 is decreasing with respect to the 294 00:10:28,799 --> 00:10:31,919 exchange rate. 295 00:10:30,360 --> 00:10:33,600 The big thing of the Mundell-Fleming 296 00:10:31,919 --> 00:10:36,000 model really comes from the fact that 297 00:10:33,600 --> 00:10:37,519 this guy is there. We Had we not had the 298 00:10:36,000 --> 00:10:39,080 exchange rate there, again we could have 299 00:10:37,519 --> 00:10:40,039 used exactly the same apparatus as we 300 00:10:39,080 --> 00:10:41,240 used 301 00:10:40,039 --> 00:10:42,319 earlier on. 302 00:10:41,240 --> 00:10:44,919 But we're going to have an exchange rate 303 00:10:42,320 --> 00:10:47,160 floating around and that will require us 304 00:10:44,919 --> 00:10:48,719 that to to build more 305 00:10:47,159 --> 00:10:50,639 a little more. We need an extra 306 00:10:48,720 --> 00:10:52,320 equation, you know, because we have an 307 00:10:50,639 --> 00:10:54,720 extra endogenous variable. 308 00:10:52,320 --> 00:10:56,680 Now, what I'm going to assume here 309 00:10:54,720 --> 00:10:59,000 as we did in in in the first part of the 310 00:10:56,679 --> 00:11:00,679 course is that both the domestic and 311 00:10:59,000 --> 00:11:02,039 foreign prices are completely fixed. So, 312 00:11:00,679 --> 00:11:03,838 I'm going to ignore Phillips curve, 313 00:11:02,039 --> 00:11:05,439 inflation, expected inflation and all 314 00:11:03,839 --> 00:11:08,280 that. Okay? I'm going to assume all that 315 00:11:05,440 --> 00:11:09,440 is zero. Expected inflation, inflation, 316 00:11:08,279 --> 00:11:11,079 zero. 317 00:11:09,440 --> 00:11:12,839 When I do that, 318 00:11:11,080 --> 00:11:14,600 the same equation, the equilibrium in 319 00:11:12,839 --> 00:11:16,400 the goods markets, 320 00:11:14,600 --> 00:11:18,000 changes a little bit. I mean, it's the 321 00:11:16,399 --> 00:11:20,079 same equation, but now I don't need to 322 00:11:18,000 --> 00:11:21,519 differentiate between real interest rate 323 00:11:20,080 --> 00:11:23,720 and nominal interest rate because 324 00:11:21,519 --> 00:11:25,039 inflation is zero. So, nominal interest 325 00:11:23,720 --> 00:11:26,200 rate is equal to the real interest rate. 326 00:11:25,039 --> 00:11:27,959 So, I'm going to stick in here the 327 00:11:26,200 --> 00:11:30,480 nominal interest rate. 328 00:11:27,960 --> 00:11:31,839 Second, I really don't 329 00:11:30,480 --> 00:11:34,200 need to differentiate between real 330 00:11:31,839 --> 00:11:36,200 exchange rate and nominal exchange rate 331 00:11:34,200 --> 00:11:38,200 because the relative prices, the prices 332 00:11:36,200 --> 00:11:40,160 themselves are not changing and so all 333 00:11:38,200 --> 00:11:42,520 that will move the the real exchange 334 00:11:40,159 --> 00:11:44,639 rate is the nominal exchange rate. Okay? 335 00:11:42,519 --> 00:11:47,399 So, that's the reason I'm going to write 336 00:11:44,639 --> 00:11:49,120 here the the nominal exchange rate 337 00:11:47,399 --> 00:11:51,039 is because it's the only thing that will 338 00:11:49,120 --> 00:11:53,000 move this variable around given that 339 00:11:51,039 --> 00:11:54,120 prices are fixed. 340 00:11:53,000 --> 00:11:56,799 Okay? 341 00:11:54,120 --> 00:11:58,200 So, that's my our equilibrium in the 342 00:11:56,799 --> 00:11:59,838 goods market and this is the thing you 343 00:11:58,200 --> 00:12:01,800 need to compare with, you know, lecture 344 00:11:59,839 --> 00:12:04,480 three or something like that. And as I 345 00:12:01,799 --> 00:12:06,799 said, this part here only lowers the 346 00:12:04,480 --> 00:12:08,399 multiplier, so not a big change. This 347 00:12:06,799 --> 00:12:09,279 one here is an extra parameter that 348 00:12:08,399 --> 00:12:11,039 shifts 349 00:12:09,279 --> 00:12:13,519 aggregate demand up and down, so you can 350 00:12:11,039 --> 00:12:15,480 treat it almost like we treated C0. 351 00:12:13,519 --> 00:12:17,799 Remember, if the consumer confidence 352 00:12:15,480 --> 00:12:19,560 goes up, then aggregate demand goes up. 353 00:12:17,799 --> 00:12:21,240 Well, here we have sort of the rest of 354 00:12:19,559 --> 00:12:23,439 the world's output goes up. It does 355 00:12:21,240 --> 00:12:24,839 exactly the same the same analysis. 356 00:12:23,440 --> 00:12:26,800 The problem we have though is that we 357 00:12:24,839 --> 00:12:27,920 have an extra variable here, which is 358 00:12:26,799 --> 00:12:30,159 the exchange rate and that's an 359 00:12:27,919 --> 00:12:32,079 endogenous variable. Okay? So, we're 360 00:12:30,159 --> 00:12:33,360 going to have to come up with some other 361 00:12:32,080 --> 00:12:36,759 equation 362 00:12:33,360 --> 00:12:39,080 to solve for that equation here. In in 363 00:12:36,759 --> 00:12:40,679 lecture three or four, what we did is, 364 00:12:39,080 --> 00:12:43,600 okay, we said we have two endogenous 365 00:12:40,679 --> 00:12:45,759 variables, output and the interest rate 366 00:12:43,600 --> 00:12:47,279 if we output and the interest rate, we 367 00:12:45,759 --> 00:12:49,000 need one more equation. Well, the other 368 00:12:47,279 --> 00:12:51,319 equation was just monetary policy that 369 00:12:49,000 --> 00:12:53,360 set the nominal interest rate. 370 00:12:51,320 --> 00:12:55,400 Here, that's not going to be enough 371 00:12:53,360 --> 00:12:57,159 because we also have an exchange rate 372 00:12:55,399 --> 00:12:59,159 floating around. Okay? So, and we need 373 00:12:57,159 --> 00:13:01,319 to bring another equation here 374 00:12:59,159 --> 00:13:03,240 uh 375 00:13:01,320 --> 00:13:05,240 to deal with this this new endogenous 376 00:13:03,240 --> 00:13:07,440 variable. 377 00:13:05,240 --> 00:13:09,320 What is that extra equation? 378 00:13:07,440 --> 00:13:10,760 Well, is the uncovered interest parity 379 00:13:09,320 --> 00:13:13,280 condition. Remember, it's the last 380 00:13:10,759 --> 00:13:14,799 expression we had in in in the previous 381 00:13:13,279 --> 00:13:15,600 lecture 382 00:13:14,799 --> 00:13:18,240 uh 383 00:13:15,600 --> 00:13:20,600 that takes this form. 384 00:13:18,240 --> 00:13:22,720 Okay? It says 385 00:13:20,600 --> 00:13:24,320 I Before I simplify lots of things, I 386 00:13:22,720 --> 00:13:26,839 wrote this down. 387 00:13:24,320 --> 00:13:28,640 And it says that the exchange rate 388 00:13:26,839 --> 00:13:31,480 is uh 389 00:13:28,639 --> 00:13:33,039 is equal to that. Okay? 390 00:13:31,480 --> 00:13:36,519 Now, what what is this 391 00:13:33,039 --> 00:13:39,360 Where does this equation come from? 392 00:13:36,519 --> 00:13:41,439 What is it trying to do? 393 00:13:39,360 --> 00:13:43,320 Remember, we talked we we talked about 394 00:13:41,440 --> 00:13:45,200 this in the context and say, well, you 395 00:13:43,320 --> 00:13:46,320 know, when you open goods markets and 396 00:13:45,200 --> 00:13:47,800 you need a relative price to decide 397 00:13:46,320 --> 00:13:50,720 where you're going to buy. 398 00:13:47,799 --> 00:13:52,719 That's what what 399 00:13:50,720 --> 00:13:55,000 the real exchange rate did. 400 00:13:52,720 --> 00:13:56,800 And and and now that then then we opened 401 00:13:55,000 --> 00:13:58,120 the capital account and then you need to 402 00:13:56,799 --> 00:14:00,120 people need to decide where they're 403 00:13:58,120 --> 00:14:03,600 going to invest their money. And that 404 00:14:00,120 --> 00:14:03,600 equation was related to that. 405 00:14:03,720 --> 00:14:06,879 The expected rate of return has to be 406 00:14:05,039 --> 00:14:08,519 the same for like domestic Exactly. It's 407 00:14:06,879 --> 00:14:10,639 what equalizes expected rate of return. 408 00:14:08,519 --> 00:14:13,159 In equilibrium, that has to happen. 409 00:14:10,639 --> 00:14:14,439 Okay? Again, in reality, there is risk 410 00:14:13,159 --> 00:14:16,759 adjustment, there is lots of other 411 00:14:14,440 --> 00:14:19,000 factors that we're removing from here. 412 00:14:16,759 --> 00:14:20,519 But absent those other factors, 413 00:14:19,000 --> 00:14:22,159 the the returns have to be similar in 414 00:14:20,519 --> 00:14:23,399 both places because if one asset is 415 00:14:22,159 --> 00:14:25,919 giving more return than the other 416 00:14:23,399 --> 00:14:27,078 expected return, then then then people 417 00:14:25,919 --> 00:14:29,199 are going to invest all their portfolios 418 00:14:27,078 --> 00:14:32,120 in that asset. And what happens is those 419 00:14:29,200 --> 00:14:33,759 flows that try to go to the worst those 420 00:14:32,120 --> 00:14:35,919 assets that give the highest return and 421 00:14:33,759 --> 00:14:36,919 that equalizing expected return in 422 00:14:35,919 --> 00:14:39,479 equilibrium. 423 00:14:36,919 --> 00:14:42,120 And that's the equation that does that. 424 00:14:39,480 --> 00:14:43,279 Exactly that. How do I know that? Well, 425 00:14:42,120 --> 00:14:46,560 remember, 426 00:14:43,279 --> 00:14:48,720 uh I can divide this by the exchange 427 00:14:46,559 --> 00:14:50,639 rate on both sides and then what you get 428 00:14:48,720 --> 00:14:52,800 is one 429 00:14:50,639 --> 00:14:54,958 equal to a numerator that has the 430 00:14:52,799 --> 00:14:57,439 nominal exchange rate 431 00:14:54,958 --> 00:14:59,719 times the expected appreciation of the 432 00:14:57,440 --> 00:15:01,480 currency plus 433 00:14:59,720 --> 00:15:03,160 and in the denominator you have the the 434 00:15:01,480 --> 00:15:04,759 the foreign interest rate. 435 00:15:03,159 --> 00:15:06,719 And so, you have to when you compare the 436 00:15:04,759 --> 00:15:07,919 two, you have to compare 437 00:15:06,720 --> 00:15:09,519 one 438 00:15:07,919 --> 00:15:11,120 base interest rate, either the domestic 439 00:15:09,519 --> 00:15:12,600 or the foreign, plus the expected 440 00:15:11,120 --> 00:15:14,159 appreciation or depreciation of that 441 00:15:12,600 --> 00:15:15,360 currency. And that's what this term is 442 00:15:14,159 --> 00:15:19,000 doing here. 443 00:15:15,360 --> 00:15:19,000 This divided by that. Okay? 444 00:15:19,320 --> 00:15:22,760 Good. So, what do we get out of this? Uh 445 00:15:21,320 --> 00:15:24,920 one thing we're going to do for for 446 00:15:22,759 --> 00:15:26,879 quite a while because it will simplify 447 00:15:24,919 --> 00:15:31,039 things a lot, but sometimes also lead to 448 00:15:26,879 --> 00:15:32,838 confusion in in in in 449 00:15:31,039 --> 00:15:35,599 in the way we understand why currencies 450 00:15:32,839 --> 00:15:37,640 depreciate or appreciate, but we will 451 00:15:35,600 --> 00:15:39,519 pause and and I'll remind you of this 452 00:15:37,639 --> 00:15:40,480 repeatedly. We're going to assume for 453 00:15:39,519 --> 00:15:41,679 now 454 00:15:40,480 --> 00:15:44,120 that the 455 00:15:41,679 --> 00:15:45,519 expected exchange rate for T plus one is 456 00:15:44,120 --> 00:15:47,799 fixed. 457 00:15:45,519 --> 00:15:49,199 Okay? And and until I tell you 458 00:15:47,799 --> 00:15:52,479 otherwise, 459 00:15:49,200 --> 00:15:52,480 we're going to make this assumption. 460 00:15:53,279 --> 00:15:56,360 Now, 461 00:15:54,000 --> 00:15:59,320 that's a huge simplification, completely 462 00:15:56,360 --> 00:16:01,759 unrealistic, and so on. But it will help 463 00:15:59,320 --> 00:16:02,720 me explain the mechanism. 464 00:16:01,759 --> 00:16:04,078 I mean, one of the things that moves 465 00:16:02,720 --> 00:16:05,480 exchange rates a lot is that people have 466 00:16:04,078 --> 00:16:08,359 lots of expectations about future 467 00:16:05,480 --> 00:16:10,159 exchange rate. We'll get to that later. 468 00:16:08,360 --> 00:16:12,480 But for now, so you understand the 469 00:16:10,159 --> 00:16:13,519 mechanism, how the Mundell-Fleming model 470 00:16:12,480 --> 00:16:15,360 works, 471 00:16:13,519 --> 00:16:17,000 I'm going to assume that we all know 472 00:16:15,360 --> 00:16:18,440 what the expected exchange rate We all 473 00:16:17,000 --> 00:16:20,320 We all have a common expected exchange 474 00:16:18,440 --> 00:16:22,440 rate and it's fixed. 475 00:16:20,320 --> 00:16:24,600 Okay? 476 00:16:22,440 --> 00:16:26,800 We may move it as a parameter, but I 477 00:16:24,600 --> 00:16:28,879 won't say I'm not going to endogenize 478 00:16:26,799 --> 00:16:31,078 that. I'm going to take it as fixed 479 00:16:28,879 --> 00:16:33,240 and I I may move it around to show you 480 00:16:31,078 --> 00:16:35,039 what happens when that changes, but I'm 481 00:16:33,240 --> 00:16:37,279 not going to endogenize it. 482 00:16:35,039 --> 00:16:37,279 Okay? 483 00:16:38,039 --> 00:16:43,199 Otherwise, I need more equations. 484 00:16:39,919 --> 00:16:45,000 One more. I want to stop this this this 485 00:16:43,200 --> 00:16:47,480 sequence of equations that I would have 486 00:16:45,000 --> 00:16:49,399 to build, but 487 00:16:47,480 --> 00:16:51,480 later we'll understand more that what I 488 00:16:49,399 --> 00:16:53,039 just said, but but for now, just take 489 00:16:51,480 --> 00:16:54,879 this as fixed. So, if I take this as 490 00:16:53,039 --> 00:16:57,000 fixed, now I have an equation. Remember, 491 00:16:54,879 --> 00:17:00,200 we was looking for an equation 492 00:16:57,000 --> 00:17:01,839 here for my exchange rate. 493 00:17:00,200 --> 00:17:02,879 Once I do that, then I have what I 494 00:17:01,839 --> 00:17:04,640 wanted. 495 00:17:02,879 --> 00:17:06,199 I have an equation for my exchange rate 496 00:17:04,640 --> 00:17:07,400 today. It's just 497 00:17:06,199 --> 00:17:08,920 function of 498 00:17:07,400 --> 00:17:10,280 domestic interest rate, international 499 00:17:08,920 --> 00:17:12,400 interest rate, 500 00:17:10,279 --> 00:17:13,399 and the expected exchange rate. 501 00:17:12,400 --> 00:17:15,439 Okay? 502 00:17:13,400 --> 00:17:17,120 So, I know the following, for example. I 503 00:17:15,439 --> 00:17:18,720 know that an increase in the domestic 504 00:17:17,119 --> 00:17:20,438 interest rate, 505 00:17:18,720 --> 00:17:22,319 other things equal, 506 00:17:20,439 --> 00:17:23,720 appreciates exchange rate. You know, I 507 00:17:22,319 --> 00:17:25,678 can see it in the equation. If I move 508 00:17:23,720 --> 00:17:27,000 the domestic interest rate up, the 509 00:17:25,679 --> 00:17:29,200 exchange rate goes up. That's an 510 00:17:27,000 --> 00:17:31,240 appreciation. The dollar becomes 511 00:17:29,200 --> 00:17:33,559 more expensive. 512 00:17:31,240 --> 00:17:36,120 Even simpler. Suppose we start with a 513 00:17:33,559 --> 00:17:37,279 situation in which the domestic and the 514 00:17:36,119 --> 00:17:38,759 international interest rate were the 515 00:17:37,279 --> 00:17:40,240 same. 516 00:17:38,759 --> 00:17:41,679 And now I increase the international 517 00:17:40,240 --> 00:17:45,039 interest rate. And I'm saying the 518 00:17:41,679 --> 00:17:47,040 exchange rate will appreciate. 519 00:17:45,039 --> 00:17:48,480 Well, first of all, 520 00:17:47,039 --> 00:17:50,279 let me let me start from something even 521 00:17:48,480 --> 00:17:52,440 simpler. Suppose that 522 00:17:50,279 --> 00:17:53,839 suppose that that 523 00:17:52,440 --> 00:17:55,720 this interest rate is equal to 524 00:17:53,839 --> 00:17:57,199 international interest rate before 525 00:17:55,720 --> 00:17:58,519 analyzing the change I'm about to 526 00:17:57,200 --> 00:18:00,160 analyze, 527 00:17:58,519 --> 00:18:02,079 then from this equation, what do I know 528 00:18:00,160 --> 00:18:03,880 I know about the exchange rate? What is 529 00:18:02,079 --> 00:18:05,279 it equal to? 530 00:18:03,880 --> 00:18:07,120 If the domestic interest rate is equal 531 00:18:05,279 --> 00:18:09,200 to international interest rate, 532 00:18:07,119 --> 00:18:11,479 what is the exchange rate today equal 533 00:18:09,200 --> 00:18:11,480 to? 534 00:18:12,839 --> 00:18:15,959 The expected exchange rate of next year. 535 00:18:14,279 --> 00:18:17,759 If I have the same interest rates, I 536 00:18:15,960 --> 00:18:19,720 cannot expect a capital gain or loss on 537 00:18:17,759 --> 00:18:21,679 the currency position because I have 538 00:18:19,720 --> 00:18:23,519 already an equal interest rate in in the 539 00:18:21,679 --> 00:18:25,200 two bonds. Okay? 540 00:18:23,519 --> 00:18:27,158 So then, I'm starting from a situation 541 00:18:25,200 --> 00:18:28,600 where the current exchange rate is equal 542 00:18:27,159 --> 00:18:30,960 to expected exchange rate and these two 543 00:18:28,599 --> 00:18:32,279 are equal. And now, I'm going to 544 00:18:30,960 --> 00:18:33,559 increase the interest rate, the domestic 545 00:18:32,279 --> 00:18:35,639 interest rate. 546 00:18:33,559 --> 00:18:38,119 And it's very easy for you to read from 547 00:18:35,640 --> 00:18:40,240 here that the exchange rate will go up. 548 00:18:38,119 --> 00:18:42,239 The currency will appreciate. 549 00:18:40,240 --> 00:18:43,880 Why? 550 00:18:42,240 --> 00:18:46,039 This is not an easy 551 00:18:43,880 --> 00:18:47,120 thing to answer unless you know 552 00:18:46,039 --> 00:18:49,399 unless you have read the book or 553 00:18:47,119 --> 00:18:49,399 something. 554 00:18:50,720 --> 00:18:54,960 If the interest rate goes up, then like 555 00:18:53,000 --> 00:18:56,720 money supply should go down, which would 556 00:18:54,960 --> 00:18:57,720 generally increase the value of money. 557 00:18:56,720 --> 00:18:59,519 No. 558 00:18:57,720 --> 00:19:00,880 No money here. 559 00:18:59,519 --> 00:19:03,000 That money is only related to the 560 00:19:00,880 --> 00:19:04,520 mechanism we used to increase 561 00:19:03,000 --> 00:19:07,359 interest rate, but 562 00:19:04,519 --> 00:19:09,000 I'm saying just use that equation 563 00:19:07,359 --> 00:19:10,799 and the logic behind that equation, the 564 00:19:09,000 --> 00:19:13,200 uncovered interest parity. 565 00:19:10,799 --> 00:19:14,399 Why is it that if I you know, we went to 566 00:19:13,200 --> 00:19:16,159 from a situation which interest rate 567 00:19:14,400 --> 00:19:18,040 were the same, now I increase the 568 00:19:16,159 --> 00:19:21,520 domestic interest rate, I'm saying the 569 00:19:18,039 --> 00:19:21,519 the exchange rate has to appreciate. 570 00:19:23,759 --> 00:19:27,960 No, no, but that's the description of 571 00:19:25,559 --> 00:19:31,720 Yeah, that's that's We know that. 572 00:19:27,960 --> 00:19:31,720 The question is what? What is the logic? 573 00:19:32,839 --> 00:19:35,319 Yeah, 574 00:19:33,559 --> 00:19:37,000 we have We know the result, but I'm 575 00:19:35,319 --> 00:19:39,799 asking is for an economic explanation 576 00:19:37,000 --> 00:19:39,799 for that result. 577 00:19:40,720 --> 00:19:44,960 More people will want to invest in the 578 00:19:43,039 --> 00:19:46,759 currency that you are in currency, so 579 00:19:44,960 --> 00:19:48,159 the demand will go up and so the value 580 00:19:46,759 --> 00:19:49,679 Well, if you go to Wall Street, you want 581 00:19:48,159 --> 00:19:50,640 to rate, they will explain it in those 582 00:19:49,679 --> 00:19:52,159 terms. 583 00:19:50,640 --> 00:19:54,000 It's not the right explanation, but they 584 00:19:52,159 --> 00:19:57,120 they will explain on those terms. And 585 00:19:54,000 --> 00:19:58,799 there is some logic behind that because 586 00:19:57,119 --> 00:20:00,279 this equation assumes that the arbitrage 587 00:19:58,799 --> 00:20:02,159 happens instantaneously. Immediately 588 00:20:00,279 --> 00:20:03,960 things move. But, but before that 589 00:20:02,160 --> 00:20:06,360 happens, you know, some people will 590 00:20:03,960 --> 00:20:08,759 start they buy more of the one that has 591 00:20:06,359 --> 00:20:10,679 more return. But, this equation already 592 00:20:08,759 --> 00:20:13,119 solved all that. 593 00:20:10,680 --> 00:20:15,840 And that's when this assumption 594 00:20:13,119 --> 00:20:17,719 matters and and is a little annoying. 595 00:20:15,839 --> 00:20:19,319 It bothers me for a logical reason. But, 596 00:20:17,720 --> 00:20:20,839 but we're going to use it to understand 597 00:20:19,319 --> 00:20:23,359 the mechanism. 598 00:20:20,839 --> 00:20:24,720 You see, if if I keep the exchange rate 599 00:20:23,359 --> 00:20:26,519 fixed, we started with a situation where 600 00:20:24,720 --> 00:20:27,920 the exchange rate was equal to expected 601 00:20:26,519 --> 00:20:29,680 exchange rate. 602 00:20:27,920 --> 00:20:32,320 If I keep it fixed 603 00:20:29,680 --> 00:20:34,480 and I appreciate the currency today, 604 00:20:32,319 --> 00:20:36,919 then what do I expect 605 00:20:34,480 --> 00:20:38,759 to happen to the dollar, let's talk 606 00:20:36,920 --> 00:20:40,600 about the dollar, from this period to 607 00:20:38,759 --> 00:20:42,640 the next one? Remember, we start from a 608 00:20:40,599 --> 00:20:43,959 situation where the exchange rate was 609 00:20:42,640 --> 00:20:45,759 equal to the expected exchange rate. 610 00:20:43,960 --> 00:20:48,720 Now, I increase the interest rate and I 611 00:20:45,759 --> 00:20:50,119 said the exchange rate appreciate. 612 00:20:48,720 --> 00:20:51,880 Then what do you expect 613 00:20:50,119 --> 00:20:53,479 the exchange rate to do over the next 614 00:20:51,880 --> 00:20:54,960 period? 615 00:20:53,480 --> 00:20:55,920 If I haven't moved expected exchange 616 00:20:54,960 --> 00:20:58,200 rate and now the exchange rate move 617 00:20:55,920 --> 00:20:59,440 above the expected exchange rate. 618 00:20:58,200 --> 00:21:01,680 What do you expect the exchange rate to 619 00:20:59,440 --> 00:21:01,680 do? 620 00:21:03,400 --> 00:21:09,400 Exactly, it has to depreciate. 621 00:21:05,880 --> 00:21:11,880 So, the reason depreciation happens here 622 00:21:09,400 --> 00:21:13,800 is because you need to expect to 623 00:21:11,880 --> 00:21:16,160 depreciate the dollar from this period 624 00:21:13,799 --> 00:21:19,559 to the next one. Why do I need to expect 625 00:21:16,160 --> 00:21:19,560 exchange rate to depreciate? 626 00:21:20,279 --> 00:21:23,240 So, I'm appreciating the currency 627 00:21:21,400 --> 00:21:25,240 because I need in equilibrium I need to 628 00:21:23,240 --> 00:21:27,640 expect to depreciate. That is, I need to 629 00:21:25,240 --> 00:21:30,079 expect to lose money money on the 630 00:21:27,640 --> 00:21:32,600 currency part of the trade. 631 00:21:30,079 --> 00:21:34,759 Why is that? Confusion is good. You you 632 00:21:32,599 --> 00:21:38,480 learn from that. 633 00:21:34,759 --> 00:21:38,480 And this can be very confusing, I know. 634 00:21:40,400 --> 00:21:44,040 What is this equation trying to do? 635 00:21:46,160 --> 00:21:49,480 We are trying to make the expected 636 00:21:47,920 --> 00:21:50,680 returns the same. That's the whole idea 637 00:21:49,480 --> 00:21:53,519 of this. 638 00:21:50,680 --> 00:21:55,080 So, if I I'm now telling you that one 639 00:21:53,519 --> 00:21:56,680 bond is paying a higher interest than 640 00:21:55,079 --> 00:21:57,879 the other one, 641 00:21:56,680 --> 00:21:59,799 I need to 642 00:21:57,880 --> 00:22:02,120 offset that somehow. 643 00:21:59,799 --> 00:22:04,319 How do I offset it? By expecting a 644 00:22:02,119 --> 00:22:05,759 depreciation of the currency 645 00:22:04,319 --> 00:22:08,359 of the bond 646 00:22:05,759 --> 00:22:10,400 that is, you know, of of the bond that 647 00:22:08,359 --> 00:22:11,439 is denominated 648 00:22:10,400 --> 00:22:14,720 in the currency that is expected to 649 00:22:11,440 --> 00:22:16,000 depreciate. So, what I need to do is 650 00:22:14,720 --> 00:22:17,279 compensate for the interest rate 651 00:22:16,000 --> 00:22:18,679 differential with an expected 652 00:22:17,279 --> 00:22:20,079 depreciation of the currency that is 653 00:22:18,679 --> 00:22:22,160 paying 654 00:22:20,079 --> 00:22:24,159 a higher interest rate. 655 00:22:22,160 --> 00:22:25,880 So, that's what in this model when I fix 656 00:22:24,160 --> 00:22:27,519 the expected exchange rate, the only way 657 00:22:25,880 --> 00:22:29,440 I can do that is by appreciating the 658 00:22:27,519 --> 00:22:32,319 currency today so I can expect it to 659 00:22:29,440 --> 00:22:33,960 depreciate in the future. 660 00:22:32,319 --> 00:22:35,079 That's the logic. 661 00:22:33,960 --> 00:22:37,079 Okay? 662 00:22:35,079 --> 00:22:38,639 Now, how what is the connection with 663 00:22:37,079 --> 00:22:40,960 what in Wall Street what they will tell 664 00:22:38,640 --> 00:22:43,759 you is to say, "Well, before this may 665 00:22:40,960 --> 00:22:45,640 happen not instantaneously. It happens 666 00:22:43,759 --> 00:22:48,400 somewhat slowly. So, traders immediately 667 00:22:45,640 --> 00:22:50,160 will go to the US dollar 668 00:22:48,400 --> 00:22:52,000 bond because they see that they have a 669 00:22:50,160 --> 00:22:53,120 higher return." 670 00:22:52,000 --> 00:22:56,079 And it will be the case until the 671 00:22:53,119 --> 00:22:57,559 currency really appreciates. 672 00:22:56,079 --> 00:22:59,960 The Once the currency appreciates 673 00:22:57,559 --> 00:23:01,319 enough, then that that advantage 674 00:22:59,960 --> 00:23:02,640 disappear. That's what this condition is 675 00:23:01,319 --> 00:23:03,678 doing. It's making the expected return 676 00:23:02,640 --> 00:23:05,600 the same. 677 00:23:03,679 --> 00:23:07,240 But, in the process of the exchange rate 678 00:23:05,599 --> 00:23:08,759 going from the initial exchange rate to 679 00:23:07,240 --> 00:23:10,440 to to the new 680 00:23:08,759 --> 00:23:11,960 equilibrium exchange rate, there may be 681 00:23:10,440 --> 00:23:14,320 an opportunity there. And that's when 682 00:23:11,960 --> 00:23:16,240 you start seeing these flows. Okay? 683 00:23:14,319 --> 00:23:19,960 That happens very very fast. But, that's 684 00:23:16,240 --> 00:23:19,960 when you can see some of those flows. 685 00:23:24,039 --> 00:23:27,519 I mean, in these markets that happens 686 00:23:25,480 --> 00:23:29,200 very very quickly. So, what is typically 687 00:23:27,519 --> 00:23:30,519 wrong is that then an analyst comes and 688 00:23:29,200 --> 00:23:31,679 tells you explaining a story why the 689 00:23:30,519 --> 00:23:33,200 exchange rate is going to continue to 690 00:23:31,679 --> 00:23:34,679 appreciate, well, that's just way too 691 00:23:33,200 --> 00:23:36,679 late. You're already in this 692 00:23:34,679 --> 00:23:38,800 environment. You lost the trade. 693 00:23:36,679 --> 00:23:38,800 Okay? 694 00:23:41,079 --> 00:23:44,639 Okay. 695 00:23:42,679 --> 00:23:47,560 What about an increase in the foreign 696 00:23:44,640 --> 00:23:48,960 interest rate, I star? 697 00:23:47,559 --> 00:23:50,440 So, an increase in the foreign interest 698 00:23:48,960 --> 00:23:51,960 rate is Let's start from the same 699 00:23:50,440 --> 00:23:53,279 situation we had before. We start from 700 00:23:51,960 --> 00:23:55,000 interest rate equal to international 701 00:23:53,279 --> 00:23:56,799 interest rate. Therefore, the exchange 702 00:23:55,000 --> 00:23:58,039 rate is equal to expected exchange rate. 703 00:23:56,799 --> 00:23:59,359 And now 704 00:23:58,039 --> 00:24:01,839 the 705 00:23:59,359 --> 00:24:03,839 foreign interest rate goes up. 706 00:24:01,839 --> 00:24:05,919 Okay? What is going on now in the US? 707 00:24:03,839 --> 00:24:08,399 The US is sort of stabilizing here and 708 00:24:05,920 --> 00:24:10,279 and and Europe is beginning to hike a 709 00:24:08,400 --> 00:24:12,120 little more than the US. 710 00:24:10,279 --> 00:24:13,639 So, 711 00:24:12,119 --> 00:24:16,199 we know from the equation that that 712 00:24:13,640 --> 00:24:18,280 means the exchange rate will 713 00:24:16,200 --> 00:24:19,519 fall. That is, will drop here. So, that 714 00:24:18,279 --> 00:24:21,160 that means 715 00:24:19,519 --> 00:24:23,599 the exchange rate is depreciating. The 716 00:24:21,160 --> 00:24:26,920 dollar is depreciating. 717 00:24:23,599 --> 00:24:26,919 Why is the dollar depreciating? 718 00:24:30,920 --> 00:24:34,360 It's the same mechanism. Like 719 00:24:32,960 --> 00:24:36,079 the exchange rate you previously said 720 00:24:34,359 --> 00:24:39,639 was facing like ET with the interest 721 00:24:36,079 --> 00:24:41,359 rate starting Yeah, that's correct. 722 00:24:39,640 --> 00:24:43,360 I mean, the the issue here in terms of 723 00:24:41,359 --> 00:24:44,759 the economics is that 724 00:24:43,359 --> 00:24:46,399 remember, if we start from the same 725 00:24:44,759 --> 00:24:48,000 interest rate and now 726 00:24:46,400 --> 00:24:49,120 all the lines I'm giving you doesn't 727 00:24:48,000 --> 00:24:50,640 need to start from the same interest 728 00:24:49,119 --> 00:24:51,799 rate. It's just a lot simpler to start 729 00:24:50,640 --> 00:24:53,000 from the 730 00:24:51,799 --> 00:24:54,200 from the same interest. But, suppose we 731 00:24:53,000 --> 00:24:56,000 start with the same interest rate and 732 00:24:54,200 --> 00:24:57,679 now I increase this one, 733 00:24:56,000 --> 00:24:59,319 then that means the foreign bond is 734 00:24:57,679 --> 00:25:01,519 paying a higher interest rate than the 735 00:24:59,319 --> 00:25:03,439 domestic bond. I need to equalize the 736 00:25:01,519 --> 00:25:05,400 expected returns. The only way I can do 737 00:25:03,440 --> 00:25:08,320 that is by having an expected 738 00:25:05,400 --> 00:25:09,920 appreciation of the dollar. 739 00:25:08,319 --> 00:25:11,200 Since the expected exchange rate we fix 740 00:25:09,920 --> 00:25:12,800 it here, the only way I can give you an 741 00:25:11,200 --> 00:25:16,640 expected appreciation of the dollar is 742 00:25:12,799 --> 00:25:18,119 to by depreciating the dollar today. 743 00:25:16,640 --> 00:25:19,480 Okay? 744 00:25:18,119 --> 00:25:21,559 So, this is the same mechanism, the same 745 00:25:19,480 --> 00:25:24,319 logic. It's symmetric. 746 00:25:21,559 --> 00:25:25,879 That's That's the mechanism. 747 00:25:24,319 --> 00:25:26,720 Now, is this true that in the very short 748 00:25:25,880 --> 00:25:29,720 run 749 00:25:26,720 --> 00:25:31,200 when when I star goes up and and I 750 00:25:29,720 --> 00:25:32,880 doesn't move, then lots of people go and 751 00:25:31,200 --> 00:25:34,880 buy foreign bonds and that produces sort 752 00:25:32,880 --> 00:25:37,760 of, you know, demand for euros and blah 753 00:25:34,880 --> 00:25:40,320 blah blah blah. But, that's very quick. 754 00:25:37,759 --> 00:25:43,200 Machines do it for you now. So, 755 00:25:40,319 --> 00:25:43,200 it happens very quickly. 756 00:25:43,440 --> 00:25:47,679 So, this equation shows you what happens 757 00:25:45,039 --> 00:25:51,119 after all that mess has already cleared. 758 00:25:47,679 --> 00:25:51,120 Which happens in milliseconds now. 759 00:25:53,799 --> 00:25:56,359 Okay. 760 00:25:56,599 --> 00:26:00,678 What What if I change the expected 761 00:25:58,000 --> 00:26:02,640 exchange rate? So, again, I'm fixing it, 762 00:26:00,679 --> 00:26:04,440 but I can move it around. I'm treating 763 00:26:02,640 --> 00:26:05,280 it as a parameter. When I say that I fix 764 00:26:04,440 --> 00:26:07,400 it, 765 00:26:05,279 --> 00:26:08,599 I just don't want to endogenize. I don't 766 00:26:07,400 --> 00:26:10,000 want to make it another endogenous 767 00:26:08,599 --> 00:26:11,839 variable. 768 00:26:10,000 --> 00:26:13,319 So, what happens here if the exchange 769 00:26:11,839 --> 00:26:14,799 rate we start with the same situation we 770 00:26:13,319 --> 00:26:16,639 had before and now the expected exchange 771 00:26:14,799 --> 00:26:17,919 rate goes up. Well, from the equation 772 00:26:16,640 --> 00:26:19,320 it's very clear. 773 00:26:17,920 --> 00:26:21,160 The current exchange rate immediately 774 00:26:19,319 --> 00:26:23,559 rises. 775 00:26:21,160 --> 00:26:24,920 One for one, in fact. Okay? If I have 776 00:26:23,559 --> 00:26:26,839 the these two interest rates are the 777 00:26:24,920 --> 00:26:28,560 same and now I move the expected 778 00:26:26,839 --> 00:26:31,799 exchange rate up, then the current 779 00:26:28,559 --> 00:26:33,599 exchange rate immediately jumps. 780 00:26:31,799 --> 00:26:35,799 So, this If we expect the dollar to 781 00:26:33,599 --> 00:26:37,839 appreciate in the future, 782 00:26:35,799 --> 00:26:40,480 then it appreciates today. 783 00:26:37,839 --> 00:26:40,480 Why is that? 784 00:26:40,839 --> 00:26:44,919 Expectations are very powerful in 785 00:26:43,000 --> 00:26:47,440 financial assets in general. This is the 786 00:26:44,920 --> 00:26:49,480 first time you come but and we'll talk a 787 00:26:47,440 --> 00:26:51,519 lot more about that in the 788 00:26:49,480 --> 00:26:53,279 next week. But, 789 00:26:51,519 --> 00:26:55,119 but you can see it here. 790 00:26:53,279 --> 00:26:56,678 So, if I move the exchange rate today 791 00:26:55,119 --> 00:26:58,119 up, 792 00:26:56,679 --> 00:26:59,840 the expected exchange rate means we 793 00:26:58,119 --> 00:27:04,079 expect the exchange rate to be, you 794 00:26:59,839 --> 00:27:05,959 know, today the dollar is is 90 cents on 795 00:27:04,079 --> 00:27:07,960 90 cents 796 00:27:05,960 --> 00:27:09,679 0.9 euros per dollar. 797 00:27:07,960 --> 00:27:12,360 Well, suppose I expect 798 00:27:09,679 --> 00:27:13,360 1 euro per dollar in the next period. 799 00:27:12,359 --> 00:27:16,479 What will happen to the exchange rate 800 00:27:13,359 --> 00:27:19,119 today? Well, it jumps today to one. 801 00:27:16,480 --> 00:27:19,120 Why is that? 802 00:27:24,759 --> 00:27:28,480 The dollar will be more expensive to buy 803 00:27:26,200 --> 00:27:30,440 there. So, people will 804 00:27:28,480 --> 00:27:34,279 Okay, that's that's your friend the 805 00:27:30,440 --> 00:27:34,279 trader there. Okay? But, 806 00:27:36,119 --> 00:27:38,799 yes, 807 00:27:39,079 --> 00:27:41,799 that's true. 808 00:27:42,640 --> 00:27:46,320 That's true. What does that mean? 809 00:27:46,799 --> 00:27:49,559 No. 810 00:27:48,160 --> 00:27:51,440 It is true it's more expensive, but why 811 00:27:49,559 --> 00:27:53,678 would Why did you want to buy it in to 812 00:27:51,440 --> 00:27:54,759 start with? I mean, who cares that 813 00:27:53,679 --> 00:27:57,640 something is more expensive if you are 814 00:27:54,759 --> 00:27:57,640 not planning to buy it? 815 00:27:59,720 --> 00:28:04,600 Um because the the current price is only 816 00:28:02,240 --> 00:28:07,279 also taking into account future prices. 817 00:28:04,599 --> 00:28:09,678 That's what the question says. 818 00:28:07,279 --> 00:28:12,039 So, um because it gets part of its 819 00:28:09,679 --> 00:28:13,360 cuz it it's value at the present moment 820 00:28:12,039 --> 00:28:15,399 takes into account 821 00:28:13,359 --> 00:28:16,959 some of its value in the future. I I You 822 00:28:15,400 --> 00:28:19,360 know, whenever we we This is an 823 00:28:16,960 --> 00:28:21,679 arbitrage type relationship. And what I 824 00:28:19,359 --> 00:28:23,879 suggest is whenever you come across an 825 00:28:21,679 --> 00:28:25,560 arbitrage type argument, 826 00:28:23,880 --> 00:28:27,159 you ask the question, "Well, suppose 827 00:28:25,559 --> 00:28:29,158 not." 828 00:28:27,159 --> 00:28:31,120 Suppose this didn't happen. 829 00:28:29,159 --> 00:28:32,400 What would then happen? What would look 830 00:28:31,119 --> 00:28:34,879 odd? 831 00:28:32,400 --> 00:28:36,159 Okay? That's Almost any arbitrage that's 832 00:28:34,880 --> 00:28:38,040 a good way of thinking about this. It's 833 00:28:36,159 --> 00:28:40,640 okay. The equation tells me that the 834 00:28:38,039 --> 00:28:44,399 exchange rate has to jump right away. 835 00:28:40,640 --> 00:28:46,960 Well, suppose not. What goes wrong? 836 00:28:44,400 --> 00:28:48,519 That's I I think that's the way the 837 00:28:46,960 --> 00:28:49,759 the easiest way to think about any of 838 00:28:48,519 --> 00:28:52,000 these things, asset pricing in general, 839 00:28:49,759 --> 00:28:54,039 by the way. 840 00:28:52,000 --> 00:28:55,400 Well, suppose not. Suppose the expected 841 00:28:54,039 --> 00:28:57,359 exchange rate goes up, the interest 842 00:28:55,400 --> 00:28:59,400 rates haven't changed, and the exchange 843 00:28:57,359 --> 00:29:00,879 rate today doesn't move. What happens 844 00:28:59,400 --> 00:29:02,280 then? 845 00:29:00,880 --> 00:29:05,280 Remember, we start in a situation with 846 00:29:02,279 --> 00:29:07,759 both interest rates are the same. 847 00:29:05,279 --> 00:29:10,200 Now, the expected exchange rate went up 848 00:29:07,759 --> 00:29:12,799 by 10% say, 849 00:29:10,200 --> 00:29:16,080 and uh 850 00:29:12,799 --> 00:29:17,480 the current exchange rate hasn't moved. 851 00:29:16,079 --> 00:29:19,720 I'm sure that between the two you can 852 00:29:17,480 --> 00:29:22,240 design this trade. 853 00:29:19,720 --> 00:29:22,240 What do you do? 854 00:29:25,799 --> 00:29:29,200 Everyone will buy foreign bonds in like 855 00:29:27,440 --> 00:29:32,840 the next period. 856 00:29:29,200 --> 00:29:32,840 No one will in the first period. 857 00:29:33,200 --> 00:29:37,519 Uh No, no, but what do you do today? 858 00:29:38,880 --> 00:29:43,240 Suppose it's you're not a trader and and 859 00:29:40,880 --> 00:29:44,760 then now you see, "Whoops, the exchange 860 00:29:43,240 --> 00:29:46,279 the dollar will appreciate 10%, the 861 00:29:44,759 --> 00:29:47,759 interest rates are the same, and the 862 00:29:46,279 --> 00:29:50,119 exchange rate is not moving today, what 863 00:29:47,759 --> 00:29:50,119 do you do? 864 00:29:58,799 --> 00:30:01,839 Which bond do you buy? 865 00:30:05,359 --> 00:30:08,759 Of course, because you have a 10% 866 00:30:07,039 --> 00:30:10,960 expected capital gain from buying that 867 00:30:08,759 --> 00:30:12,079 bond. If that doesn't happen, the both 868 00:30:10,960 --> 00:30:13,840 the two bonds are paying the same 869 00:30:12,079 --> 00:30:15,079 interest rate and now I tell you, well, 870 00:30:13,839 --> 00:30:16,439 yeah, but one is going to appreciate by 871 00:30:15,079 --> 00:30:19,119 10%. 872 00:30:16,440 --> 00:30:21,039 Relative to the other, okay? So, clearly 873 00:30:19,119 --> 00:30:23,239 that you go short massively the foreign 874 00:30:21,039 --> 00:30:25,440 bond and you go very long the US bond. 875 00:30:23,240 --> 00:30:26,799 That's what you do. 876 00:30:25,440 --> 00:30:28,440 We all want to do the same, so happens 877 00:30:26,799 --> 00:30:31,279 very quickly. 878 00:30:28,440 --> 00:30:33,039 And the exchange is appreciated today 879 00:30:31,279 --> 00:30:35,480 up to a point in which that that 880 00:30:33,039 --> 00:30:37,359 incentive is no longer there. 881 00:30:35,480 --> 00:30:38,360 And that in this particular case, if the 882 00:30:37,359 --> 00:30:40,000 interest rate are the same, that will 883 00:30:38,359 --> 00:30:42,159 happen only if the exchange rate today 884 00:30:40,000 --> 00:30:44,799 jumps exactly by the same amount as 885 00:30:42,160 --> 00:30:46,519 expected appreciation of the 886 00:30:44,799 --> 00:30:47,759 expected value of the 887 00:30:46,519 --> 00:30:50,680 dollar 888 00:30:47,759 --> 00:30:51,839 changing the future. Okay? 889 00:30:50,680 --> 00:30:52,840 Good. 890 00:30:51,839 --> 00:30:54,879 Think about this. Play with these 891 00:30:52,839 --> 00:30:55,879 things. I know it can be confusing, but 892 00:30:54,880 --> 00:30:57,760 and I 893 00:30:55,880 --> 00:30:59,080 always start with, let me move 894 00:30:57,759 --> 00:31:00,759 something. 895 00:30:59,079 --> 00:31:02,359 The equation tells me this is what it 896 00:31:00,759 --> 00:31:03,839 has to happen to the exchange rate. 897 00:31:02,359 --> 00:31:05,039 Well, suppose that didn't happen to the 898 00:31:03,839 --> 00:31:07,079 exchange rate. 899 00:31:05,039 --> 00:31:08,639 And then you say, oh, then I clearly 900 00:31:07,079 --> 00:31:10,559 invest in this bond. This dominates the 901 00:31:08,640 --> 00:31:13,080 other one. Well, that condition tells 902 00:31:10,559 --> 00:31:15,319 you, no, no, in equilibrium, you have to 903 00:31:13,079 --> 00:31:17,000 be indifferent. So, so the only thing 904 00:31:15,319 --> 00:31:18,279 that can move is the exchange rate. 905 00:31:17,000 --> 00:31:20,160 And the exchange has to move until you 906 00:31:18,279 --> 00:31:22,240 are indifferent again. 907 00:31:20,160 --> 00:31:24,840 After you have done some change to some 908 00:31:22,240 --> 00:31:26,000 argument on the right hand side, okay? 909 00:31:24,839 --> 00:31:27,919 That's the way you need to think about 910 00:31:26,000 --> 00:31:29,559 this. 911 00:31:27,920 --> 00:31:33,039 So, 912 00:31:29,559 --> 00:31:35,839 I here I'm just plotting 913 00:31:33,039 --> 00:31:37,720 uh this this relationship 914 00:31:35,839 --> 00:31:40,839 in the space of exchange rate in the 915 00:31:37,720 --> 00:31:42,519 x-axis and the domestic interest rate 916 00:31:40,839 --> 00:31:44,079 here. Okay? 917 00:31:42,519 --> 00:31:45,759 So, that's an upward sloping 918 00:31:44,079 --> 00:31:47,679 relationship. You You can see here as I 919 00:31:45,759 --> 00:31:49,319 move the interest rate up 920 00:31:47,680 --> 00:31:51,200 or the other way around, but anyways, as 921 00:31:49,319 --> 00:31:52,599 I move the interest rate up 922 00:31:51,200 --> 00:31:54,600 the exchange rate is going up. So, 923 00:31:52,599 --> 00:31:56,079 that's a positive relationship. 924 00:31:54,599 --> 00:31:57,279 I can do it the other way around. As I 925 00:31:56,079 --> 00:31:59,439 move the exchange rate up, then the 926 00:31:57,279 --> 00:32:01,119 domestic interest rate has to go up. I'm 927 00:31:59,440 --> 00:32:03,320 taking as parameters 928 00:32:01,119 --> 00:32:05,639 the foreign interest rate 929 00:32:03,319 --> 00:32:08,000 and and and the expected exchange rate. 930 00:32:05,640 --> 00:32:09,240 So, if I take as parameter this and that 931 00:32:08,000 --> 00:32:10,960 then I have a positive relationship 932 00:32:09,240 --> 00:32:13,279 between the exchange rate 933 00:32:10,960 --> 00:32:14,960 and the domestic interest rate, okay? 934 00:32:13,279 --> 00:32:17,440 So, that's going to be the 935 00:32:14,960 --> 00:32:19,120 I'm plotting the UIP uncovered interest 936 00:32:17,440 --> 00:32:21,720 parity condition. 937 00:32:19,119 --> 00:32:23,799 Notice this point here is interesting. 938 00:32:21,720 --> 00:32:26,559 This point tells you that when the 939 00:32:23,799 --> 00:32:28,599 domestic interest rate I is equal to the 940 00:32:26,559 --> 00:32:31,678 international interest rate 941 00:32:28,599 --> 00:32:33,119 then the exchange rate has to be equal 942 00:32:31,679 --> 00:32:35,519 to the expected exchange rate, which is 943 00:32:33,119 --> 00:32:36,559 the question I asked before. 944 00:32:35,519 --> 00:32:38,319 Remember, I asked you a question, what 945 00:32:36,559 --> 00:32:39,319 suppose that we start with an interest 946 00:32:38,319 --> 00:32:40,639 rate 947 00:32:39,319 --> 00:32:42,559 that is equal to the international 948 00:32:40,640 --> 00:32:43,880 interest rate. 949 00:32:42,559 --> 00:32:45,079 Uh uh 950 00:32:43,880 --> 00:32:46,960 what the exchange rate what is the 951 00:32:45,079 --> 00:32:48,639 exchange rate? And you said the answer 952 00:32:46,960 --> 00:32:50,360 was, well, it has to be equal to the 953 00:32:48,640 --> 00:32:52,440 expected exchange rate. That's that 954 00:32:50,359 --> 00:32:53,639 point here. 955 00:32:52,440 --> 00:32:55,279 Okay? 956 00:32:53,640 --> 00:32:57,400 If the interest rate domestic interest 957 00:32:55,279 --> 00:32:59,319 rate is above that 958 00:32:57,400 --> 00:33:01,280 the international interest rate 959 00:32:59,319 --> 00:33:03,119 then the exchange rate 960 00:33:01,279 --> 00:33:05,399 today has to be above the expected 961 00:33:03,119 --> 00:33:07,079 exchange rate because that will give you 962 00:33:05,400 --> 00:33:09,440 expected depreciation of the currency, 963 00:33:07,079 --> 00:33:11,559 which will compensate for the fact that 964 00:33:09,440 --> 00:33:13,679 the domestic bond is paying a higher 965 00:33:11,559 --> 00:33:15,279 interest rate than international bond. 966 00:33:13,679 --> 00:33:17,960 Okay? 967 00:33:15,279 --> 00:33:19,519 Conversely, if if the domestic bond is 968 00:33:17,960 --> 00:33:21,920 paying a lower interest rate, then the 969 00:33:19,519 --> 00:33:23,079 exchange rate today is very depreciated 970 00:33:21,920 --> 00:33:25,759 because you have to expect it to 971 00:33:23,079 --> 00:33:27,879 appreciate in order to compensate for 972 00:33:25,759 --> 00:33:29,559 the interest rate differential. 973 00:33:27,880 --> 00:33:32,240 Are we okay? 974 00:33:29,559 --> 00:33:34,839 Probably not, but 975 00:33:32,240 --> 00:33:37,039 this requires practice, I tell you. 976 00:33:34,839 --> 00:33:37,039 Uh 977 00:33:40,640 --> 00:33:44,000 Okay. 978 00:33:41,679 --> 00:33:45,280 So, but now we have a 979 00:33:44,000 --> 00:33:46,359 an equation for the exchange rate at 980 00:33:45,279 --> 00:33:50,039 least. 981 00:33:46,359 --> 00:33:52,479 So, I can go back to my I yes I I yes is 982 00:33:50,039 --> 00:33:53,720 the IS equation in the open economy. 983 00:33:52,480 --> 00:33:56,000 And now I have an equation for the 984 00:33:53,720 --> 00:33:58,559 exchange rate, so I can replace it. 985 00:33:56,000 --> 00:34:01,279 This is nice because I I'm I have two 986 00:33:58,559 --> 00:34:02,960 new parameters, expected exchange rate 987 00:34:01,279 --> 00:34:04,319 and international interest rate, but now 988 00:34:02,960 --> 00:34:06,160 this is also function of the interest 989 00:34:04,319 --> 00:34:08,639 rate. So, at this moment I have one 990 00:34:06,160 --> 00:34:10,320 equation in two unknowns really after I 991 00:34:08,639 --> 00:34:11,839 solve out for the exchange rate. I have 992 00:34:10,320 --> 00:34:13,960 one equation and two unknowns. The two 993 00:34:11,840 --> 00:34:15,800 unknowns are output and the domestic 994 00:34:13,960 --> 00:34:17,679 interest rate. 995 00:34:15,800 --> 00:34:19,800 All the rest are parameters. 996 00:34:17,679 --> 00:34:21,599 So, that's the same situation we were at 997 00:34:19,800 --> 00:34:24,760 in lecture three or so. 998 00:34:21,599 --> 00:34:27,079 So, then we need an extra equation. 999 00:34:24,760 --> 00:34:28,560 The extra equation was monetary policy, 1000 00:34:27,079 --> 00:34:31,039 the LM. 1001 00:34:28,559 --> 00:34:32,358 We're going to do exactly the same here. 1002 00:34:31,039 --> 00:34:34,039 Okay, the LM is the same. It's the 1003 00:34:32,358 --> 00:34:37,639 domestic central bank 1004 00:34:34,039 --> 00:34:40,159 sets the interest rate. So, now I'm set. 1005 00:34:37,639 --> 00:34:42,239 Now we have the IS-LM model in the open 1006 00:34:40,159 --> 00:34:43,640 economy. This is the Mundell-Fleming 1007 00:34:42,239 --> 00:34:45,559 model, okay? That's what the 1008 00:34:43,639 --> 00:34:47,799 Mundell-Fleming model is. 1009 00:34:45,559 --> 00:34:47,799 So, 1010 00:34:47,960 --> 00:34:52,159 just a more complicated IS 1011 00:34:50,960 --> 00:34:55,039 with a 1012 00:34:52,159 --> 00:34:59,119 UIP 1013 00:34:55,039 --> 00:35:00,759 uh uh um driven exchange rate 1014 00:34:59,119 --> 00:35:03,119 and then the LM is the same as in the 1015 00:35:00,760 --> 00:35:05,280 closed economy. 1016 00:35:03,119 --> 00:35:05,279 Okay? 1017 00:35:05,358 --> 00:35:09,079 So, this is the Mundell-Fleming model. 1018 00:35:09,760 --> 00:35:14,359 So, notice that that So, one thing we 1019 00:35:12,599 --> 00:35:17,000 know already, we knew from the previous 1020 00:35:14,358 --> 00:35:18,639 lecture that that we have a smaller 1021 00:35:17,000 --> 00:35:19,840 multiplier in the open economy because 1022 00:35:18,639 --> 00:35:21,400 we have the imports that are also 1023 00:35:19,840 --> 00:35:22,640 responding to output. We have a new 1024 00:35:21,400 --> 00:35:24,680 parameter. 1025 00:35:22,639 --> 00:35:26,039 But now we also know that 1026 00:35:24,679 --> 00:35:28,599 an increase in the interest rate, so 1027 00:35:26,039 --> 00:35:30,920 monetary policy in the open economy has 1028 00:35:28,599 --> 00:35:32,319 two effects now. It used to have only 1029 00:35:30,920 --> 00:35:33,880 this effect. Remember, it affected the 1030 00:35:32,320 --> 00:35:35,359 domestic investment. So, an increase in 1031 00:35:33,880 --> 00:35:36,880 the interest rate 1032 00:35:35,358 --> 00:35:38,559 would lead to 1033 00:35:36,880 --> 00:35:40,160 uh um 1034 00:35:38,559 --> 00:35:42,079 a reduction in aggregate demand because 1035 00:35:40,159 --> 00:35:43,159 investment would fall. 1036 00:35:42,079 --> 00:35:44,559 Remember, that's what was the role of 1037 00:35:43,159 --> 00:35:46,440 the interest rate. 1038 00:35:44,559 --> 00:35:48,320 That's the way monetary policy worked in 1039 00:35:46,440 --> 00:35:50,358 the closed economy. It was through this 1040 00:35:48,320 --> 00:35:51,960 channel here. 1041 00:35:50,358 --> 00:35:54,440 Now we have a second channel, which is 1042 00:35:51,960 --> 00:35:54,440 this one. 1043 00:35:54,840 --> 00:35:58,559 So, when the interest rate goes up 1044 00:35:57,000 --> 00:36:00,800 it's contractionary for two reasons. 1045 00:35:58,559 --> 00:36:02,960 One, for the reason we had before, which 1046 00:36:00,800 --> 00:36:06,680 is that investment falls. But there is a 1047 00:36:02,960 --> 00:36:06,679 second reason it's contractionary. 1048 00:36:06,960 --> 00:36:09,920 What is that second reason? 1049 00:36:18,800 --> 00:36:23,160 I mean, it's only here. It's only second 1050 00:36:21,280 --> 00:36:24,519 Yeah. 1051 00:36:23,159 --> 00:36:25,440 It's because it appreciates the exchange 1052 00:36:24,519 --> 00:36:27,519 rate. And when you appreciate the 1053 00:36:25,440 --> 00:36:28,920 exchange rate, net exports decline. 1054 00:36:27,519 --> 00:36:31,358 Okay? So, more of the domestic 1055 00:36:28,920 --> 00:36:34,240 consumption is diverted to foreign goods 1056 00:36:31,358 --> 00:36:37,519 and less of foreign demand is is 1057 00:36:34,239 --> 00:36:38,879 allocated to our exports, okay? So, 1058 00:36:37,519 --> 00:36:40,119 that's the second channel. So, in an 1059 00:36:38,880 --> 00:36:41,840 open economy and the smaller is the 1060 00:36:40,119 --> 00:36:45,358 economy, the more important is this 1061 00:36:41,840 --> 00:36:47,519 term, the more powerful is that channel. 1062 00:36:45,358 --> 00:36:47,519 Okay? 1063 00:36:53,119 --> 00:36:56,599 The US cares very little about this 1064 00:36:54,760 --> 00:36:58,200 effect. 1065 00:36:56,599 --> 00:37:01,119 Most of the economies care a lot about 1066 00:36:58,199 --> 00:37:01,119 this effect, okay? 1067 00:37:01,559 --> 00:37:05,039 Because the US is a relatively closed 1068 00:37:03,119 --> 00:37:06,199 economy, believe it or not. 1069 00:37:05,039 --> 00:37:08,400 So, 1070 00:37:06,199 --> 00:37:11,279 this is sort of the start diagram of the 1071 00:37:08,400 --> 00:37:14,760 Mundell-Fleming model. 1072 00:37:11,280 --> 00:37:15,800 So, this thing here is our old IS-LM 1073 00:37:14,760 --> 00:37:17,120 model. 1074 00:37:15,800 --> 00:37:19,200 It's just that this IS is a little 1075 00:37:17,119 --> 00:37:20,639 thicker now. It has net exports in there 1076 00:37:19,199 --> 00:37:22,559 and so on, but it looks exactly the 1077 00:37:20,639 --> 00:37:24,639 same. That is 1078 00:37:22,559 --> 00:37:27,400 plots equilibrium in financial and and 1079 00:37:24,639 --> 00:37:29,679 and and the goods market 1080 00:37:27,400 --> 00:37:31,160 the combinations of output and domestic 1081 00:37:29,679 --> 00:37:32,559 interest rate that are consistent with 1082 00:37:31,159 --> 00:37:34,960 equilibrium 1083 00:37:32,559 --> 00:37:36,199 in in both markets. That's the case 1084 00:37:34,960 --> 00:37:37,440 here, okay? 1085 00:37:36,199 --> 00:37:39,239 This is the IS, which is all the 1086 00:37:37,440 --> 00:37:40,960 combinations of 1087 00:37:39,239 --> 00:37:41,959 domestic output and domestic interest 1088 00:37:40,960 --> 00:37:44,199 rate that are consistent with 1089 00:37:41,960 --> 00:37:45,280 equilibrium in goods market. 1090 00:37:44,199 --> 00:37:46,679 This is the interest rate that is 1091 00:37:45,280 --> 00:37:48,400 consistent with equilibrium in financial 1092 00:37:46,679 --> 00:37:49,759 markets. That's what the Fed does in the 1093 00:37:48,400 --> 00:37:53,000 US. 1094 00:37:49,760 --> 00:37:54,520 Uh that point is where both markets are 1095 00:37:53,000 --> 00:37:55,880 in equilibrium. 1096 00:37:54,519 --> 00:37:57,079 But we can take this interest rate. So, 1097 00:37:55,880 --> 00:37:58,519 that's what will happen. The interest 1098 00:37:57,079 --> 00:38:00,119 rate will be there in the US. The 1099 00:37:58,519 --> 00:38:02,039 interest rate is set by the Fed, not by 1100 00:38:00,119 --> 00:38:03,000 the ECB. The Fed will set the interest 1101 00:38:02,039 --> 00:38:04,358 rate. 1102 00:38:03,000 --> 00:38:06,400 That will give us some equilibrium 1103 00:38:04,358 --> 00:38:08,679 output. 1104 00:38:06,400 --> 00:38:10,680 And then we can go to the UIP condition, 1105 00:38:08,679 --> 00:38:13,079 you see I'm plotting here, and figure 1106 00:38:10,679 --> 00:38:15,440 out what the exchange rate is. 1107 00:38:13,079 --> 00:38:16,679 Because for this interest rate here 1108 00:38:15,440 --> 00:38:17,920 there's going to be some point in the 1109 00:38:16,679 --> 00:38:19,039 UIP 1110 00:38:17,920 --> 00:38:21,159 and that tells you exactly what the 1111 00:38:19,039 --> 00:38:22,079 exchange rate is. 1112 00:38:21,159 --> 00:38:25,079 Okay? 1113 00:38:22,079 --> 00:38:26,679 So, it with this set of diagrams I can 1114 00:38:25,079 --> 00:38:29,319 determine the interest rate, output, and 1115 00:38:26,679 --> 00:38:29,319 exchange rate. 1116 00:38:31,119 --> 00:38:35,639 So, I can study the effects of different 1117 00:38:32,960 --> 00:38:37,519 policies, for example, on output, the 1118 00:38:35,639 --> 00:38:39,599 interest rate, of course 1119 00:38:37,519 --> 00:38:41,400 that's the policy itself, and exchange 1120 00:38:39,599 --> 00:38:42,679 rate. So, this is the the new thing I 1121 00:38:41,400 --> 00:38:45,320 can explain. I can do a little bit of 1122 00:38:42,679 --> 00:38:46,319 asset pricing here. I can explain 1123 00:38:45,320 --> 00:38:48,080 the 1124 00:38:46,320 --> 00:38:49,559 the the behavior of the exchange rate as 1125 00:38:48,079 --> 00:38:51,719 well. 1126 00:38:49,559 --> 00:38:51,719 Okay? 1127 00:38:52,079 --> 00:38:55,880 So, this diagram, I mean, you need to 1128 00:38:53,719 --> 00:38:56,919 really control very very well. 1129 00:38:55,880 --> 00:38:57,880 So, that's what I'm going to play with 1130 00:38:56,920 --> 00:39:00,079 it 1131 00:38:57,880 --> 00:39:01,720 quite a bit. 1132 00:39:00,079 --> 00:39:03,159 Monetary policy. Let's do monetary 1133 00:39:01,719 --> 00:39:04,239 policy. We talked about monetary policy 1134 00:39:03,159 --> 00:39:06,839 already. 1135 00:39:04,239 --> 00:39:08,599 So, suppose that for whatever reason uh 1136 00:39:06,840 --> 00:39:11,240 the domestic economy 1137 00:39:08,599 --> 00:39:13,319 the domestic central bank 1138 00:39:11,239 --> 00:39:15,199 uh decides to hike interest rate. 1139 00:39:13,320 --> 00:39:17,080 Suppose the economy was overheating, 1140 00:39:15,199 --> 00:39:18,439 output was too high relative to natural 1141 00:39:17,079 --> 00:39:19,719 rate of output, 1142 00:39:18,440 --> 00:39:21,240 the typical reasons why you need to 1143 00:39:19,719 --> 00:39:22,679 raise interest rate. 1144 00:39:21,239 --> 00:39:24,319 And so, suppose that the domestic 1145 00:39:22,679 --> 00:39:26,199 interest rate goes up. 1146 00:39:24,320 --> 00:39:28,440 Well, as it used to be, that's going to 1147 00:39:26,199 --> 00:39:31,358 be contractionary. 1148 00:39:28,440 --> 00:39:32,639 What happens to the exchange rate? 1149 00:39:31,358 --> 00:39:35,358 Well, 1150 00:39:32,639 --> 00:39:38,960 I know the interest rate went up. 1151 00:39:35,358 --> 00:39:40,639 I go I look into my UIP for the higher 1152 00:39:38,960 --> 00:39:42,760 interest rate and in a current exchange 1153 00:39:40,639 --> 00:39:44,799 rate that is above 1154 00:39:42,760 --> 00:39:46,120 the old they has to go up relative to 1155 00:39:44,800 --> 00:39:47,360 all of them. When they When they 1156 00:39:46,119 --> 00:39:49,440 increase interest rate from here to 1157 00:39:47,360 --> 00:39:50,800 there, then my exchange rate has to 1158 00:39:49,440 --> 00:39:52,559 appreciate. 1159 00:39:50,800 --> 00:39:53,600 Why is that? 1160 00:39:52,559 --> 00:39:56,199 So, 1161 00:39:53,599 --> 00:39:58,920 an expansionary domestic monetary policy 1162 00:39:56,199 --> 00:40:01,719 will lead to a contraction in output, 1163 00:39:58,920 --> 00:40:02,639 which is what we get out of 1164 00:40:01,719 --> 00:40:05,039 uh 1165 00:40:02,639 --> 00:40:07,679 monetary policy, but it will also lead 1166 00:40:05,039 --> 00:40:10,159 to an appreciation of the currency. Why 1167 00:40:07,679 --> 00:40:10,159 is that? 1168 00:40:13,199 --> 00:40:18,639 That's what we just discussed. It's UIP. 1169 00:40:15,840 --> 00:40:20,120 If If I move the domestic interest rate 1170 00:40:18,639 --> 00:40:22,359 and the rest and the rest of world does 1171 00:40:20,119 --> 00:40:23,719 not follow me, so we move interest rate, 1172 00:40:22,360 --> 00:40:25,480 they don't, 1173 00:40:23,719 --> 00:40:26,480 then now I need to compensate for this 1174 00:40:25,480 --> 00:40:28,400 increase in the interest rate 1175 00:40:26,480 --> 00:40:31,480 differential and the compensation will 1176 00:40:28,400 --> 00:40:32,880 come through an expected capital loss at 1177 00:40:31,480 --> 00:40:34,360 through the currency. 1178 00:40:32,880 --> 00:40:35,599 So, if I appreciate more the currencies 1179 00:40:34,360 --> 00:40:38,120 and since I haven't moved the expected 1180 00:40:35,599 --> 00:40:40,159 exchange rate, I expect a larger loss 1181 00:40:38,119 --> 00:40:43,440 from the point of from the country's 1182 00:40:40,159 --> 00:40:45,000 from the currency side. Okay? 1183 00:40:43,440 --> 00:40:47,360 That's what it what has happened here. 1184 00:40:45,000 --> 00:40:48,719 So, that's what is behind depreciation. 1185 00:40:47,360 --> 00:40:50,640 And of course, the depreciation is 1186 00:40:48,719 --> 00:40:53,000 already built in here, 1187 00:40:50,639 --> 00:40:55,039 which is what uh 1188 00:40:53,000 --> 00:40:57,159 you know, 1189 00:40:55,039 --> 00:40:59,199 makes monetary policy more powerful than 1190 00:40:57,159 --> 00:41:00,960 the closed economy. Okay? Because you 1191 00:40:59,199 --> 00:41:03,759 get the net export channel, but that's 1192 00:41:00,960 --> 00:41:03,760 built in here. 1193 00:41:04,760 --> 00:41:08,600 Um 1194 00:41:06,239 --> 00:41:10,359 Okay, here all that I did is exactly the 1195 00:41:08,599 --> 00:41:13,480 same as we were doing in the last 30 1196 00:41:10,360 --> 00:41:15,400 minutes. I just used this this UIP. For 1197 00:41:13,480 --> 00:41:17,159 whatever domestic reason, I need to 1198 00:41:15,400 --> 00:41:18,000 raise interest rate, 1199 00:41:17,159 --> 00:41:19,719 uh 1200 00:41:18,000 --> 00:41:21,280 you know, I have contractionary monetary 1201 00:41:19,719 --> 00:41:23,079 policy. Well, one of the effects that 1202 00:41:21,280 --> 00:41:24,600 you're going to get in an open economy 1203 00:41:23,079 --> 00:41:25,759 is that your currency will tend to 1204 00:41:24,599 --> 00:41:28,599 appreciate. 1205 00:41:25,760 --> 00:41:28,600 Okay? Good. 1206 00:41:31,559 --> 00:41:35,079 What about fiscal policy? 1207 00:41:35,239 --> 00:41:37,959 Well, 1208 00:41:36,159 --> 00:41:39,759 if the Fed doesn't follow, if the 1209 00:41:37,960 --> 00:41:41,320 central bank doesn't follow, 1210 00:41:39,760 --> 00:41:42,640 and you had an expansionary fiscal 1211 00:41:41,320 --> 00:41:43,840 policy, 1212 00:41:42,639 --> 00:41:47,440 then 1213 00:41:43,840 --> 00:41:49,519 uh that will increase output. 1214 00:41:47,440 --> 00:41:51,000 It has no effect on the interest rate, 1215 00:41:49,519 --> 00:41:52,679 therefore has absolutely no effect on 1216 00:41:51,000 --> 00:41:55,159 the exchange rate. So, an expansionary 1217 00:41:52,679 --> 00:41:57,239 fiscal policy, which is accommodated by 1218 00:41:55,159 --> 00:41:58,920 the Fed, that means the interest rate is 1219 00:41:57,239 --> 00:42:00,479 kept at the same level, 1220 00:41:58,920 --> 00:42:01,519 then does not lead to an appreciation of 1221 00:42:00,480 --> 00:42:02,800 the currency. It doesn't move the 1222 00:42:01,519 --> 00:42:04,000 exchange rate. It has no implication for 1223 00:42:02,800 --> 00:42:06,360 the exchange rate. 1224 00:42:04,000 --> 00:42:06,360 Okay? 1225 00:42:08,800 --> 00:42:12,200 Now, what about this change in output? 1226 00:42:10,679 --> 00:42:15,679 Is it larger or smaller than the one we 1227 00:42:12,199 --> 00:42:15,679 did in lecture three or four? 1228 00:42:18,400 --> 00:42:21,680 It's smaller. Why? Uh because part of my 1229 00:42:20,719 --> 00:42:23,519 increase in 1230 00:42:21,679 --> 00:42:25,519 like uh demand falls on the foreign 1231 00:42:23,519 --> 00:42:26,920 Exactly, because yeah, it goes to 1232 00:42:25,519 --> 00:42:28,360 import. Perfect. 1233 00:42:26,920 --> 00:42:29,720 Okay, good. So, this is a smaller than 1234 00:42:28,360 --> 00:42:31,559 it was in the closed economy and it had 1235 00:42:29,719 --> 00:42:35,119 but it has no impact 1236 00:42:31,559 --> 00:42:37,880 on uh the exchange rate. 1237 00:42:35,119 --> 00:42:40,079 That is, the UIP has nothing to do 1238 00:42:37,880 --> 00:42:42,160 with going on expenditure. It's all 1239 00:42:40,079 --> 00:42:44,199 about financial markets. It's about 1240 00:42:42,159 --> 00:42:48,239 expected returns, things like that. So, 1241 00:42:44,199 --> 00:42:49,759 unless the fiscal policy somehow affects 1242 00:42:48,239 --> 00:42:50,319 interest rate, 1243 00:42:49,760 --> 00:42:53,240 uh 1244 00:42:50,320 --> 00:42:55,760 then there's no effect. What may happen 1245 00:42:53,239 --> 00:42:58,599 is that, for example, is that that, you 1246 00:42:55,760 --> 00:43:00,920 know, Treasury becomes very expansionary 1247 00:42:58,599 --> 00:43:02,960 and this output becomes too large for 1248 00:43:00,920 --> 00:43:06,200 what is consistent with a 1249 00:43:02,960 --> 00:43:08,079 a zero output gap or no inflation, and 1250 00:43:06,199 --> 00:43:10,199 then the Fed may react and raise 1251 00:43:08,079 --> 00:43:11,440 interest rate, and that will lead to an 1252 00:43:10,199 --> 00:43:12,679 appreciation of the exchange rate and so 1253 00:43:11,440 --> 00:43:14,000 on. And that's the reason why in 1254 00:43:12,679 --> 00:43:16,919 practice, 1255 00:43:14,000 --> 00:43:18,920 when countries have sort of expansionary 1256 00:43:16,920 --> 00:43:20,960 fiscal packages, they the currency tends 1257 00:43:18,920 --> 00:43:23,240 to appreciate. It's because 1258 00:43:20,960 --> 00:43:25,159 investors expect the Fed to react to 1259 00:43:23,239 --> 00:43:27,279 that or the central bank to react to 1260 00:43:25,159 --> 00:43:28,960 that and raise interest rate. But if the 1261 00:43:27,280 --> 00:43:30,080 Fed says, "No, no, we needed that fiscal 1262 00:43:28,960 --> 00:43:31,679 expansion. I'm not going to move the 1263 00:43:30,079 --> 00:43:34,159 interest rate," then the exchange rate 1264 00:43:31,679 --> 00:43:34,159 won't move. 1265 00:43:39,639 --> 00:43:43,319 So, let's look at Let's use a little 1266 00:43:41,639 --> 00:43:46,639 more this model and and look at other 1267 00:43:43,320 --> 00:43:46,640 shocks within this model. 1268 00:43:47,079 --> 00:43:51,279 So, 1269 00:43:48,440 --> 00:43:53,840 let's start with Suppose that that uh 1270 00:43:51,280 --> 00:43:56,519 we increase the expected exchange rate. 1271 00:43:53,840 --> 00:43:56,519 What moves? 1272 00:43:59,400 --> 00:44:02,119 In this diagram. 1273 00:44:04,440 --> 00:44:08,519 Let's go cur- cur- Does the LM move? 1274 00:44:16,159 --> 00:44:20,799 No. The LM is controlled by the domestic 1275 00:44:18,760 --> 00:44:24,000 central bank, doesn't move. 1276 00:44:20,800 --> 00:44:24,000 Does the IS move? 1277 00:44:25,599 --> 00:44:29,119 When When I ask you whether it moves, 1278 00:44:27,719 --> 00:44:30,759 you you should always fix something. So, 1279 00:44:29,119 --> 00:44:33,039 you say, "Okay, let me fix the interest 1280 00:44:30,760 --> 00:44:34,640 rate." Say, pick the point like this 1281 00:44:33,039 --> 00:44:36,279 one, say. 1282 00:44:34,639 --> 00:44:38,239 And now I have to ask the question, 1283 00:44:36,280 --> 00:44:39,640 "What happens to output now that I have 1284 00:44:38,239 --> 00:44:41,839 moved the expected exchange rate?" If I 1285 00:44:39,639 --> 00:44:43,759 get the same output back, means the IS 1286 00:44:41,840 --> 00:44:45,358 hasn't moved. If I get a different 1287 00:44:43,760 --> 00:44:48,880 output equilibrium output, then I can 1288 00:44:45,358 --> 00:44:52,000 tell you that the IS did move. 1289 00:44:48,880 --> 00:44:52,000 So, what is the answer? 1290 00:44:54,358 --> 00:44:57,880 If the interest rate doesn't move, the 1291 00:44:55,920 --> 00:44:59,440 foreign interest doesn't move, and 1292 00:44:57,880 --> 00:45:02,400 expected exchange rate goes up, what 1293 00:44:59,440 --> 00:45:04,400 happens to the current exchange rate? 1294 00:45:02,400 --> 00:45:05,599 Appreciates. 1295 00:45:04,400 --> 00:45:07,039 What happens when when there's an 1296 00:45:05,599 --> 00:45:09,199 appreciation? 1297 00:45:07,039 --> 00:45:10,759 Net exports decline. 1298 00:45:09,199 --> 00:45:14,639 That means that moves the IS to the 1299 00:45:10,760 --> 00:45:16,760 left. Okay? So, so so this movement will 1300 00:45:14,639 --> 00:45:18,879 move the IS to the left as a first 1301 00:45:16,760 --> 00:45:20,720 effect. 1302 00:45:18,880 --> 00:45:22,320 What about the UIP condition? Will it 1303 00:45:20,719 --> 00:45:23,679 move or not? We have taken that as a 1304 00:45:22,320 --> 00:45:26,000 parameter. 1305 00:45:23,679 --> 00:45:28,358 Will it move? 1306 00:45:26,000 --> 00:45:30,800 I mean, remember, I gave you a clue 1307 00:45:28,358 --> 00:45:32,719 because I said we are taking these two 1308 00:45:30,800 --> 00:45:34,920 as parameters here. 1309 00:45:32,719 --> 00:45:36,399 So, if I move a parameter, most likely I 1310 00:45:34,920 --> 00:45:38,000 will move the curve. 1311 00:45:36,400 --> 00:45:41,480 Okay? 1312 00:45:38,000 --> 00:45:41,480 But in which direction will it move? 1313 00:45:46,719 --> 00:45:51,399 To the right. Yes, because for the same 1314 00:45:49,679 --> 00:45:53,399 interest rate, 1315 00:45:51,400 --> 00:45:54,639 now I need the exchange rate to move one 1316 00:45:53,400 --> 00:45:56,519 for one, the current exchange rate to 1317 00:45:54,639 --> 00:45:58,159 move one for one with the expected 1318 00:45:56,519 --> 00:46:01,480 exchange rate, you know? 1319 00:45:58,159 --> 00:46:02,839 So, this was the exchange rate before, 1320 00:46:01,480 --> 00:46:04,679 and now the expected exchange rate moved 1321 00:46:02,840 --> 00:46:06,880 to the right. Well, in order not to 1322 00:46:04,679 --> 00:46:08,919 generate expected capital gain or loss, 1323 00:46:06,880 --> 00:46:10,960 I have to move the current exchange rate 1324 00:46:08,920 --> 00:46:13,720 by the same amount. And so, that means 1325 00:46:10,960 --> 00:46:17,599 this curve will shift to the right. 1326 00:46:13,719 --> 00:46:18,719 Okay? What if I move foreign output? 1327 00:46:17,599 --> 00:46:20,920 Down. 1328 00:46:18,719 --> 00:46:23,959 What happens? 1329 00:46:20,920 --> 00:46:27,119 Which curve moves? Well, this is not a 1330 00:46:23,960 --> 00:46:29,159 parameter here, so this is not moving. 1331 00:46:27,119 --> 00:46:30,880 This is not a parameter here, so this 1332 00:46:29,159 --> 00:46:34,759 one is not moving. 1333 00:46:30,880 --> 00:46:36,400 Only one can move. The IS. Where? 1334 00:46:34,760 --> 00:46:38,320 It will move to the left because net 1335 00:46:36,400 --> 00:46:39,800 exports will decline. 1336 00:46:38,320 --> 00:46:41,039 Now, for any given level of the interest 1337 00:46:39,800 --> 00:46:43,200 rate, now we're going to have less net 1338 00:46:41,039 --> 00:46:45,358 exports and therefore the IS moves to 1339 00:46:43,199 --> 00:46:47,079 the left. So, output falls. But there's 1340 00:46:45,358 --> 00:46:49,440 no movement here. 1341 00:46:47,079 --> 00:46:51,279 Unless the Fed reacts to that, 1342 00:46:49,440 --> 00:46:53,440 the central bank reacts to that, it 1343 00:46:51,280 --> 00:46:55,800 won't happen. 1344 00:46:53,440 --> 00:46:55,800 Okay? 1345 00:47:00,000 --> 00:47:03,519 I mean, and and and it may well be the 1346 00:47:01,920 --> 00:47:06,480 case that you want to react to that. If 1347 00:47:03,519 --> 00:47:08,400 If the whole world goes into recession, 1348 00:47:06,480 --> 00:47:11,119 the US is very likely to lower interest 1349 00:47:08,400 --> 00:47:11,960 rates because, you know, 1350 00:47:11,119 --> 00:47:13,319 it's 1351 00:47:11,960 --> 00:47:15,960 it's very contractionary if the whole 1352 00:47:13,320 --> 00:47:17,720 world goes into recession. 1353 00:47:15,960 --> 00:47:19,320 When the US goes into recession, the 1354 00:47:17,719 --> 00:47:21,358 rest of the world everyone wants to cut 1355 00:47:19,320 --> 00:47:23,400 interest rates because the US is a big 1356 00:47:21,358 --> 00:47:24,440 player. So, so it really drags everyone 1357 00:47:23,400 --> 00:47:26,639 down. 1358 00:47:24,440 --> 00:47:26,639 Okay? 1359 00:47:28,320 --> 00:47:30,720 Good. 1360 00:47:30,800 --> 00:47:34,200 The last one and I'm I'm going to repeat 1361 00:47:32,559 --> 00:47:37,159 this in the next lecture is, well, what 1362 00:47:34,199 --> 00:47:39,519 happens if the if I a star moves up? The 1363 00:47:37,159 --> 00:47:42,559 foreign interest rate moves up. 1364 00:47:39,519 --> 00:47:44,199 Well, the LM doesn't move. 1365 00:47:42,559 --> 00:47:45,840 This one will move. 1366 00:47:44,199 --> 00:47:49,199 Which way? 1367 00:47:45,840 --> 00:47:49,200 Because that was a parameter here. 1368 00:47:51,079 --> 00:47:53,799 To the right? 1369 00:47:54,400 --> 00:47:57,720 You said to the right, that's right. 1370 00:47:58,239 --> 00:48:02,079 Okay. No. 1371 00:47:59,639 --> 00:48:04,079 So, so 1372 00:48:02,079 --> 00:48:05,679 Think what happened here. If the foreign 1373 00:48:04,079 --> 00:48:09,039 interest rate goes up, 1374 00:48:05,679 --> 00:48:12,239 at any given interest rate, now the 1375 00:48:09,039 --> 00:48:14,239 domestic bond is worse than otherwise. 1376 00:48:12,239 --> 00:48:15,399 So, I need to depreciate the exchange 1377 00:48:14,239 --> 00:48:16,479 rate 1378 00:48:15,400 --> 00:48:18,160 today 1379 00:48:16,480 --> 00:48:21,440 in order to 1380 00:48:18,159 --> 00:48:21,440 expect an appreciation. 1381 00:48:21,840 --> 00:48:27,680 Okay? 1382 00:48:22,960 --> 00:48:29,960 That means this curve moves to the left. 1383 00:48:27,679 --> 00:48:29,960 Okay? 1384 00:48:30,000 --> 00:48:33,400 Okay, it moves to the left because I 1385 00:48:31,400 --> 00:48:34,800 have to expect an appreciation 1386 00:48:33,400 --> 00:48:37,039 to compensate for the interest rate 1387 00:48:34,800 --> 00:48:38,800 differential. 1388 00:48:37,039 --> 00:48:42,519 So, this will move to the left. 1389 00:48:38,800 --> 00:48:42,519 What about this curve here? 1390 00:48:43,960 --> 00:48:47,960 We solve it in the next lecture. 1391 00:48:49,440 --> 00:48:51,679 Good.