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