[00:17] Let's say let's start with the
[00:19] Mundell-Fleming model. Now this is a
[00:21] model that that
[00:23] I think it's extremely useful.
[00:26] And
[00:28] in the short term it will be important
[00:29] for you because it probably 70% of the
[00:32] quiz will be related to things that
[00:35] to this model. Meaning, you know, we're
[00:36] going to use this model for different
[00:38] things.
[00:39] But but but if you understand it well,
[00:42] you probably have 70% of the last quiz
[00:45] under control.
[00:46] So I'm going to go very slowly over it
[00:48] and please stop me if there's any step
[00:50] you don't understand. I I put the steps
[00:53] into myself so I don't
[00:54] rush because again I think it's
[00:56] important.
[00:57] Um
[00:59] to understand things.
[01:00] So here you have the exchange rate, two
[01:03] exchange rates.
[01:05] The the wide one is the
[01:08] the the
[01:10] the euro-dollar
[01:12] exchange rate.
[01:14] I'm quoting it the opposite of the way
[01:16] it's normally quoted. There are some
[01:18] conventions in effects markets but this
[01:20] is as we have defined in this course is
[01:22] if it goes up it means an appreciation
[01:24] of the local currency.
[01:26] That is the dollar.
[01:27] That is you get more of the foreign
[01:30] currency per unit of the domestic
[01:32] currency when it goes up.
[01:34] And down is a depreciation.
[01:36] And you see there that the so this is
[01:39] the the dollar became
[01:41] uh
[01:41] gained value relative to the euro
[01:43] through all this period and then it has
[01:45] lost quite a bit of value uh since sort
[01:48] of late 2022.
[01:51] For for with respect to the Japanese
[01:53] yen, that's the blue line, it's was the
[01:55] whole cycle is even more dramatic, no?
[01:57] Big appreciation of the dollar.
[01:59] Depreciation of the yen.
[02:02] Uh and and a reversal
[02:05] uh
[02:06] since late 2022 and so on.
[02:09] So what is behind this this big
[02:12] fluctuations?
[02:13] Many things. Effects are volatile like
[02:15] almost any asset price. But one of the
[02:18] main drivers of this uh
[02:20] of of of these fluctuations is
[02:23] perceptions about interest rate policy
[02:24] in the different parts of the world.
[02:26] Okay?
[02:27] So
[02:28] uh the reason we have seen a lot of this
[02:31] decline here.
[02:33] So the reason for the rise here of the
[02:35] dollar is mostly because
[02:37] investors in general perceived that the
[02:39] US was more advanced in its business
[02:42] cycle. It began to tighten interest rate
[02:43] before the rest of the world.
[02:45] And since interest rates were rising in
[02:48] in the US, that led to an appreciation
[02:50] of the dollar.
[02:51] By a mechanism they described at the end
[02:54] of the previous lecture but I'm going to
[02:56] repeat today. Remember when I talked
[02:58] about the uncovered interest rate parity
[02:59] condition? Well, it's related to what
[03:01] I'm talking about here.
[03:03] I'm going to again go go again over
[03:05] that. And a big reason for the decline
[03:07] more recently is simply that there's a
[03:11] sense that monetary policy is peaking in
[03:13] the US in terms of tightness while the
[03:15] rest of the world is catching up. Uh and
[03:18] and in the case of Europe more than
[03:20] catching up because they have further
[03:22] supply shocks coming from energy shocks
[03:24] and so on.
[03:26] So if you look for example at the
[03:27] expected in policy rate path in the case
[03:30] of the US
[03:32] nowadays
[03:33] it looks like this. So the still market
[03:35] expect some hike some hikes in the US
[03:38] but a limited amount of hikes and then
[03:40] they expect quickly the Fed to start
[03:42] undoing that. Okay? That's what this
[03:44] path is telling you. This is expected
[03:46] policy rate path. What the market thinks
[03:49] now the policy rate will be in the next
[03:51] meeting, two meetings from now, three
[03:53] meetings from now, four meetings
[03:54] meetings of the FOMC
[03:56] uh
[03:57] from now. Okay? Well, if you look at the
[03:59] same picture in Europe, it looks like
[04:00] that. It's clear that they are they are
[04:02] still there is more ahead.
[04:04] And and then you see sort of that that's
[04:07] what the market perceive at this point.
[04:09] Whether that ends up being true or not
[04:11] doesn't matter. At any point in time the
[04:13] exchange rate is determined by what the
[04:14] markets think. So so what actually
[04:17] happens is less important for an asset
[04:19] price. An asset price is a lot about
[04:21] pricing today is things that you expect
[04:23] to happen in the future. Uh what it
[04:25] expects what you expect is what matters,
[04:27] not what actually happens. And at this
[04:28] moment the market expect uh
[04:32] the euro area to go through a
[04:34] sort of a more prolonged periods of
[04:36] hiking interest rate hiking.
[04:38] Japan hasn't had hikes in interest rate
[04:40] for three three decades but even now you
[04:43] start you begin to see some
[04:45] you know,
[04:46] the scale here is very small. These are
[04:48] a few basis points. But even the point
[04:50] I'm trying to make is that certainly
[04:52] that
[04:53] people expect interest rates in the US
[04:55] to go down relative to interest rates in
[04:57] Japan.
[04:59] Not to say that the interest rate in the
[05:00] US will be lower than the interest rate
[05:02] in Japan but the direction of the change
[05:04] is in that way. So relative to where
[05:05] we're at now
[05:07] the direction of the change is is is is
[05:10] towards the US loosening monetary policy
[05:14] uh before the rest of the world does.
[05:16] Okay? And and that's what is leading to
[05:18] these big swings.
[05:21] As I said before you know, this is the
[05:23] period in which the US had to start
[05:24] tightening before the rest and and the
[05:27] currency appreciated a lot especially
[05:29] with respect to the yen because again
[05:30] the yen has been against the zero lower
[05:32] bound for a very long time. So nobody
[05:34] expected the yen to move to follow the
[05:36] US.
[05:37] And and and while with respect to
[05:39] Europe, well Europe was having
[05:40] inflationary problems and so on as well.
[05:42] So people expected it to follow the US
[05:44] at some point. For Japan, there was
[05:47] nothing like that and that's what led to
[05:48] the massive depreciation of the yen.
[05:51] Appreciation of the US dollar vis-a-vis
[05:53] the yen.
[05:54] Okay?
[05:54] So what we the Mundell-Fleming model is
[05:57] about is about first connecting these
[06:00] things, trying to understand what moves
[06:01] exchange rate, how different monetary
[06:03] policies in different places or
[06:05] different policies in different places
[06:06] of the world affect exchange rate. And
[06:09] then it's about understanding how those
[06:11] exchange rate movements affect real
[06:13] activity. Okay?
[06:15] In the short run.
[06:16] That's what the Mundell-Fleming model
[06:18] is. So it is really we're going to go
[06:20] back to our old IS-LM model. Very short
[06:24] run. We're going to even fix nominal
[06:25] prices and so on. So back to that
[06:28] environment. But we're going to do it in
[06:29] an open economy so we're going to have a
[06:31] new variable floating around which is
[06:33] the exchange rate. And and and we need
[06:35] to understand how the exchange rate
[06:36] moves when you different things happen
[06:37] in different countries. And the and and
[06:40] what is the impact of that on aggregate
[06:42] demand and hence in on output. We're
[06:44] talking about the very short run
[06:46] in the different parts of the world.
[06:48] Okay? That's the plan. That's what we
[06:50] intend to
[06:52] So let's start with the this
[06:53] Mundell-Fleming model. Remember we we
[06:56] wrote down
[06:57] uh the equilibrium in the goods market
[07:00] in the previous lecture and and and
[07:02] that's that's I'm just reproducing what
[07:04] I wrote in the previous lecture. So it
[07:06] looks exactly like the closed economy.
[07:08] Output is determined by aggregate
[07:09] demand. But it's aggregate demand for
[07:11] domestically produced goods.
[07:13] Domestically produced goods is now the
[07:15] is not the same as domestic demand
[07:18] for goods which is this. Because now
[07:20] there's a net export term. So part of
[07:22] the things that the that
[07:25] residents sort of demand they they
[07:27] demand from the rest of the world, not
[07:29] from domestic producers.
[07:30] And at the same time part of the demand
[07:32] perceived by domestic producers comes
[07:34] from the rest of the world, from
[07:35] exports, not from domestic producers. So
[07:37] that's the reason we got an extra term
[07:38] here which is this net exports.
[07:41] And we said this net exports is a
[07:43] function of three things.
[07:44] It's a function of output.
[07:47] Okay?
[07:49] And it's a it's a decreasing function of
[07:51] output. Why is that?
[07:53] Of domestic output.
[07:57] Domestic output, domestic income. Why
[08:00] isn't that decreasing function of
[08:01] domestic income?
[08:08] Why do net exports decline when domestic
[08:10] income rises?
[08:17] They buy they import more. They consume
[08:19] everything more but part of that is
[08:20] imports.
[08:21] And so part of that energy of the extra
[08:23] demand goes to foreign goods and that's
[08:26] what deteriorates net exports. Okay? And
[08:28] that's the reason we said had Had we
[08:30] just stopped there, made the net export
[08:32] function just a function of output, we
[08:34] would have not needed all this extra
[08:36] apparatus that I'm about to build
[08:38] because all that would have meant is
[08:39] that just we have a smaller multiplier.
[08:42] It would have been exactly the same as
[08:43] we did in the closed economy but with a
[08:45] smaller multiplier because you know,
[08:47] every time an output goes up now part of
[08:49] that demand goes to foreign goods rather
[08:51] than domestic goods.
[08:54] But it's not so.
[08:56] First because we have an extra another
[08:59] income that matters here which is the
[09:00] income of the rest of the world.
[09:03] Uh but more important because we also
[09:05] have an exchange rate. But let's start
[09:06] from this side. So net exports is
[09:09] increasing in the income of the rest of
[09:10] the world. Why is that?
[09:15] That is demand for domestically produced
[09:17] good rises when foreign income goes up.
[09:22] Foreign output foreign income goes up.
[09:23] Why is that?
[09:29] It's a symmetric argument, no?
[09:31] If with with imports, well
[09:34] our exports are the imports of the other
[09:36] country. So if the income in the other
[09:39] country goes up then their their imports
[09:42] will go up which is our exports that go
[09:44] up. That's the reason net exports uh
[09:47] goes up.
[09:49] And the last term
[09:51] remember
[09:52] uh is that says that net exports is
[09:56] declining
[09:57] on the real exchange rate.
[09:59] 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.