faculty of economics

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Monetary Macroeconomics
EBB130A05
Academic Year 2022-2023

Lecture 4

Output, interest rate, and the exchange rate

(Chapter 18 & 19)

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Last Week…

› We started looking at open economy models.

› We learned about the relative price between domestic and

foreign goods: the real exchange rate.

› We learned about the interest parity condition.

› We looked at the equilibrium in the goods market.

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This Week…

› We continue to look at the equilibrium in the goods market.

› We look at equilibrium in financial markets.

› We combine equilibrium in goods markets, financial markets

and central bank policy to arrive at the IS-LM-IP model.

› The IS-LM-IP model links output, the interest rate and the
exchange rate.
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Goods market in an open economy

(Chapter 18)
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Eq. output and the trade balance

› The goods market is in equilibrium when
domestic output equals (domestic and foreign)
demand – for domestic goods:

𝑌𝑌 = 𝑍𝑍

› Collecting the relations for the components of

the demand for domestic goods, 𝑍𝑍, we get:

𝐼𝐼𝐼𝐼 𝑌𝑌, ε ∗
𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑟𝑟 + 𝐺𝐺 − + 𝑋𝑋(𝑌𝑌 , ε)
ε
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Figure 18-1 The Demand for Domestic Goods and Net Exports

(a), The domestic demand for goods is an increasing function of income (output).
(b) and (c), The demand for domestic goods is obtained by subtracting the value
of imports from domestic demand and then adding exports.
(d), The trade balance is a decreasing function of output.
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Eq. output and

the trade balance
Figure 18-2 Equilibrium
Output and Net Exports

The goods market is in

equilibrium when domestic
output is equal to the
demand for domestic
goods. At the equilibrium
level of output, the trade
balance may show a
deficit or a surplus.
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Increases in
domestic
demand
Figure 18-3 The Effects of
an Increase in Government
Spending

An increase in
domestic demand
leads to an increase
in output and to a
trade deficit.
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Increase in domestic demand

› Difference with a closed economy:

 Effect on trade balance: an increase in output

leads to a trade deficit.

 Smaller effect of government spending on

output: because 𝑍𝑍𝑍𝑍 is flatter than 𝐷𝐷𝐷𝐷

- Hence the multiplier is smaller in the open

economy.

- Intuition: increase in government spending

increases demand for domestic and foreign
goods.
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Increases in
foreign
demand
Figure 18-4 The Effects of
an Increase in Foreign
Demand

An increase in
foreign demand
leads to an increase
in output and to a
trade surplus.
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Marshall-Lerner condition
› Net exports are given by:

𝑁𝑁𝑁𝑁 = 𝑋𝑋 𝑌𝑌 ∗ , ε − 𝐼𝐼𝐼𝐼(𝑌𝑌, ε)/ε

› Consider a real depreciation ε ↓.

› The Marshall-Lerner condition gives the

conditions under which a real depreciation
leads to an increase in net exports.

› In this course we will assume that this

condition holds, unless stated otherwise.
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Effects of
real
depreciation
Figure 18-4 The Effects of
an Increase in Foreign
Demand

A real depreciation
leads to an increase
in output and to a
trade surplus.
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The effects of a real depreciation

› Shift in demand, both foreign and domestic,
towards domestic goods.

› Shift in demand leads to both an increase in

domestic output and an improvement in the trade
balance.

› Relative to an increase in foreign demand, the

depreciation makes foreign goods relatively more
expensive.

› People are worse off relative to the case where

there is an increase in foreign demand, as
foreign goods become more expensive.
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J-curve
› The Marshall-Lerner condition tells us that a
real depreciation has a positive effect on net
exports.

› But is this true at any moment in time?

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J-curve
› The Marshall-Lerner condition tells us that a
real depreciation has a positive effect on net
exports.

› But is this true at any moment in time?

It turns out that this statement needs to be

qualified: in the very short run, a real exchange
rate depreciation has a negative effect on net
exports.
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J-curve
› Ultimately, the positive effect on net exports is
achieved through an effect on quantities:
volume of exports increase, volumes of imports
decrease.

› However, there is also a price-effect.

› Price-effect and effect on quantities do not kick

in at the same time.
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J-curve
› It takes time for consumers and firms to adjust
their behavior in response to a real exchange
rate depreciation.

› So in the beginning the price-effect dominates,

but quantities are hardly affected.

› Hence in the very short run imports (expressed

in terms of domestic goods) increase, because
firms and consumers pay more for foreign
goods.
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J-curve
A real depreciation leads
initially to a deterioration
and then to an
improvement of the
trade balance.
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The Real Exchange Rate and the Ratio of the Trade Deficit to GDP:
United States, 1980–1990

The large real

appreciation and
subsequent real
depreciation from
1980 to 1990 were
mirrored, with a lag,
by an increase and
then a decrease
in the trade deficit.
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Saving, investment & CA balance

› Goods market equilibrium:

𝐼𝐼𝐼𝐼
𝑌𝑌 = 𝐶𝐶 + 𝐼𝐼 + 𝐺𝐺 − + 𝑋𝑋
ε

› Denoting net exports 𝑁𝑁𝑁𝑁 = 𝑋𝑋 − 𝐼𝐼𝐼𝐼/ε, and

subtracting 𝑇𝑇 from both sides, we get:

𝑌𝑌 − 𝑇𝑇 − 𝐶𝐶 = 𝐼𝐼 + 𝐺𝐺 − 𝑇𝑇 + 𝑁𝑁𝑁𝑁
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Saving, investment & CA balance

› Income of domestic residents is equal to
output 𝑌𝑌 plus net income from abroad 𝑁𝑁𝑁𝑁, plus
net transfers 𝑁𝑁𝑇𝑇 received.

› Adding 𝑁𝑁𝑁𝑁 and 𝑁𝑁𝑁𝑁 to both sides of the

equation, we get:

𝑌𝑌 + 𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁 − 𝑇𝑇 − 𝐶𝐶 = 𝐼𝐼 + 𝐺𝐺 − 𝑇𝑇 + (𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁)

› Note that disposable income equals:

𝑌𝑌 + 𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁 − 𝑇𝑇
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Saving, investment & CA balance

› Disposable income minus consumption 𝐶𝐶
equals savings 𝑆𝑆.

› On the right hand side, we have that the

current account equals:

𝐶𝐶𝐶𝐶 = 𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁 + 𝑁𝑁𝑁𝑁

› So finally, we can write our equation:

𝑆𝑆 = 𝐼𝐼 + 𝐺𝐺 − 𝑇𝑇 + 𝐶𝐶𝐶𝐶
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Saving, investment & CA balance

› So finally, we can write our equation:

𝑆𝑆 = 𝐼𝐼 + 𝐺𝐺 − 𝑇𝑇 + 𝐶𝐶𝐶𝐶

› Or, rewriting, we arrive at an equation for the

current account:

𝐶𝐶𝐶𝐶 = 𝑆𝑆 − 𝐼𝐼 + 𝑇𝑇 − 𝐺𝐺
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Saving, investment & CA balance

› Current account equation:

𝐶𝐶𝐶𝐶 = 𝑆𝑆 − 𝐼𝐼 + 𝑇𝑇 − 𝐺𝐺

› Current account equals net savings of the

economy, determined by:
 Domestic savings 𝑆𝑆.

 Domestic investment 𝐼𝐼.

 Government surplus 𝑇𝑇 − 𝐺𝐺.

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Saving, investment & CA balance

› Current account equation:

𝐶𝐶𝐶𝐶 = 𝑆𝑆 − 𝐼𝐼 + 𝑇𝑇 − 𝐺𝐺

› Previously, we learned that a real exchange

depreciation improves the current account.

› However, in the formula the real exchange rate

doesn’t show up.

How to reconcile these two statements?

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US current account (𝐶𝐶𝐶𝐶) 1970-2014

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US net savings (𝑆𝑆 − 𝐼𝐼) 1970-2014

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US govt surplus (𝑇𝑇 − 𝐺𝐺) 1950-2010

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US current account deficits

› President Biden has implemented a large fiscal

expansion.
 Through what channels will the current

account be affected?
 What will be the net effect on the US current

account?

› According to former president Trump it is bad

to have a current account deficit.
 Do you agree? Why or why not?
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Current account deficits (Turkey)

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….leads to BOP-crisis
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….leads to BOP-crisis
› What is the difference between the US and
Turkey? Both run persistent current account
deficits.

› US borrows in domestic currency, Turkey in

foreign currency.

› Effect of a depreciation has no effect on dollar

value foreign-held US debt, while it increases
the lira value of foreign-held Turkish debt.
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2. Output, the interest rate and the

exchange rate
(see chapter 19)
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Equilibrium in goods market

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Equilibrium in the goods market

› Equilibrium condition in the goods market:

𝐼𝐼𝐼𝐼 𝑌𝑌, ε ∗
𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑟𝑟 + 𝐺𝐺 − + 𝑋𝑋 𝑌𝑌 , ε
ε
+ +, − +, + (+, −)

› Define net exports as exports minus the value

of imports:

∗ 𝐼𝐼𝐼𝐼 𝑌𝑌, ε
∗
𝑁𝑁𝑁𝑁 𝑌𝑌, 𝑌𝑌 , ε = 𝑋𝑋(𝑌𝑌 , ε) −
ε
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Equilibrium in the goods market

› We then get:

∗
𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑟𝑟 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 𝑌𝑌, 𝑌𝑌 , ε
+ +, − (−, +, −)

› If we focus on the short run, we can assume

that the domestic and foreign price level are
∗
given and constant. We set 𝑃𝑃 = 𝑃𝑃 = 1.

𝐸𝐸𝐸𝐸
› Then the real exchange rate equals ε = ∗ = 𝐸𝐸.
𝑃𝑃
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Equilibrium in the goods market

› If we take the domestic price level as given in
the short-run, there is no inflation, and the
nominal interest rate and the real interest rate
are the same: 𝑟𝑟 = 𝑖𝑖.

› Then the goods market equilibrium comes

down to:

∗
𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑖𝑖 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 𝑌𝑌, 𝑌𝑌 , 𝐸𝐸
+ +, − (−, +, −)
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Equilibrium in financial markets

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Equilibrium in financial markets

› Financial investors go for the highest expected
rate of return (remember chapter 17).

› Therefore, if investors hold both domestic and

foreign bonds, the expected rate of return
must be the same.

› Arbitrage relation between domestic and

foreign bonds, the interest parity condition,
must hold.
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Equilibrium in financial markets

› Arbitrage relation between domestic and
foreign bonds, the interest parity condition,
must hold:
𝑬𝑬𝒕𝒕
𝟏𝟏 + 𝒊𝒊𝒕𝒕 = 𝟏𝟏 + 𝒊𝒊∗𝒕𝒕
𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏
› Rewriting gives us:

𝟏𝟏 + 𝒊𝒊𝒕𝒕 𝒆𝒆
𝑬𝑬𝒕𝒕 = ∗ 𝑬𝑬𝒕𝒕+𝟏𝟏
𝟏𝟏 + 𝒊𝒊𝒕𝒕
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Equilibrium in financial markets

𝟏𝟏 + 𝒊𝒊𝒕𝒕 𝒆𝒆
𝑬𝑬𝒕𝒕 = ∗ 𝑬𝑬𝒕𝒕+𝟏𝟏
𝟏𝟏 + 𝒊𝒊𝒕𝒕
› Hence the current exchange rate 𝑬𝑬𝒕𝒕 changes in
response to three things:

 An increase in 𝒊𝒊𝒕𝒕 ↑ leads to an increase in 𝑬𝑬𝒕𝒕 ↑

 An increase in 𝒊𝒊∗𝒕𝒕 ↑ leads to a decrease in 𝑬𝑬𝒕𝒕 ↓

 An increase in 𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 ↑ leads to an increase in

𝑬𝑬𝒕𝒕 ↑
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Examples:
› Suppose investors from the euro area have the
choice between German bonds (in euros) and
UK bonds (in pounds).

› Assumptions:
 Current exchange rate and expected

exchange rate are equal: 𝑬𝑬𝒕𝒕 = 𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 = 𝟏𝟏.

 One-year interest rate on both bonds equals

2%.
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Examples:
› Q1: does interest parity hold?
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Examples:
› Q1: does interest parity hold?

› A1: yes it does. Check by substitution in the

formula.
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Examples:
› Q2: suppose the exchange rate is expected to
be 10% higher than today with the same one-
year interest rates as today. What happens to
the current exchange rate?
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Examples:
› Q2: suppose the exchange rate is expected to
be 10% higher than today with the same one-
year interest rates as today. What happens to
the current exchange rate?

› A2: 𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 =110. With 𝒊𝒊𝒕𝒕 = 𝒊𝒊∗𝒕𝒕 =0.02, we get that

1.02
𝑬𝑬𝒕𝒕 =
1.02
110 = 110. So the current exchange
rate appreciates today by 10%.
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Examples:
› Q3: The bank of England raises interest rates
from 2% to 5%. What happens to the current
exchange rate?
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Examples:
› Q3: The bank of England raises interest rates
from 2% to 5%. What happens to the current
exchange rate?

› A3: 𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 =100. With 𝒊𝒊𝒕𝒕 = 𝟎𝟎. 𝟎𝟎𝟎𝟎, and 𝒊𝒊∗𝒕𝒕 = 𝟎𝟎. 𝟎𝟎𝟎𝟎, we
get that 𝑬𝑬𝒕𝒕 = 1.02
1.05
100 = 97. So the current
exchange rate depreciates today by 3%.
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Interest rate parity

› Given 𝒊𝒊∗𝒕𝒕 and 𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 , we can draw the interest
parity relation.

𝟏𝟏+𝒊𝒊∗𝒕𝒕
› 𝒊𝒊𝒕𝒕 = 𝑬𝑬 − 𝟏𝟏.
𝑬𝑬𝒆𝒆𝒕𝒕+𝟏𝟏 𝒕𝒕
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IS-LM-IP model:
equilibrium in goods & financial
markets
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Goods and financial markets

› Goods market:
∗
𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑖𝑖 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 𝑌𝑌, 𝑌𝑌 , 𝐸𝐸

› Central bank interest rate policy:

𝑖𝑖 = 𝚤𝚤 ̅

› Interest parity condition:

𝟏𝟏 + 𝒊𝒊 � 𝒆𝒆
𝑬𝑬 = ∗ 𝑬𝑬
𝟏𝟏 + 𝒊𝒊
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Goods and financial markets

› Combining the third and the first relation gives
the open economy version of the IS and LM
relations:

IS: 𝑌𝑌 = 𝐶𝐶 𝑌𝑌 − 𝑇𝑇 + 𝐼𝐼 𝑌𝑌, 𝑖𝑖 + 𝐺𝐺 + 𝑁𝑁𝑁𝑁 𝑌𝑌, 𝑌𝑌 ,

∗ 𝟏𝟏+𝒊𝒊 �
𝑬𝑬𝒆𝒆
𝟏𝟏+𝒊𝒊∗
LM: 𝑖𝑖 = 𝚤𝚤 ̅

› Just as in closed economy, we have a

downward sloping IS-curve and a horizontal
LM-curve.
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Goods and financial markets

A change in the interest rate reduces output both directly and indirectly
(through the exchange rate). The IS curve is downward sloping. The LM
curve is horizontal, as in Chapter 6.
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Impact of monetary & fiscal policy

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M-policy in the open economy

An increase in the interest rate leads to a decrease in output and an

appreciation.
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M-policy in the open economy

An interest rate increase (𝐿𝐿𝐿𝐿 → 𝐿𝐿𝐿𝐿′) leads to a
decrease in output via two channels:

1. A higher interest rate has a negative direct effect

on investment (just as in closed economy), which
leads to a decrease in output.

2. In addition, a higher interest rate leads to an

appreciation of the exchange rate:
- Domestic goods become more expensive
relative to foreign goods.
- Net exports decrease, which leads to a decrease
in output.
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Fiscal policy in the open economy

An increase in government spending leads to an increase in output. If the

central bank keeps the interest rate unchanged, the exchange rate
also remains unchanged.
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Fiscal policy in the open economy

An increase in government spending (constant
interest rate) affects output via three channels:

1. Consumption increases as higher government

spending increases income.

2. Investment increases as income is higher and

interest rate is constant.

3. Net exports decrease: domestic output

increases, while foreign output and the
exchange rate are constant.
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Exchange rate regimes

› Up to this point we have assumed a flexible
exchange rate.

› In reality, however, there are different types of

exchange rate regimes:

 Fixed exchange rate or exchange rate peg.

 Crawling peg.
 Exchange rate bands.
 Common currency.
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Fixed exchange rate

› Fixed exchange rate regime: exchange rate is
fixed in terms of a foreign currency such as the
dollar.

› Alternatively we say that the exchange rate is

pegged to a foreign currency, such as the
dollar: an exchange rate peg.

› Fixed exchange rate does not imply that the

exchange rate never changes, but that these
changes are rare.
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Fixed exchange rate: M-policy

› Suppose the government announces to fix its

�
exchange rate at 𝐸𝐸.

› What consequences does this decision have for

monetary policy?
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Fixed exchange rate: M-policy

› Assuming financial markets find the government’s

exchange rate policy credible, we have that 𝑬𝑬𝒕𝒕 =
𝑬𝑬𝒕𝒕+𝟏𝟏 𝒆𝒆 = 𝐸𝐸� .

› From the interest parity condition…..

𝑬𝑬𝒕𝒕 ∗
𝟏𝟏 + 𝒊𝒊𝒕𝒕 = 𝟏𝟏 + 𝒊𝒊𝒕𝒕 ∗ = 𝟏𝟏 + 𝒊𝒊𝒕𝒕
𝑬𝑬𝒕𝒕+𝟏𝟏 𝒆𝒆

› In other words: the central bank must follow the

interest rate set 𝒊𝒊𝒕𝒕 ∗ set by the foreign central bank.
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Fixed exchange rate: M-policy

› In other words: under fixed exchange rates,

the central bank gives up monetary policy
as a policy instrument.

› What is a key assumption behind this result?

(hint: think of China)
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Fixed exchange rate: fiscal policy

› Question: what happens to fiscal policy if

exchange rates are fixed instead of flexible?
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Fixed exchange rate: fiscal policy

An increase in government spending leads to an increase in output. If the

central bank keeps the interest rate unchanged, the exchange rate
also remains unchanged.
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Fixed exchange rate: fiscal policy

› Answer: if the central bank does not change

interest rates in response to a fiscal stimulus,
the effects of a stimulus are the same under
fixed and flexible exchange rates.

› But in reality, the central bank might want to

raise interest rates in response to a stimulus:

 This is possible under flexible exchange rates.

 But impossible under fixed exchange rates.
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Fixed vs. flexible exchange rates

› From what you have seen thus far, fixing exchange
rates is bad in the short run:

 Trade imbalances cannot be corrected.

 Control of interest rate policy is given up.

 Fiscal policy still available, but stimulating the

economy deteriorates the trade balance.

› To see why fixed exchange rates might still be a

good idea, we need to look at the medium run, in
which prices can change.
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Other regimes: crawling peg

› A crawling peg regime is one where the nominal
exchange rate is slowly depreciating against a
foreign currency, such as the dollar.

› These countries would like to fix their exchange

rate, but this is impossible when they have a
higher inflation rate than, for example, the US.

› A fixed exchange rate in combination with a higher

domestic inflation leads to an appreciation of the
real exchange rate

𝐸𝐸𝐸𝐸
› Remember that ε = ∗, so ε ↑ if 𝑃𝑃 > 𝑃𝑃 ∗.
𝑃𝑃
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Other regimes: X-rate bands

› A group of countries maintaining their bilateral
exchange rates within some bands.

 Example: European Monetary System (EMS),

precursor to the euro.

 Member countries commit to maintain exchange rate

relative to other countries within narrow bands around
a central parity.

 Devaluations or revaluations can only occur by

common agreement.

› This system, however, does not prevent devaluations

and revaluations.
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Other regimes: common currency

› Individual countries give up independent interest
rate policy and permanently fix their nominal
exchange rates.

› Most famous example is the euro.

› Euro was introduced in response to a supposedly

failing EMS, where countries dropped out in
response to a major crisis in 1992.

› Question: is introducing a common currency a

good response to a failing exchange rate bands
system?
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Bottom Line
 We have studied equilibrium in the goods market and
financial markets.

 These equilibrium relationships determine the

relationship between output, the interest rate and the
exchange rate.

 The resulting equilibrium is described by the so-called IS-

LM-IP model, which describes how an open economy
responds to changes in monetary and fiscal policy.