WEBVTT

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Let's say let's start with the

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Mundell-Fleming model. Now this is a

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model that that

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I think it's extremely useful.

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And

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in the short term it will be important

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for you because it probably 70% of the

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quiz will be related to things that

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to this model. Meaning, you know, we're

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going to use this model for different

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things.

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But but but if you understand it well,

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you probably have 70% of the last quiz

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under control.

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So I'm going to go very slowly over it

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and please stop me if there's any step

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you don't understand. I I put the steps

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into myself so I don't

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rush because again I think it's

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important.

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Um

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to understand things.

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So here you have the exchange rate, two

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exchange rates.

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The the wide one is the

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the the

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the euro-dollar

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exchange rate.

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I'm quoting it the opposite of the way

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it's normally quoted. There are some

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conventions in effects markets but this

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is as we have defined in this course is

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if it goes up it means an appreciation

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of the local currency.

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That is the dollar.

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That is you get more of the foreign

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currency per unit of the domestic

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currency when it goes up.

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And down is a depreciation.

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And you see there that the so this is

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the the dollar became

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uh

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gained value relative to the euro

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through all this period and then it has

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lost quite a bit of value uh since sort

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of late 2022.

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For for with respect to the Japanese

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yen, that's the blue line, it's was the

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whole cycle is even more dramatic, no?

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Big appreciation of the dollar.

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Depreciation of the yen.

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Uh and and a reversal

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uh

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since late 2022 and so on.

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So what is behind this this big

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fluctuations?

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Many things. Effects are volatile like

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almost any asset price. But one of the

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main drivers of this uh

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of of of these fluctuations is

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perceptions about interest rate policy

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in the different parts of the world.

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Okay?

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So

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uh the reason we have seen a lot of this

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decline here.

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So the reason for the rise here of the

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dollar is mostly because

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investors in general perceived that the

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US was more advanced in its business

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cycle. It began to tighten interest rate

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before the rest of the world.

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And since interest rates were rising in

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in the US, that led to an appreciation

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of the dollar.

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By a mechanism they described at the end

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of the previous lecture but I'm going to

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repeat today. Remember when I talked

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about the uncovered interest rate parity

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condition? Well, it's related to what

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I'm talking about here.

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I'm going to again go go again over

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that. And a big reason for the decline

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more recently is simply that there's a

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sense that monetary policy is peaking in

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the US in terms of tightness while the

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rest of the world is catching up. Uh and

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and in the case of Europe more than

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catching up because they have further

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supply shocks coming from energy shocks

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and so on.

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So if you look for example at the

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expected in policy rate path in the case

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of the US

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nowadays

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it looks like this. So the still market

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expect some hike some hikes in the US

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but a limited amount of hikes and then

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they expect quickly the Fed to start

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undoing that. Okay? That's what this

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path is telling you. This is expected

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policy rate path. What the market thinks

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now the policy rate will be in the next

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meeting, two meetings from now, three

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meetings from now, four meetings

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meetings of the FOMC

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uh

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from now. Okay? Well, if you look at the

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same picture in Europe, it looks like

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that. It's clear that they are they are

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still there is more ahead.

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And and then you see sort of that that's

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what the market perceive at this point.

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Whether that ends up being true or not

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doesn't matter. At any point in time the

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exchange rate is determined by what the

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markets think. So so what actually

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happens is less important for an asset

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price. An asset price is a lot about

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pricing today is things that you expect

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to happen in the future. Uh what it

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expects what you expect is what matters,

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not what actually happens. And at this

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moment the market expect uh

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the euro area to go through a

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sort of a more prolonged periods of

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hiking interest rate hiking.

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Japan hasn't had hikes in interest rate

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for three three decades but even now you

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start you begin to see some

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you know,

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the scale here is very small. These are

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a few basis points. But even the point

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I'm trying to make is that certainly

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that

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people expect interest rates in the US

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to go down relative to interest rates in

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Japan.

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Not to say that the interest rate in the

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US will be lower than the interest rate

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in Japan but the direction of the change

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is in that way. So relative to where

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we're at now

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the direction of the change is is is is

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towards the US loosening monetary policy

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uh before the rest of the world does.

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Okay? And and that's what is leading to

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these big swings.

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As I said before you know, this is the

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period in which the US had to start

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tightening before the rest and and the

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currency appreciated a lot especially

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with respect to the yen because again

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the yen has been against the zero lower

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bound for a very long time. So nobody

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expected the yen to move to follow the

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US.

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And and and while with respect to

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Europe, well Europe was having

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inflationary problems and so on as well.

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So people expected it to follow the US

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at some point. For Japan, there was

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nothing like that and that's what led to

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the massive depreciation of the yen.

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Appreciation of the US dollar vis-a-vis

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the yen.

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Okay?

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So what we the Mundell-Fleming model is

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about is about first connecting these

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things, trying to understand what moves

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exchange rate, how different monetary

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policies in different places or

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different policies in different places

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of the world affect exchange rate. And

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then it's about understanding how those

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exchange rate movements affect real

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activity. Okay?

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In the short run.

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That's what the Mundell-Fleming model

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is. So it is really we're going to go

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back to our old IS-LM model. Very short

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run. We're going to even fix nominal

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prices and so on. So back to that

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environment. But we're going to do it in

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an open economy so we're going to have a

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new variable floating around which is

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the exchange rate. And and and we need

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to understand how the exchange rate

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moves when you different things happen

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in different countries. And the and and

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what is the impact of that on aggregate

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demand and hence in on output. We're

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talking about the very short run

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in the different parts of the world.

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Okay? That's the plan. That's what we

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intend to

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So let's start with the this

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Mundell-Fleming model. Remember we we

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wrote down

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uh the equilibrium in the goods market

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in the previous lecture and and and

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that's that's I'm just reproducing what

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I wrote in the previous lecture. So it

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looks exactly like the closed economy.

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Output is determined by aggregate

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demand. But it's aggregate demand for

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domestically produced goods.

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Domestically produced goods is now the

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is not the same as domestic demand

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for goods which is this. Because now

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there's a net export term. So part of

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the things that the that

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residents sort of demand they they

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demand from the rest of the world, not

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from domestic producers.

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And at the same time part of the demand

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perceived by domestic producers comes

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from the rest of the world, from

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exports, not from domestic producers. So

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that's the reason we got an extra term

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here which is this net exports.

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And we said this net exports is a

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function of three things.

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It's a function of output.

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Okay?

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And it's a it's a decreasing function of

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output. Why is that?

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Of domestic output.

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Domestic output, domestic income. Why

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isn't that decreasing function of

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domestic income?

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Why do net exports decline when domestic

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income rises?

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They buy they import more. They consume

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everything more but part of that is

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imports.

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And so part of that energy of the extra

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demand goes to foreign goods and that's

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what deteriorates net exports. Okay? And

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that's the reason we said had Had we

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just stopped there, made the net export

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function just a function of output, we

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would have not needed all this extra

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apparatus that I'm about to build

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because all that would have meant is

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that just we have a smaller multiplier.

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It would have been exactly the same as

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we did in the closed economy but with a

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smaller multiplier because you know,

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every time an output goes up now part of

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that demand goes to foreign goods rather

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than domestic goods.

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But it's not so.

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First because we have an extra another

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income that matters here which is the

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income of the rest of the world.

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Uh but more important because we also

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have an exchange rate. But let's start

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from this side. So net exports is

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increasing in the income of the rest of

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the world. Why is that?

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That is demand for domestically produced

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good rises when foreign income goes up.

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Foreign output foreign income goes up.

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Why is that?

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It's a symmetric argument, no?

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If with with imports, well

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our exports are the imports of the other

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country. So if the income in the other

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country goes up then their their imports

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will go up which is our exports that go

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up. That's the reason net exports uh

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goes up.

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And the last term

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remember

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uh is that says that net exports is

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declining

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on the real exchange rate.

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Why is that?

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What happens when the real exchange rate

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goes up?

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Net exports are going to be more

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expensive relative to foreign goods.

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Exactly. Our goods become more expensive

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relative to foreign goods and that

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affects us from two dimensions. First,

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our exports will tend to decline because

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our goods are more expensive and also

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our imports are going to tend to

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increase because foreign goods are

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cheaper. Okay? And so that's the reason

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this

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is decreasing with respect to the

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exchange rate.

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The big thing of the Mundell-Fleming

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model really comes from the fact that

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this guy is there. We Had we not had the

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exchange rate there, again we could have

00:10:37.519 --> 00:10:40.039
used exactly the same apparatus as we

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used

00:10:40.039 --> 00:10:42.319
earlier on.

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But we're going to have an exchange rate

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floating around and that will require us

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that to to build more

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a little more. We need an extra

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equation, you know, because we have an

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extra endogenous variable.

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Now, what I'm going to assume here

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as we did in in in the first part of the

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course is that both the domestic and

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foreign prices are completely fixed. So,

00:11:00.679 --> 00:11:03.838
I'm going to ignore Phillips curve,

00:11:02.039 --> 00:11:05.439
inflation, expected inflation and all

00:11:03.839 --> 00:11:08.280
that. Okay? I'm going to assume all that

00:11:05.440 --> 00:11:09.440
is zero. Expected inflation, inflation,

00:11:08.279 --> 00:11:11.079
zero.

00:11:09.440 --> 00:11:12.839
When I do that,

00:11:11.080 --> 00:11:14.600
the same equation, the equilibrium in

00:11:12.839 --> 00:11:16.400
the goods markets,

00:11:14.600 --> 00:11:18.000
changes a little bit. I mean, it's the

00:11:16.399 --> 00:11:20.079
same equation, but now I don't need to

00:11:18.000 --> 00:11:21.519
differentiate between real interest rate

00:11:20.080 --> 00:11:23.720
and nominal interest rate because

00:11:21.519 --> 00:11:25.039
inflation is zero. So, nominal interest

00:11:23.720 --> 00:11:26.200
rate is equal to the real interest rate.

00:11:25.039 --> 00:11:27.959
So, I'm going to stick in here the

00:11:26.200 --> 00:11:30.480
nominal interest rate.

00:11:27.960 --> 00:11:31.839
Second, I really don't

00:11:30.480 --> 00:11:34.200
need to differentiate between real

00:11:31.839 --> 00:11:36.200
exchange rate and nominal exchange rate

00:11:34.200 --> 00:11:38.200
because the relative prices, the prices

00:11:36.200 --> 00:11:40.160
themselves are not changing and so all

00:11:38.200 --> 00:11:42.520
that will move the the real exchange

00:11:40.159 --> 00:11:44.639
rate is the nominal exchange rate. Okay?

00:11:42.519 --> 00:11:47.399
So, that's the reason I'm going to write

00:11:44.639 --> 00:11:49.120
here the the nominal exchange rate

00:11:47.399 --> 00:11:51.039
is because it's the only thing that will

00:11:49.120 --> 00:11:53.000
move this variable around given that

00:11:51.039 --> 00:11:54.120
prices are fixed.

00:11:53.000 --> 00:11:56.799
Okay?

00:11:54.120 --> 00:11:58.200
So, that's my our equilibrium in the

00:11:56.799 --> 00:11:59.838
goods market and this is the thing you

00:11:58.200 --> 00:12:01.800
need to compare with, you know, lecture

00:11:59.839 --> 00:12:04.480
three or something like that. And as I

00:12:01.799 --> 00:12:06.799
said, this part here only lowers the

00:12:04.480 --> 00:12:08.399
multiplier, so not a big change. This

00:12:06.799 --> 00:12:09.279
one here is an extra parameter that

00:12:08.399 --> 00:12:11.039
shifts

00:12:09.279 --> 00:12:13.519
aggregate demand up and down, so you can

00:12:11.039 --> 00:12:15.480
treat it almost like we treated C0.

00:12:13.519 --> 00:12:17.799
Remember, if the consumer confidence

00:12:15.480 --> 00:12:19.560
goes up, then aggregate demand goes up.

00:12:17.799 --> 00:12:21.240
Well, here we have sort of the rest of

00:12:19.559 --> 00:12:23.439
the world's output goes up. It does

00:12:21.240 --> 00:12:24.839
exactly the same the same analysis.

00:12:23.440 --> 00:12:26.800
The problem we have though is that we

00:12:24.839 --> 00:12:27.920
have an extra variable here, which is

00:12:26.799 --> 00:12:30.159
the exchange rate and that's an

00:12:27.919 --> 00:12:32.079
endogenous variable. Okay? So, we're

00:12:30.159 --> 00:12:33.360
going to have to come up with some other

00:12:32.080 --> 00:12:36.759
equation

00:12:33.360 --> 00:12:39.080
to solve for that equation here. In in

00:12:36.759 --> 00:12:40.679
lecture three or four, what we did is,

00:12:39.080 --> 00:12:43.600
okay, we said we have two endogenous

00:12:40.679 --> 00:12:45.759
variables, output and the interest rate

00:12:43.600 --> 00:12:47.279
if we output and the interest rate, we

00:12:45.759 --> 00:12:49.000
need one more equation. Well, the other

00:12:47.279 --> 00:12:51.319
equation was just monetary policy that

00:12:49.000 --> 00:12:53.360
set the nominal interest rate.

00:12:51.320 --> 00:12:55.400
Here, that's not going to be enough

00:12:53.360 --> 00:12:57.159
because we also have an exchange rate

00:12:55.399 --> 00:12:59.159
floating around. Okay? So, and we need

00:12:57.159 --> 00:13:01.319
to bring another equation here

00:12:59.159 --> 00:13:03.240
uh

00:13:01.320 --> 00:13:05.240
to deal with this this new endogenous

00:13:03.240 --> 00:13:07.440
variable.

00:13:05.240 --> 00:13:09.320
What is that extra equation?

00:13:07.440 --> 00:13:10.760
Well, is the uncovered interest parity

00:13:09.320 --> 00:13:13.280
condition. Remember, it's the last

00:13:10.759 --> 00:13:14.799
expression we had in in in the previous

00:13:13.279 --> 00:13:15.600
lecture

00:13:14.799 --> 00:13:18.240
uh

00:13:15.600 --> 00:13:20.600
that takes this form.

00:13:18.240 --> 00:13:22.720
Okay? It says

00:13:20.600 --> 00:13:24.320
I Before I simplify lots of things, I

00:13:22.720 --> 00:13:26.839
wrote this down.

00:13:24.320 --> 00:13:28.640
And it says that the exchange rate

00:13:26.839 --> 00:13:31.480
is uh

00:13:28.639 --> 00:13:33.039
is equal to that. Okay?

00:13:31.480 --> 00:13:36.519
Now, what what is this

00:13:33.039 --> 00:13:39.360
Where does this equation come from?

00:13:36.519 --> 00:13:41.439
What is it trying to do?

00:13:39.360 --> 00:13:43.320
Remember, we talked we we talked about

00:13:41.440 --> 00:13:45.200
this in the context and say, well, you

00:13:43.320 --> 00:13:46.320
know, when you open goods markets and

00:13:45.200 --> 00:13:47.800
you need a relative price to decide

00:13:46.320 --> 00:13:50.720
where you're going to buy.

00:13:47.799 --> 00:13:52.719
That's what what

00:13:50.720 --> 00:13:55.000
the real exchange rate did.

00:13:52.720 --> 00:13:56.800
And and and now that then then we opened

00:13:55.000 --> 00:13:58.120
the capital account and then you need to

00:13:56.799 --> 00:14:00.120
people need to decide where they're

00:13:58.120 --> 00:14:03.600
going to invest their money. And that

00:14:00.120 --> 00:14:03.600
equation was related to that.

00:14:03.720 --> 00:14:06.879
The expected rate of return has to be

00:14:05.039 --> 00:14:08.519
the same for like domestic Exactly. It's

00:14:06.879 --> 00:14:10.639
what equalizes expected rate of return.

00:14:08.519 --> 00:14:13.159
In equilibrium, that has to happen.

00:14:10.639 --> 00:14:14.439
Okay? Again, in reality, there is risk

00:14:13.159 --> 00:14:16.759
adjustment, there is lots of other

00:14:14.440 --> 00:14:19.000
factors that we're removing from here.

00:14:16.759 --> 00:14:20.519
But absent those other factors,

00:14:19.000 --> 00:14:22.159
the the returns have to be similar in

00:14:20.519 --> 00:14:23.399
both places because if one asset is

00:14:22.159 --> 00:14:25.919
giving more return than the other

00:14:23.399 --> 00:14:27.078
expected return, then then then people

00:14:25.919 --> 00:14:29.199
are going to invest all their portfolios

00:14:27.078 --> 00:14:32.120
in that asset. And what happens is those

00:14:29.200 --> 00:14:33.759
flows that try to go to the worst those

00:14:32.120 --> 00:14:35.919
assets that give the highest return and

00:14:33.759 --> 00:14:36.919
that equalizing expected return in

00:14:35.919 --> 00:14:39.479
equilibrium.

00:14:36.919 --> 00:14:42.120
And that's the equation that does that.

00:14:39.480 --> 00:14:43.279
Exactly that. How do I know that? Well,

00:14:42.120 --> 00:14:46.560
remember,

00:14:43.279 --> 00:14:48.720
uh I can divide this by the exchange

00:14:46.559 --> 00:14:50.639
rate on both sides and then what you get

00:14:48.720 --> 00:14:52.800
is one

00:14:50.639 --> 00:14:54.958
equal to a numerator that has the

00:14:52.799 --> 00:14:57.439
nominal exchange rate

00:14:54.958 --> 00:14:59.719
times the expected appreciation of the

00:14:57.440 --> 00:15:01.480
currency plus

00:14:59.720 --> 00:15:03.160
and in the denominator you have the the

00:15:01.480 --> 00:15:04.759
the foreign interest rate.

00:15:03.159 --> 00:15:06.719
And so, you have to when you compare the

00:15:04.759 --> 00:15:07.919
two, you have to compare

00:15:06.720 --> 00:15:09.519
one

00:15:07.919 --> 00:15:11.120
base interest rate, either the domestic

00:15:09.519 --> 00:15:12.600
or the foreign, plus the expected

00:15:11.120 --> 00:15:14.159
appreciation or depreciation of that

00:15:12.600 --> 00:15:15.360
currency. And that's what this term is

00:15:14.159 --> 00:15:19.000
doing here.

00:15:15.360 --> 00:15:19.000
This divided by that. Okay?

00:15:19.320 --> 00:15:22.760
Good. So, what do we get out of this? Uh

00:15:21.320 --> 00:15:24.920
one thing we're going to do for for

00:15:22.759 --> 00:15:26.879
quite a while because it will simplify

00:15:24.919 --> 00:15:31.039
things a lot, but sometimes also lead to

00:15:26.879 --> 00:15:32.838
confusion in in in in

00:15:31.039 --> 00:15:35.599
in the way we understand why currencies

00:15:32.839 --> 00:15:37.640
depreciate or appreciate, but we will

00:15:35.600 --> 00:15:39.519
pause and and I'll remind you of this

00:15:37.639 --> 00:15:40.480
repeatedly. We're going to assume for

00:15:39.519 --> 00:15:41.679
now

00:15:40.480 --> 00:15:44.120
that the

00:15:41.679 --> 00:15:45.519
expected exchange rate for T plus one is

00:15:44.120 --> 00:15:47.799
fixed.

00:15:45.519 --> 00:15:49.199
Okay? And and until I tell you

00:15:47.799 --> 00:15:52.479
otherwise,

00:15:49.200 --> 00:15:52.480
we're going to make this assumption.

00:15:53.279 --> 00:15:56.360
Now,

00:15:54.000 --> 00:15:59.320
that's a huge simplification, completely

00:15:56.360 --> 00:16:01.759
unrealistic, and so on. But it will help

00:15:59.320 --> 00:16:02.720
me explain the mechanism.

00:16:01.759 --> 00:16:04.078
I mean, one of the things that moves

00:16:02.720 --> 00:16:05.480
exchange rates a lot is that people have

00:16:04.078 --> 00:16:08.359
lots of expectations about future

00:16:05.480 --> 00:16:10.159
exchange rate. We'll get to that later.

00:16:08.360 --> 00:16:12.480
But for now, so you understand the

00:16:10.159 --> 00:16:13.519
mechanism, how the Mundell-Fleming model

00:16:12.480 --> 00:16:15.360
works,

00:16:13.519 --> 00:16:17.000
I'm going to assume that we all know

00:16:15.360 --> 00:16:18.440
what the expected exchange rate We all

00:16:17.000 --> 00:16:20.320
We all have a common expected exchange

00:16:18.440 --> 00:16:22.440
rate and it's fixed.

00:16:20.320 --> 00:16:24.600
Okay?

00:16:22.440 --> 00:16:26.800
We may move it as a parameter, but I

00:16:24.600 --> 00:16:28.879
won't say I'm not going to endogenize

00:16:26.799 --> 00:16:31.078
that. I'm going to take it as fixed

00:16:28.879 --> 00:16:33.240
and I I may move it around to show you

00:16:31.078 --> 00:16:35.039
what happens when that changes, but I'm

00:16:33.240 --> 00:16:37.279
not going to endogenize it.

00:16:35.039 --> 00:16:37.279
Okay?

00:16:38.039 --> 00:16:43.199
Otherwise, I need more equations.

00:16:39.919 --> 00:16:45.000
One more. I want to stop this this this

00:16:43.200 --> 00:16:47.480
sequence of equations that I would have

00:16:45.000 --> 00:16:49.399
to build, but

00:16:47.480 --> 00:16:51.480
later we'll understand more that what I

00:16:49.399 --> 00:16:53.039
just said, but but for now, just take

00:16:51.480 --> 00:16:54.879
this as fixed. So, if I take this as

00:16:53.039 --> 00:16:57.000
fixed, now I have an equation. Remember,

00:16:54.879 --> 00:17:00.200
we was looking for an equation

00:16:57.000 --> 00:17:01.839
here for my exchange rate.

00:17:00.200 --> 00:17:02.879
Once I do that, then I have what I

00:17:01.839 --> 00:17:04.640
wanted.

00:17:02.879 --> 00:17:06.199
I have an equation for my exchange rate

00:17:04.640 --> 00:17:07.400
today. It's just

00:17:06.199 --> 00:17:08.920
function of

00:17:07.400 --> 00:17:10.280
domestic interest rate, international

00:17:08.920 --> 00:17:12.400
interest rate,

00:17:10.279 --> 00:17:13.399
and the expected exchange rate.

00:17:12.400 --> 00:17:15.439
Okay?

00:17:13.400 --> 00:17:17.120
So, I know the following, for example. I

00:17:15.439 --> 00:17:18.720
know that an increase in the domestic

00:17:17.119 --> 00:17:20.438
interest rate,

00:17:18.720 --> 00:17:22.319
other things equal,

00:17:20.439 --> 00:17:23.720
appreciates exchange rate. You know, I

00:17:22.319 --> 00:17:25.678
can see it in the equation. If I move

00:17:23.720 --> 00:17:27.000
the domestic interest rate up, the

00:17:25.679 --> 00:17:29.200
exchange rate goes up. That's an

00:17:27.000 --> 00:17:31.240
appreciation. The dollar becomes

00:17:29.200 --> 00:17:33.559
more expensive.

00:17:31.240 --> 00:17:36.120
Even simpler. Suppose we start with a

00:17:33.559 --> 00:17:37.279
situation in which the domestic and the

00:17:36.119 --> 00:17:38.759
international interest rate were the

00:17:37.279 --> 00:17:40.240
same.

00:17:38.759 --> 00:17:41.679
And now I increase the international

00:17:40.240 --> 00:17:45.039
interest rate. And I'm saying the

00:17:41.679 --> 00:17:47.040
exchange rate will appreciate.

00:17:45.039 --> 00:17:48.480
Well, first of all,

00:17:47.039 --> 00:17:50.279
let me let me start from something even

00:17:48.480 --> 00:17:52.440
simpler. Suppose that

00:17:50.279 --> 00:17:53.839
suppose that that

00:17:52.440 --> 00:17:55.720
this interest rate is equal to

00:17:53.839 --> 00:17:57.199
international interest rate before

00:17:55.720 --> 00:17:58.519
analyzing the change I'm about to

00:17:57.200 --> 00:18:00.160
analyze,

00:17:58.519 --> 00:18:02.079
then from this equation, what do I know

00:18:00.160 --> 00:18:03.880
I know about the exchange rate? What is

00:18:02.079 --> 00:18:05.279
it equal to?

00:18:03.880 --> 00:18:07.120
If the domestic interest rate is equal

00:18:05.279 --> 00:18:09.200
to international interest rate,

00:18:07.119 --> 00:18:11.479
what is the exchange rate today equal

00:18:09.200 --> 00:18:11.480
to?

00:18:12.839 --> 00:18:15.959
The expected exchange rate of next year.

00:18:14.279 --> 00:18:17.759
If I have the same interest rates, I

00:18:15.960 --> 00:18:19.720
cannot expect a capital gain or loss on

00:18:17.759 --> 00:18:21.679
the currency position because I have

00:18:19.720 --> 00:18:23.519
already an equal interest rate in in the

00:18:21.679 --> 00:18:25.200
two bonds. Okay?

00:18:23.519 --> 00:18:27.158
So then, I'm starting from a situation

00:18:25.200 --> 00:18:28.600
where the current exchange rate is equal

00:18:27.159 --> 00:18:30.960
to expected exchange rate and these two

00:18:28.599 --> 00:18:32.279
are equal. And now, I'm going to

00:18:30.960 --> 00:18:33.559
increase the interest rate, the domestic

00:18:32.279 --> 00:18:35.639
interest rate.

00:18:33.559 --> 00:18:38.119
And it's very easy for you to read from

00:18:35.640 --> 00:18:40.240
here that the exchange rate will go up.

00:18:38.119 --> 00:18:42.239
The currency will appreciate.

00:18:40.240 --> 00:18:43.880
Why?

00:18:42.240 --> 00:18:46.039
This is not an easy

00:18:43.880 --> 00:18:47.120
thing to answer unless you know

00:18:46.039 --> 00:18:49.399
unless you have read the book or

00:18:47.119 --> 00:18:49.399
something.

00:18:50.720 --> 00:18:54.960
If the interest rate goes up, then like

00:18:53.000 --> 00:18:56.720
money supply should go down, which would

00:18:54.960 --> 00:18:57.720
generally increase the value of money.

00:18:56.720 --> 00:18:59.519
No.

00:18:57.720 --> 00:19:00.880
No money here.

00:18:59.519 --> 00:19:03.000
That money is only related to the

00:19:00.880 --> 00:19:04.520
mechanism we used to increase

00:19:03.000 --> 00:19:07.359
interest rate, but

00:19:04.519 --> 00:19:09.000
I'm saying just use that equation

00:19:07.359 --> 00:19:10.799
and the logic behind that equation, the

00:19:09.000 --> 00:19:13.200
uncovered interest parity.

00:19:10.799 --> 00:19:14.399
Why is it that if I you know, we went to

00:19:13.200 --> 00:19:16.159
from a situation which interest rate

00:19:14.400 --> 00:19:18.040
were the same, now I increase the

00:19:16.159 --> 00:19:21.520
domestic interest rate, I'm saying the

00:19:18.039 --> 00:19:21.519
the exchange rate has to appreciate.

00:19:23.759 --> 00:19:27.960
No, no, but that's the description of

00:19:25.559 --> 00:19:31.720
Yeah, that's that's We know that.

00:19:27.960 --> 00:19:31.720
The question is what? What is the logic?

00:19:32.839 --> 00:19:35.319
Yeah,

00:19:33.559 --> 00:19:37.000
we have We know the result, but I'm

00:19:35.319 --> 00:19:39.799
asking is for an economic explanation

00:19:37.000 --> 00:19:39.799
for that result.

00:19:40.720 --> 00:19:44.960
More people will want to invest in the

00:19:43.039 --> 00:19:46.759
currency that you are in currency, so

00:19:44.960 --> 00:19:48.159
the demand will go up and so the value

00:19:46.759 --> 00:19:49.679
Well, if you go to Wall Street, you want

00:19:48.159 --> 00:19:50.640
to rate, they will explain it in those

00:19:49.679 --> 00:19:52.159
terms.

00:19:50.640 --> 00:19:54.000
It's not the right explanation, but they

00:19:52.159 --> 00:19:57.120
they will explain on those terms. And

00:19:54.000 --> 00:19:58.799
there is some logic behind that because

00:19:57.119 --> 00:20:00.279
this equation assumes that the arbitrage

00:19:58.799 --> 00:20:02.159
happens instantaneously. Immediately

00:20:00.279 --> 00:20:03.960
things move. But, but before that

00:20:02.160 --> 00:20:06.360
happens, you know, some people will

00:20:03.960 --> 00:20:08.759
start they buy more of the one that has

00:20:06.359 --> 00:20:10.679
more return. But, this equation already

00:20:08.759 --> 00:20:13.119
solved all that.

00:20:10.680 --> 00:20:15.840
And that's when this assumption

00:20:13.119 --> 00:20:17.719
matters and and is a little annoying.

00:20:15.839 --> 00:20:19.319
It bothers me for a logical reason. But,

00:20:17.720 --> 00:20:20.839
but we're going to use it to understand

00:20:19.319 --> 00:20:23.359
the mechanism.

00:20:20.839 --> 00:20:24.720
You see, if if I keep the exchange rate

00:20:23.359 --> 00:20:26.519
fixed, we started with a situation where

00:20:24.720 --> 00:20:27.920
the exchange rate was equal to expected

00:20:26.519 --> 00:20:29.680
exchange rate.

00:20:27.920 --> 00:20:32.320
If I keep it fixed

00:20:29.680 --> 00:20:34.480
and I appreciate the currency today,

00:20:32.319 --> 00:20:36.919
then what do I expect

00:20:34.480 --> 00:20:38.759
to happen to the dollar, let's talk

00:20:36.920 --> 00:20:40.600
about the dollar, from this period to

00:20:38.759 --> 00:20:42.640
the next one? Remember, we start from a

00:20:40.599 --> 00:20:43.959
situation where the exchange rate was

00:20:42.640 --> 00:20:45.759
equal to the expected exchange rate.

00:20:43.960 --> 00:20:48.720
Now, I increase the interest rate and I

00:20:45.759 --> 00:20:50.119
said the exchange rate appreciate.

00:20:48.720 --> 00:20:51.880
Then what do you expect

00:20:50.119 --> 00:20:53.479
the exchange rate to do over the next

00:20:51.880 --> 00:20:54.960
period?

00:20:53.480 --> 00:20:55.920
If I haven't moved expected exchange

00:20:54.960 --> 00:20:58.200
rate and now the exchange rate move

00:20:55.920 --> 00:20:59.440
above the expected exchange rate.

00:20:58.200 --> 00:21:01.680
What do you expect the exchange rate to

00:20:59.440 --> 00:21:01.680
do?

00:21:03.400 --> 00:21:09.400
Exactly, it has to depreciate.

00:21:05.880 --> 00:21:11.880
So, the reason depreciation happens here

00:21:09.400 --> 00:21:13.800
is because you need to expect to

00:21:11.880 --> 00:21:16.160
depreciate the dollar from this period

00:21:13.799 --> 00:21:19.559
to the next one. Why do I need to expect

00:21:16.160 --> 00:21:19.560
exchange rate to depreciate?

00:21:20.279 --> 00:21:23.240
So, I'm appreciating the currency

00:21:21.400 --> 00:21:25.240
because I need in equilibrium I need to

00:21:23.240 --> 00:21:27.640
expect to depreciate. That is, I need to

00:21:25.240 --> 00:21:30.079
expect to lose money money on the

00:21:27.640 --> 00:21:32.600
currency part of the trade.

00:21:30.079 --> 00:21:34.759
Why is that? Confusion is good. You you

00:21:32.599 --> 00:21:38.480
learn from that.

00:21:34.759 --> 00:21:38.480
And this can be very confusing, I know.

00:21:40.400 --> 00:21:44.040
What is this equation trying to do?

00:21:46.160 --> 00:21:49.480
We are trying to make the expected

00:21:47.920 --> 00:21:50.680
returns the same. That's the whole idea

00:21:49.480 --> 00:21:53.519
of this.

00:21:50.680 --> 00:21:55.080
So, if I I'm now telling you that one

00:21:53.519 --> 00:21:56.680
bond is paying a higher interest than

00:21:55.079 --> 00:21:57.879
the other one,

00:21:56.680 --> 00:21:59.799
I need to

00:21:57.880 --> 00:22:02.120
offset that somehow.

00:21:59.799 --> 00:22:04.319
How do I offset it? By expecting a

00:22:02.119 --> 00:22:05.759
depreciation of the currency

00:22:04.319 --> 00:22:08.359
of the bond

00:22:05.759 --> 00:22:10.400
that is, you know, of of the bond that

00:22:08.359 --> 00:22:11.439
is denominated

00:22:10.400 --> 00:22:14.720
in the currency that is expected to

00:22:11.440 --> 00:22:16.000
depreciate. So, what I need to do is

00:22:14.720 --> 00:22:17.279
compensate for the interest rate

00:22:16.000 --> 00:22:18.679
differential with an expected

00:22:17.279 --> 00:22:20.079
depreciation of the currency that is

00:22:18.679 --> 00:22:22.160
paying

00:22:20.079 --> 00:22:24.159
a higher interest rate.

00:22:22.160 --> 00:22:25.880
So, that's what in this model when I fix

00:22:24.160 --> 00:22:27.519
the expected exchange rate, the only way

00:22:25.880 --> 00:22:29.440
I can do that is by appreciating the

00:22:27.519 --> 00:22:32.319
currency today so I can expect it to

00:22:29.440 --> 00:22:33.960
depreciate in the future.

00:22:32.319 --> 00:22:35.079
That's the logic.

00:22:33.960 --> 00:22:37.079
Okay?

00:22:35.079 --> 00:22:38.639
Now, how what is the connection with

00:22:37.079 --> 00:22:40.960
what in Wall Street what they will tell

00:22:38.640 --> 00:22:43.759
you is to say, "Well, before this may

00:22:40.960 --> 00:22:45.640
happen not instantaneously. It happens

00:22:43.759 --> 00:22:48.400
somewhat slowly. So, traders immediately

00:22:45.640 --> 00:22:50.160
will go to the US dollar

00:22:48.400 --> 00:22:52.000
bond because they see that they have a

00:22:50.160 --> 00:22:53.120
higher return."

00:22:52.000 --> 00:22:56.079
And it will be the case until the

00:22:53.119 --> 00:22:57.559
currency really appreciates.

00:22:56.079 --> 00:22:59.960
The Once the currency appreciates

00:22:57.559 --> 00:23:01.319
enough, then that that advantage

00:22:59.960 --> 00:23:02.640
disappear. That's what this condition is

00:23:01.319 --> 00:23:03.678
doing. It's making the expected return

00:23:02.640 --> 00:23:05.600
the same.

00:23:03.679 --> 00:23:07.240
But, in the process of the exchange rate

00:23:05.599 --> 00:23:08.759
going from the initial exchange rate to

00:23:07.240 --> 00:23:10.440
to to the new

00:23:08.759 --> 00:23:11.960
equilibrium exchange rate, there may be

00:23:10.440 --> 00:23:14.320
an opportunity there. And that's when

00:23:11.960 --> 00:23:16.240
you start seeing these flows. Okay?

00:23:14.319 --> 00:23:19.960
That happens very very fast. But, that's

00:23:16.240 --> 00:23:19.960
when you can see some of those flows.

00:23:24.039 --> 00:23:27.519
I mean, in these markets that happens

00:23:25.480 --> 00:23:29.200
very very quickly. So, what is typically

00:23:27.519 --> 00:23:30.519
wrong is that then an analyst comes and

00:23:29.200 --> 00:23:31.679
tells you explaining a story why the

00:23:30.519 --> 00:23:33.200
exchange rate is going to continue to

00:23:31.679 --> 00:23:34.679
appreciate, well, that's just way too

00:23:33.200 --> 00:23:36.679
late. You're already in this

00:23:34.679 --> 00:23:38.800
environment. You lost the trade.

00:23:36.679 --> 00:23:38.800
Okay?

00:23:41.079 --> 00:23:44.639
Okay.

00:23:42.679 --> 00:23:47.560
What about an increase in the foreign

00:23:44.640 --> 00:23:48.960
interest rate, I star?

00:23:47.559 --> 00:23:50.440
So, an increase in the foreign interest

00:23:48.960 --> 00:23:51.960
rate is Let's start from the same

00:23:50.440 --> 00:23:53.279
situation we had before. We start from

00:23:51.960 --> 00:23:55.000
interest rate equal to international

00:23:53.279 --> 00:23:56.799
interest rate. Therefore, the exchange

00:23:55.000 --> 00:23:58.039
rate is equal to expected exchange rate.

00:23:56.799 --> 00:23:59.359
And now

00:23:58.039 --> 00:24:01.839
the

00:23:59.359 --> 00:24:03.839
foreign interest rate goes up.

00:24:01.839 --> 00:24:05.919
Okay? What is going on now in the US?

00:24:03.839 --> 00:24:08.399
The US is sort of stabilizing here and

00:24:05.920 --> 00:24:10.279
and and Europe is beginning to hike a

00:24:08.400 --> 00:24:12.120
little more than the US.

00:24:10.279 --> 00:24:13.639
So,

00:24:12.119 --> 00:24:16.199
we know from the equation that that

00:24:13.640 --> 00:24:18.280
means the exchange rate will

00:24:16.200 --> 00:24:19.519
fall. That is, will drop here. So, that

00:24:18.279 --> 00:24:21.160
that means

00:24:19.519 --> 00:24:23.599
the exchange rate is depreciating. The

00:24:21.160 --> 00:24:26.920
dollar is depreciating.

00:24:23.599 --> 00:24:26.919
Why is the dollar depreciating?

00:24:30.920 --> 00:24:34.360
It's the same mechanism. Like

00:24:32.960 --> 00:24:36.079
the exchange rate you previously said

00:24:34.359 --> 00:24:39.639
was facing like ET with the interest

00:24:36.079 --> 00:24:41.359
rate starting Yeah, that's correct.

00:24:39.640 --> 00:24:43.360
I mean, the the issue here in terms of

00:24:41.359 --> 00:24:44.759
the economics is that

00:24:43.359 --> 00:24:46.399
remember, if we start from the same

00:24:44.759 --> 00:24:48.000
interest rate and now

00:24:46.400 --> 00:24:49.120
all the lines I'm giving you doesn't

00:24:48.000 --> 00:24:50.640
need to start from the same interest

00:24:49.119 --> 00:24:51.799
rate. It's just a lot simpler to start

00:24:50.640 --> 00:24:53.000
from the

00:24:51.799 --> 00:24:54.200
from the same interest. But, suppose we

00:24:53.000 --> 00:24:56.000
start with the same interest rate and

00:24:54.200 --> 00:24:57.679
now I increase this one,

00:24:56.000 --> 00:24:59.319
then that means the foreign bond is

00:24:57.679 --> 00:25:01.519
paying a higher interest rate than the

00:24:59.319 --> 00:25:03.439
domestic bond. I need to equalize the

00:25:01.519 --> 00:25:05.400
expected returns. The only way I can do

00:25:03.440 --> 00:25:08.320
that is by having an expected

00:25:05.400 --> 00:25:09.920
appreciation of the dollar.

00:25:08.319 --> 00:25:11.200
Since the expected exchange rate we fix

00:25:09.920 --> 00:25:12.800
it here, the only way I can give you an

00:25:11.200 --> 00:25:16.640
expected appreciation of the dollar is

00:25:12.799 --> 00:25:18.119
to by depreciating the dollar today.

00:25:16.640 --> 00:25:19.480
Okay?

00:25:18.119 --> 00:25:21.559
So, this is the same mechanism, the same

00:25:19.480 --> 00:25:24.319
logic. It's symmetric.

00:25:21.559 --> 00:25:25.879
That's That's the mechanism.

00:25:24.319 --> 00:25:26.720
Now, is this true that in the very short

00:25:25.880 --> 00:25:29.720
run

00:25:26.720 --> 00:25:31.200
when when I star goes up and and I

00:25:29.720 --> 00:25:32.880
doesn't move, then lots of people go and

00:25:31.200 --> 00:25:34.880
buy foreign bonds and that produces sort

00:25:32.880 --> 00:25:37.760
of, you know, demand for euros and blah

00:25:34.880 --> 00:25:40.320
blah blah blah. But, that's very quick.

00:25:37.759 --> 00:25:43.200
Machines do it for you now. So,

00:25:40.319 --> 00:25:43.200
it happens very quickly.

00:25:43.440 --> 00:25:47.679
So, this equation shows you what happens

00:25:45.039 --> 00:25:51.119
after all that mess has already cleared.

00:25:47.679 --> 00:25:51.120
Which happens in milliseconds now.

00:25:53.799 --> 00:25:56.359
Okay.

00:25:56.599 --> 00:26:00.678
What What if I change the expected

00:25:58.000 --> 00:26:02.640
exchange rate? So, again, I'm fixing it,

00:26:00.679 --> 00:26:04.440
but I can move it around. I'm treating

00:26:02.640 --> 00:26:05.280
it as a parameter. When I say that I fix

00:26:04.440 --> 00:26:07.400
it,

00:26:05.279 --> 00:26:08.599
I just don't want to endogenize. I don't

00:26:07.400 --> 00:26:10.000
want to make it another endogenous

00:26:08.599 --> 00:26:11.839
variable.

00:26:10.000 --> 00:26:13.319
So, what happens here if the exchange

00:26:11.839 --> 00:26:14.799
rate we start with the same situation we

00:26:13.319 --> 00:26:16.639
had before and now the expected exchange

00:26:14.799 --> 00:26:17.919
rate goes up. Well, from the equation

00:26:16.640 --> 00:26:19.320
it's very clear.

00:26:17.920 --> 00:26:21.160
The current exchange rate immediately

00:26:19.319 --> 00:26:23.559
rises.

00:26:21.160 --> 00:26:24.920
One for one, in fact. Okay? If I have

00:26:23.559 --> 00:26:26.839
the these two interest rates are the

00:26:24.920 --> 00:26:28.560
same and now I move the expected

00:26:26.839 --> 00:26:31.799
exchange rate up, then the current

00:26:28.559 --> 00:26:33.599
exchange rate immediately jumps.

00:26:31.799 --> 00:26:35.799
So, this If we expect the dollar to

00:26:33.599 --> 00:26:37.839
appreciate in the future,

00:26:35.799 --> 00:26:40.480
then it appreciates today.

00:26:37.839 --> 00:26:40.480
Why is that?

00:26:40.839 --> 00:26:44.919
Expectations are very powerful in

00:26:43.000 --> 00:26:47.440
financial assets in general. This is the

00:26:44.920 --> 00:26:49.480
first time you come but and we'll talk a

00:26:47.440 --> 00:26:51.519
lot more about that in the

00:26:49.480 --> 00:26:53.279
next week. But,

00:26:51.519 --> 00:26:55.119
but you can see it here.

00:26:53.279 --> 00:26:56.678
So, if I move the exchange rate today

00:26:55.119 --> 00:26:58.119
up,

00:26:56.679 --> 00:26:59.840
the expected exchange rate means we

00:26:58.119 --> 00:27:04.079
expect the exchange rate to be, you

00:26:59.839 --> 00:27:05.959
know, today the dollar is is 90 cents on

00:27:04.079 --> 00:27:07.960
90 cents

00:27:05.960 --> 00:27:09.679
0.9 euros per dollar.

00:27:07.960 --> 00:27:12.360
Well, suppose I expect

00:27:09.679 --> 00:27:13.360
1 euro per dollar in the next period.

00:27:12.359 --> 00:27:16.479
What will happen to the exchange rate

00:27:13.359 --> 00:27:19.119
today? Well, it jumps today to one.

00:27:16.480 --> 00:27:19.120
Why is that?

00:27:24.759 --> 00:27:28.480
The dollar will be more expensive to buy

00:27:26.200 --> 00:27:30.440
there. So, people will

00:27:28.480 --> 00:27:34.279
Okay, that's that's your friend the

00:27:30.440 --> 00:27:34.279
trader there. Okay? But,

00:27:36.119 --> 00:27:38.799
yes,

00:27:39.079 --> 00:27:41.799
that's true.

00:27:42.640 --> 00:27:46.320
That's true. What does that mean?

00:27:46.799 --> 00:27:49.559
No.

00:27:48.160 --> 00:27:51.440
It is true it's more expensive, but why

00:27:49.559 --> 00:27:53.678
would Why did you want to buy it in to

00:27:51.440 --> 00:27:54.759
start with? I mean, who cares that

00:27:53.679 --> 00:27:57.640
something is more expensive if you are

00:27:54.759 --> 00:27:57.640
not planning to buy it?

00:27:59.720 --> 00:28:04.600
Um because the the current price is only

00:28:02.240 --> 00:28:07.279
also taking into account future prices.

00:28:04.599 --> 00:28:09.678
That's what the question says.

00:28:07.279 --> 00:28:12.039
So, um because it gets part of its

00:28:09.679 --> 00:28:13.360
cuz it it's value at the present moment

00:28:12.039 --> 00:28:15.399
takes into account

00:28:13.359 --> 00:28:16.959
some of its value in the future. I I You

00:28:15.400 --> 00:28:19.360
know, whenever we we This is an

00:28:16.960 --> 00:28:21.679
arbitrage type relationship. And what I

00:28:19.359 --> 00:28:23.879
suggest is whenever you come across an

00:28:21.679 --> 00:28:25.560
arbitrage type argument,

00:28:23.880 --> 00:28:27.159
you ask the question, "Well, suppose

00:28:25.559 --> 00:28:29.158
not."

00:28:27.159 --> 00:28:31.120
Suppose this didn't happen.

00:28:29.159 --> 00:28:32.400
What would then happen? What would look

00:28:31.119 --> 00:28:34.879
odd?

00:28:32.400 --> 00:28:36.159
Okay? That's Almost any arbitrage that's

00:28:34.880 --> 00:28:38.040
a good way of thinking about this. It's

00:28:36.159 --> 00:28:40.640
okay. The equation tells me that the

00:28:38.039 --> 00:28:44.399
exchange rate has to jump right away.

00:28:40.640 --> 00:28:46.960
Well, suppose not. What goes wrong?

00:28:44.400 --> 00:28:48.519
That's I I think that's the way the

00:28:46.960 --> 00:28:49.759
the easiest way to think about any of

00:28:48.519 --> 00:28:52.000
these things, asset pricing in general,

00:28:49.759 --> 00:28:54.039
by the way.

00:28:52.000 --> 00:28:55.400
Well, suppose not. Suppose the expected

00:28:54.039 --> 00:28:57.359
exchange rate goes up, the interest

00:28:55.400 --> 00:28:59.400
rates haven't changed, and the exchange

00:28:57.359 --> 00:29:00.879
rate today doesn't move. What happens

00:28:59.400 --> 00:29:02.280
then?

00:29:00.880 --> 00:29:05.280
Remember, we start in a situation with

00:29:02.279 --> 00:29:07.759
both interest rates are the same.

00:29:05.279 --> 00:29:10.200
Now, the expected exchange rate went up

00:29:07.759 --> 00:29:12.799
by 10% say,

00:29:10.200 --> 00:29:16.080
and uh

00:29:12.799 --> 00:29:17.480
the current exchange rate hasn't moved.

00:29:16.079 --> 00:29:19.720
I'm sure that between the two you can

00:29:17.480 --> 00:29:22.240
design this trade.

00:29:19.720 --> 00:29:22.240
What do you do?

00:29:25.799 --> 00:29:29.200
Everyone will buy foreign bonds in like

00:29:27.440 --> 00:29:32.840
the next period.

00:29:29.200 --> 00:29:32.840
No one will in the first period.

00:29:33.200 --> 00:29:37.519
Uh No, no, but what do you do today?

00:29:38.880 --> 00:29:43.240
Suppose it's you're not a trader and and

00:29:40.880 --> 00:29:44.760
then now you see, "Whoops, the exchange

00:29:43.240 --> 00:29:46.279
the dollar will appreciate 10%, the

00:29:44.759 --> 00:29:47.759
interest rates are the same, and the

00:29:46.279 --> 00:29:50.119
exchange rate is not moving today, what

00:29:47.759 --> 00:29:50.119
do you do?

00:29:58.799 --> 00:30:01.839
Which bond do you buy?

00:30:05.359 --> 00:30:08.759
Of course, because you have a 10%

00:30:07.039 --> 00:30:10.960
expected capital gain from buying that

00:30:08.759 --> 00:30:12.079
bond. If that doesn't happen, the both

00:30:10.960 --> 00:30:13.840
the two bonds are paying the same

00:30:12.079 --> 00:30:15.079
interest rate and now I tell you, well,

00:30:13.839 --> 00:30:16.439
yeah, but one is going to appreciate by

00:30:15.079 --> 00:30:19.119
10%.

00:30:16.440 --> 00:30:21.039
Relative to the other, okay? So, clearly

00:30:19.119 --> 00:30:23.239
that you go short massively the foreign

00:30:21.039 --> 00:30:25.440
bond and you go very long the US bond.

00:30:23.240 --> 00:30:26.799
That's what you do.

00:30:25.440 --> 00:30:28.440
We all want to do the same, so happens

00:30:26.799 --> 00:30:31.279
very quickly.

00:30:28.440 --> 00:30:33.039
And the exchange is appreciated today

00:30:31.279 --> 00:30:35.480
up to a point in which that that

00:30:33.039 --> 00:30:37.359
incentive is no longer there.

00:30:35.480 --> 00:30:38.360
And that in this particular case, if the

00:30:37.359 --> 00:30:40.000
interest rate are the same, that will

00:30:38.359 --> 00:30:42.159
happen only if the exchange rate today

00:30:40.000 --> 00:30:44.799
jumps exactly by the same amount as

00:30:42.160 --> 00:30:46.519
expected appreciation of the

00:30:44.799 --> 00:30:47.759
expected value of the

00:30:46.519 --> 00:30:50.680
dollar

00:30:47.759 --> 00:30:51.839
changing the future. Okay?

00:30:50.680 --> 00:30:52.840
Good.

00:30:51.839 --> 00:30:54.879
Think about this. Play with these

00:30:52.839 --> 00:30:55.879
things. I know it can be confusing, but

00:30:54.880 --> 00:30:57.760
and I

00:30:55.880 --> 00:30:59.080
always start with, let me move

00:30:57.759 --> 00:31:00.759
something.

00:30:59.079 --> 00:31:02.359
The equation tells me this is what it

00:31:00.759 --> 00:31:03.839
has to happen to the exchange rate.

00:31:02.359 --> 00:31:05.039
Well, suppose that didn't happen to the

00:31:03.839 --> 00:31:07.079
exchange rate.

00:31:05.039 --> 00:31:08.639
And then you say, oh, then I clearly

00:31:07.079 --> 00:31:10.559
invest in this bond. This dominates the

00:31:08.640 --> 00:31:13.080
other one. Well, that condition tells

00:31:10.559 --> 00:31:15.319
you, no, no, in equilibrium, you have to

00:31:13.079 --> 00:31:17.000
be indifferent. So, so the only thing

00:31:15.319 --> 00:31:18.279
that can move is the exchange rate.

00:31:17.000 --> 00:31:20.160
And the exchange has to move until you

00:31:18.279 --> 00:31:22.240
are indifferent again.

00:31:20.160 --> 00:31:24.840
After you have done some change to some

00:31:22.240 --> 00:31:26.000
argument on the right hand side, okay?

00:31:24.839 --> 00:31:27.919
That's the way you need to think about

00:31:26.000 --> 00:31:29.559
this.

00:31:27.920 --> 00:31:33.039
So,

00:31:29.559 --> 00:31:35.839
I here I'm just plotting

00:31:33.039 --> 00:31:37.720
uh this this relationship

00:31:35.839 --> 00:31:40.839
in the space of exchange rate in the

00:31:37.720 --> 00:31:42.519
x-axis and the domestic interest rate

00:31:40.839 --> 00:31:44.079
here. Okay?

00:31:42.519 --> 00:31:45.759
So, that's an upward sloping

00:31:44.079 --> 00:31:47.679
relationship. You You can see here as I

00:31:45.759 --> 00:31:49.319
move the interest rate up

00:31:47.680 --> 00:31:51.200
or the other way around, but anyways, as

00:31:49.319 --> 00:31:52.599
I move the interest rate up

00:31:51.200 --> 00:31:54.600
the exchange rate is going up. So,

00:31:52.599 --> 00:31:56.079
that's a positive relationship.

00:31:54.599 --> 00:31:57.279
I can do it the other way around. As I

00:31:56.079 --> 00:31:59.439
move the exchange rate up, then the

00:31:57.279 --> 00:32:01.119
domestic interest rate has to go up. I'm

00:31:59.440 --> 00:32:03.320
taking as parameters

00:32:01.119 --> 00:32:05.639
the foreign interest rate

00:32:03.319 --> 00:32:08.000
and and and the expected exchange rate.

00:32:05.640 --> 00:32:09.240
So, if I take as parameter this and that

00:32:08.000 --> 00:32:10.960
then I have a positive relationship

00:32:09.240 --> 00:32:13.279
between the exchange rate

00:32:10.960 --> 00:32:14.960
and the domestic interest rate, okay?

00:32:13.279 --> 00:32:17.440
So, that's going to be the

00:32:14.960 --> 00:32:19.120
I'm plotting the UIP uncovered interest

00:32:17.440 --> 00:32:21.720
parity condition.

00:32:19.119 --> 00:32:23.799
Notice this point here is interesting.

00:32:21.720 --> 00:32:26.559
This point tells you that when the

00:32:23.799 --> 00:32:28.599
domestic interest rate I is equal to the

00:32:26.559 --> 00:32:31.678
international interest rate

00:32:28.599 --> 00:32:33.119
then the exchange rate has to be equal

00:32:31.679 --> 00:32:35.519
to the expected exchange rate, which is

00:32:33.119 --> 00:32:36.559
the question I asked before.

00:32:35.519 --> 00:32:38.319
Remember, I asked you a question, what

00:32:36.559 --> 00:32:39.319
suppose that we start with an interest

00:32:38.319 --> 00:32:40.639
rate

00:32:39.319 --> 00:32:42.559
that is equal to the international

00:32:40.640 --> 00:32:43.880
interest rate.

00:32:42.559 --> 00:32:45.079
Uh uh

00:32:43.880 --> 00:32:46.960
what the exchange rate what is the

00:32:45.079 --> 00:32:48.639
exchange rate? And you said the answer

00:32:46.960 --> 00:32:50.360
was, well, it has to be equal to the

00:32:48.640 --> 00:32:52.440
expected exchange rate. That's that

00:32:50.359 --> 00:32:53.639
point here.

00:32:52.440 --> 00:32:55.279
Okay?

00:32:53.640 --> 00:32:57.400
If the interest rate domestic interest

00:32:55.279 --> 00:32:59.319
rate is above that

00:32:57.400 --> 00:33:01.280
the international interest rate

00:32:59.319 --> 00:33:03.119
then the exchange rate

00:33:01.279 --> 00:33:05.399
today has to be above the expected

00:33:03.119 --> 00:33:07.079
exchange rate because that will give you

00:33:05.400 --> 00:33:09.440
expected depreciation of the currency,

00:33:07.079 --> 00:33:11.559
which will compensate for the fact that

00:33:09.440 --> 00:33:13.679
the domestic bond is paying a higher

00:33:11.559 --> 00:33:15.279
interest rate than international bond.

00:33:13.679 --> 00:33:17.960
Okay?

00:33:15.279 --> 00:33:19.519
Conversely, if if the domestic bond is

00:33:17.960 --> 00:33:21.920
paying a lower interest rate, then the

00:33:19.519 --> 00:33:23.079
exchange rate today is very depreciated

00:33:21.920 --> 00:33:25.759
because you have to expect it to

00:33:23.079 --> 00:33:27.879
appreciate in order to compensate for

00:33:25.759 --> 00:33:29.559
the interest rate differential.

00:33:27.880 --> 00:33:32.240
Are we okay?

00:33:29.559 --> 00:33:34.839
Probably not, but

00:33:32.240 --> 00:33:37.039
this requires practice, I tell you.

00:33:34.839 --> 00:33:37.039
Uh

00:33:40.640 --> 00:33:44.000
Okay.

00:33:41.679 --> 00:33:45.280
So, but now we have a

00:33:44.000 --> 00:33:46.359
an equation for the exchange rate at

00:33:45.279 --> 00:33:50.039
least.

00:33:46.359 --> 00:33:52.479
So, I can go back to my I yes I I yes is

00:33:50.039 --> 00:33:53.720
the IS equation in the open economy.

00:33:52.480 --> 00:33:56.000
And now I have an equation for the

00:33:53.720 --> 00:33:58.559
exchange rate, so I can replace it.

00:33:56.000 --> 00:34:01.279
This is nice because I I'm I have two

00:33:58.559 --> 00:34:02.960
new parameters, expected exchange rate

00:34:01.279 --> 00:34:04.319
and international interest rate, but now

00:34:02.960 --> 00:34:06.160
this is also function of the interest

00:34:04.319 --> 00:34:08.639
rate. So, at this moment I have one

00:34:06.160 --> 00:34:10.320
equation in two unknowns really after I

00:34:08.639 --> 00:34:11.839
solve out for the exchange rate. I have

00:34:10.320 --> 00:34:13.960
one equation and two unknowns. The two

00:34:11.840 --> 00:34:15.800
unknowns are output and the domestic

00:34:13.960 --> 00:34:17.679
interest rate.

00:34:15.800 --> 00:34:19.800
All the rest are parameters.

00:34:17.679 --> 00:34:21.599
So, that's the same situation we were at

00:34:19.800 --> 00:34:24.760
in lecture three or so.

00:34:21.599 --> 00:34:27.079
So, then we need an extra equation.

00:34:24.760 --> 00:34:28.560
The extra equation was monetary policy,

00:34:27.079 --> 00:34:31.039
the LM.

00:34:28.559 --> 00:34:32.358
We're going to do exactly the same here.

00:34:31.039 --> 00:34:34.039
Okay, the LM is the same. It's the

00:34:32.358 --> 00:34:37.639
domestic central bank

00:34:34.039 --> 00:34:40.159
sets the interest rate. So, now I'm set.

00:34:37.639 --> 00:34:42.239
Now we have the IS-LM model in the open

00:34:40.159 --> 00:34:43.640
economy. This is the Mundell-Fleming

00:34:42.239 --> 00:34:45.559
model, okay? That's what the

00:34:43.639 --> 00:34:47.799
Mundell-Fleming model is.

00:34:45.559 --> 00:34:47.799
So,

00:34:47.960 --> 00:34:52.159
just a more complicated IS

00:34:50.960 --> 00:34:55.039
with a

00:34:52.159 --> 00:34:59.119
UIP

00:34:55.039 --> 00:35:00.759
uh uh um driven exchange rate

00:34:59.119 --> 00:35:03.119
and then the LM is the same as in the

00:35:00.760 --> 00:35:05.280
closed economy.

00:35:03.119 --> 00:35:05.279
Okay?

00:35:05.358 --> 00:35:09.079
So, this is the Mundell-Fleming model.

00:35:09.760 --> 00:35:14.359
So, notice that that So, one thing we

00:35:12.599 --> 00:35:17.000
know already, we knew from the previous

00:35:14.358 --> 00:35:18.639
lecture that that we have a smaller

00:35:17.000 --> 00:35:19.840
multiplier in the open economy because

00:35:18.639 --> 00:35:21.400
we have the imports that are also

00:35:19.840 --> 00:35:22.640
responding to output. We have a new

00:35:21.400 --> 00:35:24.680
parameter.

00:35:22.639 --> 00:35:26.039
But now we also know that

00:35:24.679 --> 00:35:28.599
an increase in the interest rate, so

00:35:26.039 --> 00:35:30.920
monetary policy in the open economy has

00:35:28.599 --> 00:35:32.319
two effects now. It used to have only

00:35:30.920 --> 00:35:33.880
this effect. Remember, it affected the

00:35:32.320 --> 00:35:35.359
domestic investment. So, an increase in

00:35:33.880 --> 00:35:36.880
the interest rate

00:35:35.358 --> 00:35:38.559
would lead to

00:35:36.880 --> 00:35:40.160
uh um

00:35:38.559 --> 00:35:42.079
a reduction in aggregate demand because

00:35:40.159 --> 00:35:43.159
investment would fall.

00:35:42.079 --> 00:35:44.559
Remember, that's what was the role of

00:35:43.159 --> 00:35:46.440
the interest rate.

00:35:44.559 --> 00:35:48.320
That's the way monetary policy worked in

00:35:46.440 --> 00:35:50.358
the closed economy. It was through this

00:35:48.320 --> 00:35:51.960
channel here.

00:35:50.358 --> 00:35:54.440
Now we have a second channel, which is

00:35:51.960 --> 00:35:54.440
this one.

00:35:54.840 --> 00:35:58.559
So, when the interest rate goes up

00:35:57.000 --> 00:36:00.800
it's contractionary for two reasons.

00:35:58.559 --> 00:36:02.960
One, for the reason we had before, which

00:36:00.800 --> 00:36:06.680
is that investment falls. But there is a

00:36:02.960 --> 00:36:06.679
second reason it's contractionary.

00:36:06.960 --> 00:36:09.920
What is that second reason?

00:36:18.800 --> 00:36:23.160
I mean, it's only here. It's only second

00:36:21.280 --> 00:36:24.519
Yeah.

00:36:23.159 --> 00:36:25.440
It's because it appreciates the exchange

00:36:24.519 --> 00:36:27.519
rate. And when you appreciate the

00:36:25.440 --> 00:36:28.920
exchange rate, net exports decline.

00:36:27.519 --> 00:36:31.358
Okay? So, more of the domestic

00:36:28.920 --> 00:36:34.240
consumption is diverted to foreign goods

00:36:31.358 --> 00:36:37.519
and less of foreign demand is is

00:36:34.239 --> 00:36:38.879
allocated to our exports, okay? So,

00:36:37.519 --> 00:36:40.119
that's the second channel. So, in an

00:36:38.880 --> 00:36:41.840
open economy and the smaller is the

00:36:40.119 --> 00:36:45.358
economy, the more important is this

00:36:41.840 --> 00:36:47.519
term, the more powerful is that channel.

00:36:45.358 --> 00:36:47.519
Okay?

00:36:53.119 --> 00:36:56.599
The US cares very little about this

00:36:54.760 --> 00:36:58.200
effect.

00:36:56.599 --> 00:37:01.119
Most of the economies care a lot about

00:36:58.199 --> 00:37:01.119
this effect, okay?

00:37:01.559 --> 00:37:05.039
Because the US is a relatively closed

00:37:03.119 --> 00:37:06.199
economy, believe it or not.

00:37:05.039 --> 00:37:08.400
So,

00:37:06.199 --> 00:37:11.279
this is sort of the start diagram of the

00:37:08.400 --> 00:37:14.760
Mundell-Fleming model.

00:37:11.280 --> 00:37:15.800
So, this thing here is our old IS-LM

00:37:14.760 --> 00:37:17.120
model.

00:37:15.800 --> 00:37:19.200
It's just that this IS is a little

00:37:17.119 --> 00:37:20.639
thicker now. It has net exports in there

00:37:19.199 --> 00:37:22.559
and so on, but it looks exactly the

00:37:20.639 --> 00:37:24.639
same. That is

00:37:22.559 --> 00:37:27.400
plots equilibrium in financial and and

00:37:24.639 --> 00:37:29.679
and and the goods market

00:37:27.400 --> 00:37:31.160
the combinations of output and domestic

00:37:29.679 --> 00:37:32.559
interest rate that are consistent with

00:37:31.159 --> 00:37:34.960
equilibrium

00:37:32.559 --> 00:37:36.199
in in both markets. That's the case

00:37:34.960 --> 00:37:37.440
here, okay?

00:37:36.199 --> 00:37:39.239
This is the IS, which is all the

00:37:37.440 --> 00:37:40.960
combinations of

00:37:39.239 --> 00:37:41.959
domestic output and domestic interest

00:37:40.960 --> 00:37:44.199
rate that are consistent with

00:37:41.960 --> 00:37:45.280
equilibrium in goods market.

00:37:44.199 --> 00:37:46.679
This is the interest rate that is

00:37:45.280 --> 00:37:48.400
consistent with equilibrium in financial

00:37:46.679 --> 00:37:49.759
markets. That's what the Fed does in the

00:37:48.400 --> 00:37:53.000
US.

00:37:49.760 --> 00:37:54.520
Uh that point is where both markets are

00:37:53.000 --> 00:37:55.880
in equilibrium.

00:37:54.519 --> 00:37:57.079
But we can take this interest rate. So,

00:37:55.880 --> 00:37:58.519
that's what will happen. The interest

00:37:57.079 --> 00:38:00.119
rate will be there in the US. The

00:37:58.519 --> 00:38:02.039
interest rate is set by the Fed, not by

00:38:00.119 --> 00:38:03.000
the ECB. The Fed will set the interest

00:38:02.039 --> 00:38:04.358
rate.

00:38:03.000 --> 00:38:06.400
That will give us some equilibrium

00:38:04.358 --> 00:38:08.679
output.

00:38:06.400 --> 00:38:10.680
And then we can go to the UIP condition,

00:38:08.679 --> 00:38:13.079
you see I'm plotting here, and figure

00:38:10.679 --> 00:38:15.440
out what the exchange rate is.

00:38:13.079 --> 00:38:16.679
Because for this interest rate here

00:38:15.440 --> 00:38:17.920
there's going to be some point in the

00:38:16.679 --> 00:38:19.039
UIP

00:38:17.920 --> 00:38:21.159
and that tells you exactly what the

00:38:19.039 --> 00:38:22.079
exchange rate is.

00:38:21.159 --> 00:38:25.079
Okay?

00:38:22.079 --> 00:38:26.679
So, it with this set of diagrams I can

00:38:25.079 --> 00:38:29.319
determine the interest rate, output, and

00:38:26.679 --> 00:38:29.319
exchange rate.

00:38:31.119 --> 00:38:35.639
So, I can study the effects of different

00:38:32.960 --> 00:38:37.519
policies, for example, on output, the

00:38:35.639 --> 00:38:39.599
interest rate, of course

00:38:37.519 --> 00:38:41.400
that's the policy itself, and exchange

00:38:39.599 --> 00:38:42.679
rate. So, this is the the new thing I

00:38:41.400 --> 00:38:45.320
can explain. I can do a little bit of

00:38:42.679 --> 00:38:46.319
asset pricing here. I can explain

00:38:45.320 --> 00:38:48.080
the

00:38:46.320 --> 00:38:49.559
the the behavior of the exchange rate as

00:38:48.079 --> 00:38:51.719
well.

00:38:49.559 --> 00:38:51.719
Okay?

00:38:52.079 --> 00:38:55.880
So, this diagram, I mean, you need to

00:38:53.719 --> 00:38:56.919
really control very very well.

00:38:55.880 --> 00:38:57.880
So, that's what I'm going to play with

00:38:56.920 --> 00:39:00.079
it

00:38:57.880 --> 00:39:01.720
quite a bit.

00:39:00.079 --> 00:39:03.159
Monetary policy. Let's do monetary

00:39:01.719 --> 00:39:04.239
policy. We talked about monetary policy

00:39:03.159 --> 00:39:06.839
already.

00:39:04.239 --> 00:39:08.599
So, suppose that for whatever reason uh

00:39:06.840 --> 00:39:11.240
the domestic economy

00:39:08.599 --> 00:39:13.319
the domestic central bank

00:39:11.239 --> 00:39:15.199
uh decides to hike interest rate.

00:39:13.320 --> 00:39:17.080
Suppose the economy was overheating,

00:39:15.199 --> 00:39:18.439
output was too high relative to natural

00:39:17.079 --> 00:39:19.719
rate of output,

00:39:18.440 --> 00:39:21.240
the typical reasons why you need to

00:39:19.719 --> 00:39:22.679
raise interest rate.

00:39:21.239 --> 00:39:24.319
And so, suppose that the domestic

00:39:22.679 --> 00:39:26.199
interest rate goes up.

00:39:24.320 --> 00:39:28.440
Well, as it used to be, that's going to

00:39:26.199 --> 00:39:31.358
be contractionary.

00:39:28.440 --> 00:39:32.639
What happens to the exchange rate?

00:39:31.358 --> 00:39:35.358
Well,

00:39:32.639 --> 00:39:38.960
I know the interest rate went up.

00:39:35.358 --> 00:39:40.639
I go I look into my UIP for the higher

00:39:38.960 --> 00:39:42.760
interest rate and in a current exchange

00:39:40.639 --> 00:39:44.799
rate that is above

00:39:42.760 --> 00:39:46.120
the old they has to go up relative to

00:39:44.800 --> 00:39:47.360
all of them. When they When they

00:39:46.119 --> 00:39:49.440
increase interest rate from here to

00:39:47.360 --> 00:39:50.800
there, then my exchange rate has to

00:39:49.440 --> 00:39:52.559
appreciate.

00:39:50.800 --> 00:39:53.600
Why is that?

00:39:52.559 --> 00:39:56.199
So,

00:39:53.599 --> 00:39:58.920
an expansionary domestic monetary policy

00:39:56.199 --> 00:40:01.719
will lead to a contraction in output,

00:39:58.920 --> 00:40:02.639
which is what we get out of

00:40:01.719 --> 00:40:05.039
uh

00:40:02.639 --> 00:40:07.679
monetary policy, but it will also lead

00:40:05.039 --> 00:40:10.159
to an appreciation of the currency. Why

00:40:07.679 --> 00:40:10.159
is that?

00:40:13.199 --> 00:40:18.639
That's what we just discussed. It's UIP.

00:40:15.840 --> 00:40:20.120
If If I move the domestic interest rate

00:40:18.639 --> 00:40:22.359
and the rest and the rest of world does

00:40:20.119 --> 00:40:23.719
not follow me, so we move interest rate,

00:40:22.360 --> 00:40:25.480
they don't,

00:40:23.719 --> 00:40:26.480
then now I need to compensate for this

00:40:25.480 --> 00:40:28.400
increase in the interest rate

00:40:26.480 --> 00:40:31.480
differential and the compensation will

00:40:28.400 --> 00:40:32.880
come through an expected capital loss at

00:40:31.480 --> 00:40:34.360
through the currency.

00:40:32.880 --> 00:40:35.599
So, if I appreciate more the currencies

00:40:34.360 --> 00:40:38.120
and since I haven't moved the expected

00:40:35.599 --> 00:40:40.159
exchange rate, I expect a larger loss

00:40:38.119 --> 00:40:43.440
from the point of from the country's

00:40:40.159 --> 00:40:45.000
from the currency side. Okay?

00:40:43.440 --> 00:40:47.360
That's what it what has happened here.

00:40:45.000 --> 00:40:48.719
So, that's what is behind depreciation.

00:40:47.360 --> 00:40:50.640
And of course, the depreciation is

00:40:48.719 --> 00:40:53.000
already built in here,

00:40:50.639 --> 00:40:55.039
which is what uh

00:40:53.000 --> 00:40:57.159
you know,

00:40:55.039 --> 00:40:59.199
makes monetary policy more powerful than

00:40:57.159 --> 00:41:00.960
the closed economy. Okay? Because you

00:40:59.199 --> 00:41:03.759
get the net export channel, but that's

00:41:00.960 --> 00:41:03.760
built in here.

00:41:04.760 --> 00:41:08.600
Um

00:41:06.239 --> 00:41:10.359
Okay, here all that I did is exactly the

00:41:08.599 --> 00:41:13.480
same as we were doing in the last 30

00:41:10.360 --> 00:41:15.400
minutes. I just used this this UIP. For

00:41:13.480 --> 00:41:17.159
whatever domestic reason, I need to

00:41:15.400 --> 00:41:18.000
raise interest rate,

00:41:17.159 --> 00:41:19.719
uh

00:41:18.000 --> 00:41:21.280
you know, I have contractionary monetary

00:41:19.719 --> 00:41:23.079
policy. Well, one of the effects that

00:41:21.280 --> 00:41:24.600
you're going to get in an open economy

00:41:23.079 --> 00:41:25.759
is that your currency will tend to

00:41:24.599 --> 00:41:28.599
appreciate.

00:41:25.760 --> 00:41:28.600
Okay? Good.

00:41:31.559 --> 00:41:35.079
What about fiscal policy?

00:41:35.239 --> 00:41:37.959
Well,

00:41:36.159 --> 00:41:39.759
if the Fed doesn't follow, if the

00:41:37.960 --> 00:41:41.320
central bank doesn't follow,

00:41:39.760 --> 00:41:42.640
and you had an expansionary fiscal

00:41:41.320 --> 00:41:43.840
policy,

00:41:42.639 --> 00:41:47.440
then

00:41:43.840 --> 00:41:49.519
uh that will increase output.

00:41:47.440 --> 00:41:51.000
It has no effect on the interest rate,

00:41:49.519 --> 00:41:52.679
therefore has absolutely no effect on

00:41:51.000 --> 00:41:55.159
the exchange rate. So, an expansionary

00:41:52.679 --> 00:41:57.239
fiscal policy, which is accommodated by

00:41:55.159 --> 00:41:58.920
the Fed, that means the interest rate is

00:41:57.239 --> 00:42:00.479
kept at the same level,

00:41:58.920 --> 00:42:01.519
then does not lead to an appreciation of

00:42:00.480 --> 00:42:02.800
the currency. It doesn't move the

00:42:01.519 --> 00:42:04.000
exchange rate. It has no implication for

00:42:02.800 --> 00:42:06.360
the exchange rate.

00:42:04.000 --> 00:42:06.360
Okay?

00:42:08.800 --> 00:42:12.200
Now, what about this change in output?

00:42:10.679 --> 00:42:15.679
Is it larger or smaller than the one we

00:42:12.199 --> 00:42:15.679
did in lecture three or four?

00:42:18.400 --> 00:42:21.680
It's smaller. Why? Uh because part of my

00:42:20.719 --> 00:42:23.519
increase in

00:42:21.679 --> 00:42:25.519
like uh demand falls on the foreign

00:42:23.519 --> 00:42:26.920
Exactly, because yeah, it goes to

00:42:25.519 --> 00:42:28.360
import. Perfect.

00:42:26.920 --> 00:42:29.720
Okay, good. So, this is a smaller than

00:42:28.360 --> 00:42:31.559
it was in the closed economy and it had

00:42:29.719 --> 00:42:35.119
but it has no impact

00:42:31.559 --> 00:42:37.880
on uh the exchange rate.

00:42:35.119 --> 00:42:40.079
That is, the UIP has nothing to do

00:42:37.880 --> 00:42:42.160
with going on expenditure. It's all

00:42:40.079 --> 00:42:44.199
about financial markets. It's about

00:42:42.159 --> 00:42:48.239
expected returns, things like that. So,

00:42:44.199 --> 00:42:49.759
unless the fiscal policy somehow affects

00:42:48.239 --> 00:42:50.319
interest rate,

00:42:49.760 --> 00:42:53.240
uh

00:42:50.320 --> 00:42:55.760
then there's no effect. What may happen

00:42:53.239 --> 00:42:58.599
is that, for example, is that that, you

00:42:55.760 --> 00:43:00.920
know, Treasury becomes very expansionary

00:42:58.599 --> 00:43:02.960
and this output becomes too large for

00:43:00.920 --> 00:43:06.200
what is consistent with a

00:43:02.960 --> 00:43:08.079
a zero output gap or no inflation, and

00:43:06.199 --> 00:43:10.199
then the Fed may react and raise

00:43:08.079 --> 00:43:11.440
interest rate, and that will lead to an

00:43:10.199 --> 00:43:12.679
appreciation of the exchange rate and so

00:43:11.440 --> 00:43:14.000
on. And that's the reason why in

00:43:12.679 --> 00:43:16.919
practice,

00:43:14.000 --> 00:43:18.920
when countries have sort of expansionary

00:43:16.920 --> 00:43:20.960
fiscal packages, they the currency tends

00:43:18.920 --> 00:43:23.240
to appreciate. It's because

00:43:20.960 --> 00:43:25.159
investors expect the Fed to react to

00:43:23.239 --> 00:43:27.279
that or the central bank to react to

00:43:25.159 --> 00:43:28.960
that and raise interest rate. But if the

00:43:27.280 --> 00:43:30.080
Fed says, "No, no, we needed that fiscal

00:43:28.960 --> 00:43:31.679
expansion. I'm not going to move the

00:43:30.079 --> 00:43:34.159
interest rate," then the exchange rate

00:43:31.679 --> 00:43:34.159
won't move.

00:43:39.639 --> 00:43:43.319
So, let's look at Let's use a little

00:43:41.639 --> 00:43:46.639
more this model and and look at other

00:43:43.320 --> 00:43:46.640
shocks within this model.

00:43:47.079 --> 00:43:51.279
So,

00:43:48.440 --> 00:43:53.840
let's start with Suppose that that uh

00:43:51.280 --> 00:43:56.519
we increase the expected exchange rate.

00:43:53.840 --> 00:43:56.519
What moves?

00:43:59.400 --> 00:44:02.119
In this diagram.

00:44:04.440 --> 00:44:08.519
Let's go cur- cur- Does the LM move?

00:44:16.159 --> 00:44:20.799
No. The LM is controlled by the domestic

00:44:18.760 --> 00:44:24.000
central bank, doesn't move.

00:44:20.800 --> 00:44:24.000
Does the IS move?

00:44:25.599 --> 00:44:29.119
When When I ask you whether it moves,

00:44:27.719 --> 00:44:30.759
you you should always fix something. So,

00:44:29.119 --> 00:44:33.039
you say, "Okay, let me fix the interest

00:44:30.760 --> 00:44:34.640
rate." Say, pick the point like this

00:44:33.039 --> 00:44:36.279
one, say.

00:44:34.639 --> 00:44:38.239
And now I have to ask the question,

00:44:36.280 --> 00:44:39.640
"What happens to output now that I have

00:44:38.239 --> 00:44:41.839
moved the expected exchange rate?" If I

00:44:39.639 --> 00:44:43.759
get the same output back, means the IS

00:44:41.840 --> 00:44:45.358
hasn't moved. If I get a different

00:44:43.760 --> 00:44:48.880
output equilibrium output, then I can

00:44:45.358 --> 00:44:52.000
tell you that the IS did move.

00:44:48.880 --> 00:44:52.000
So, what is the answer?

00:44:54.358 --> 00:44:57.880
If the interest rate doesn't move, the

00:44:55.920 --> 00:44:59.440
foreign interest doesn't move, and

00:44:57.880 --> 00:45:02.400
expected exchange rate goes up, what

00:44:59.440 --> 00:45:04.400
happens to the current exchange rate?

00:45:02.400 --> 00:45:05.599
Appreciates.

00:45:04.400 --> 00:45:07.039
What happens when when there's an

00:45:05.599 --> 00:45:09.199
appreciation?

00:45:07.039 --> 00:45:10.759
Net exports decline.

00:45:09.199 --> 00:45:14.639
That means that moves the IS to the

00:45:10.760 --> 00:45:16.760
left. Okay? So, so so this movement will

00:45:14.639 --> 00:45:18.879
move the IS to the left as a first

00:45:16.760 --> 00:45:20.720
effect.

00:45:18.880 --> 00:45:22.320
What about the UIP condition? Will it

00:45:20.719 --> 00:45:23.679
move or not? We have taken that as a

00:45:22.320 --> 00:45:26.000
parameter.

00:45:23.679 --> 00:45:28.358
Will it move?

00:45:26.000 --> 00:45:30.800
I mean, remember, I gave you a clue

00:45:28.358 --> 00:45:32.719
because I said we are taking these two

00:45:30.800 --> 00:45:34.920
as parameters here.

00:45:32.719 --> 00:45:36.399
So, if I move a parameter, most likely I

00:45:34.920 --> 00:45:38.000
will move the curve.

00:45:36.400 --> 00:45:41.480
Okay?

00:45:38.000 --> 00:45:41.480
But in which direction will it move?

00:45:46.719 --> 00:45:51.399
To the right. Yes, because for the same

00:45:49.679 --> 00:45:53.399
interest rate,

00:45:51.400 --> 00:45:54.639
now I need the exchange rate to move one

00:45:53.400 --> 00:45:56.519
for one, the current exchange rate to

00:45:54.639 --> 00:45:58.159
move one for one with the expected

00:45:56.519 --> 00:46:01.480
exchange rate, you know?

00:45:58.159 --> 00:46:02.839
So, this was the exchange rate before,

00:46:01.480 --> 00:46:04.679
and now the expected exchange rate moved

00:46:02.840 --> 00:46:06.880
to the right. Well, in order not to

00:46:04.679 --> 00:46:08.919
generate expected capital gain or loss,

00:46:06.880 --> 00:46:10.960
I have to move the current exchange rate

00:46:08.920 --> 00:46:13.720
by the same amount. And so, that means

00:46:10.960 --> 00:46:17.599
this curve will shift to the right.

00:46:13.719 --> 00:46:18.719
Okay? What if I move foreign output?

00:46:17.599 --> 00:46:20.920
Down.

00:46:18.719 --> 00:46:23.959
What happens?

00:46:20.920 --> 00:46:27.119
Which curve moves? Well, this is not a

00:46:23.960 --> 00:46:29.159
parameter here, so this is not moving.

00:46:27.119 --> 00:46:30.880
This is not a parameter here, so this

00:46:29.159 --> 00:46:34.759
one is not moving.

00:46:30.880 --> 00:46:36.400
Only one can move. The IS. Where?

00:46:34.760 --> 00:46:38.320
It will move to the left because net

00:46:36.400 --> 00:46:39.800
exports will decline.

00:46:38.320 --> 00:46:41.039
Now, for any given level of the interest

00:46:39.800 --> 00:46:43.200
rate, now we're going to have less net

00:46:41.039 --> 00:46:45.358
exports and therefore the IS moves to

00:46:43.199 --> 00:46:47.079
the left. So, output falls. But there's

00:46:45.358 --> 00:46:49.440
no movement here.

00:46:47.079 --> 00:46:51.279
Unless the Fed reacts to that,

00:46:49.440 --> 00:46:53.440
the central bank reacts to that, it

00:46:51.280 --> 00:46:55.800
won't happen.

00:46:53.440 --> 00:46:55.800
Okay?

00:47:00.000 --> 00:47:03.519
I mean, and and and it may well be the

00:47:01.920 --> 00:47:06.480
case that you want to react to that. If

00:47:03.519 --> 00:47:08.400
If the whole world goes into recession,

00:47:06.480 --> 00:47:11.119
the US is very likely to lower interest

00:47:08.400 --> 00:47:11.960
rates because, you know,

00:47:11.119 --> 00:47:13.319
it's

00:47:11.960 --> 00:47:15.960
it's very contractionary if the whole

00:47:13.320 --> 00:47:17.720
world goes into recession.

00:47:15.960 --> 00:47:19.320
When the US goes into recession, the

00:47:17.719 --> 00:47:21.358
rest of the world everyone wants to cut

00:47:19.320 --> 00:47:23.400
interest rates because the US is a big

00:47:21.358 --> 00:47:24.440
player. So, so it really drags everyone

00:47:23.400 --> 00:47:26.639
down.

00:47:24.440 --> 00:47:26.639
Okay?

00:47:28.320 --> 00:47:30.720
Good.

00:47:30.800 --> 00:47:34.200
The last one and I'm I'm going to repeat

00:47:32.559 --> 00:47:37.159
this in the next lecture is, well, what

00:47:34.199 --> 00:47:39.519
happens if the if I a star moves up? The

00:47:37.159 --> 00:47:42.559
foreign interest rate moves up.

00:47:39.519 --> 00:47:44.199
Well, the LM doesn't move.

00:47:42.559 --> 00:47:45.840
This one will move.

00:47:44.199 --> 00:47:49.199
Which way?

00:47:45.840 --> 00:47:49.200
Because that was a parameter here.

00:47:51.079 --> 00:47:53.799
To the right?

00:47:54.400 --> 00:47:57.720
You said to the right, that's right.

00:47:58.239 --> 00:48:02.079
Okay. No.

00:47:59.639 --> 00:48:04.079
So, so

00:48:02.079 --> 00:48:05.679
Think what happened here. If the foreign

00:48:04.079 --> 00:48:09.039
interest rate goes up,

00:48:05.679 --> 00:48:12.239
at any given interest rate, now the

00:48:09.039 --> 00:48:14.239
domestic bond is worse than otherwise.

00:48:12.239 --> 00:48:15.399
So, I need to depreciate the exchange

00:48:14.239 --> 00:48:16.479
rate

00:48:15.400 --> 00:48:18.160
today

00:48:16.480 --> 00:48:21.440
in order to

00:48:18.159 --> 00:48:21.440
expect an appreciation.

00:48:21.840 --> 00:48:27.680
Okay?

00:48:22.960 --> 00:48:29.960
That means this curve moves to the left.

00:48:27.679 --> 00:48:29.960
Okay?

00:48:30.000 --> 00:48:33.400
Okay, it moves to the left because I

00:48:31.400 --> 00:48:34.800
have to expect an appreciation

00:48:33.400 --> 00:48:37.039
to compensate for the interest rate

00:48:34.800 --> 00:48:38.800
differential.

00:48:37.039 --> 00:48:42.519
So, this will move to the left.

00:48:38.800 --> 00:48:42.519
What about this curve here?

00:48:43.960 --> 00:48:47.960
We solve it in the next lecture.

00:48:49.440 --> 00:48:51.679
Good.