Lecture Material 18 - B

Macroeconomics
Eighth Edition, Global Edition
Chapter 19
Output, the Interest Rate, and the
Exchange Rate
– Copyright © 2021 Pearson Education Ltd.
Chapter 19 Outline
Output, the Interest Rate, and the Exchange Rate
19.1 Equilibrium in the Goods Market
19.2 Equilibrium in Financial Markets
19.3 Putting Goods and Financial Markets Together
19.4 The Effects of Policy in an Open Economy
19.5 Fixed Exchange Rates
APPENDIX Fixed Exchange Rates, Interest Rates, and
Capital Mobility
Copyright © 2021 Pearson Education Ltd.
2
Output, the Interest Rate, and the
Exchange Rate
• In Chapter 18, we treated the exchange rate as one of the
policy instruments available to the government.
• The exchange rate is not a policy instrument, but instead it
is determined in the foreign exchange market.
• In this chapter, we examine the implications of equilibrium
in both the goods market and financial markets, including
the foreign exchange market.
• The model is an extension to the open economy of the
I S-L M model and it is known as the Mundell-Fleming
model.
19.1 Equilibrium in the Goods Market

• Recall the equilibrium condition in Chapter 18:
𝑌, 𝜀
𝑌 𝐶 𝑌 𝑇 𝐼 𝑌, 𝑟 𝐺 𝐼𝑀 𝑋 𝑌∗, 𝜀
𝜀
, , ,
which can be rewritten as:

𝑌 𝐶 𝑌 𝑇 𝐼 𝑌, 𝑟 𝐺 𝑁𝑋 𝑌, 𝑌 ∗ , 𝜀 19.1
, , ,
• If ε = E, then goods market equilibrium implies that output

depends negatively on both the nominal interest rate and
the nominal exchange rate:
𝑌 𝐶 𝑌 𝑇 𝐼 𝑌, 𝑖 𝐺 𝑁𝑋 𝑌, 𝑌 ∗ , 𝐸 19.2
, , ,
4
19.2 Equilibrium in Financial Markets (1 of 2)
• Recall the arbitrage relation or the interest parity condition
in Chapter 17:
1 𝑖
𝐸 𝐸 19.4
1 𝑖∗
• Assume the expected future exchange rate as given, so

1 𝑖
𝐸 𝐸 19.5
1 𝑖∗
which tells us that:

– An increase in the domestic interest rate leads to an
increase in the exchange rate.
– An increase in the foreign interest rate leads to a
decrease in the exchange rate.
– An increase in the expected future exchange rate leads
to an increase in the current exchange rate.
FOCUS: Capital Flows, Sudden Stops, and the

Limits to the Interest Parity Condition
Figure 1 Net Purchases of Brazilian Equities since 2000
Source: IMF BOP statistics.

6
19.2 Equilibrium in Financial Markets (2 of 2)
Figure 19.1 The Relation between the Interest Rate and the
Exchange Rate Implied by Interest Parity
A higher domestic interest rate leads to a higher exchange

rate—an appreciation.
19.3 Putting Goods and Financial

Markets Together (1 of 2)
• The open economy versions of the familiar I S and L M
relations:
1 𝑖
𝐼𝑆: 𝑌 𝐶 𝑌 𝑇 𝐼 𝑌, 𝑖 𝐺 𝑁𝑋 𝑌, 𝑌 ∗ , 𝐸
1 𝑖∗
𝐿𝑀: 𝑖 𝚤̄
• An increase in the interest rate now has two effects:

– The direct effect on investment
– The secondary effect through the exchange rate
8
19.3 Putting Goods and Financial
Markets Together (2 of 2)
Figure 19.2 The I S–L M Model in an Open Economy
An increase in the interest rate reduces output both directly and

indirectly (through the exchange rate). The IS curve is downward
sloping. The L M curve is horizontal, as in Chapter 6.
19.4 The Effects of Policy in an Open

Economy (1 of 2)
Figure 19.3 The Effects of an Increase in the Interest Rate
An increase in the interest rate leads to a decrease in output
and an appreciation.
10
19.4 The Effects of Policy in an Open
Economy (2 of 2)
Figure 19.4 The Effects of an Increase in Government
Spending with an Unchanged Interest Rate
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.
11
FOCUS: Monetary Contraction and Fiscal Expansion:

The United States in the Early 1980s
• The combined effects of higher interest rates and a fiscal expansion were very
much in line with what the Mundell-Fleming model predicts.
• By the mid-1980s, the twin-deficits (the budget deficit and the trade deficit)
were the main macroeconomic policy issue.
Table 2 Major U.S. Macroeconomic Variables, 1980–1984

1980 1981 1982 1983 1984
GDP growth (%) −0.5 1.8 −2.2 3.9 6.2
Unemployment rate (%) 7.1 7.6 9.7 9.6 7.5
Inflation (CPI) (%) 12.5 8.9 3.8 3.8 3.9
Interest rate (real) (%) 11.5 14.0 10.6 8.6 9.6
Real interest rate (%) 2.5 4.9 6.0 5.1 5.9
Real exchange rate 85 101 111 117 129
Trade surplus (% of GDP) −0.5 −0.4 −0.6 −1.5 −2.7
Inflation: rate of change of the CPI. The nominal interest rate is the three-month T-bill rate. The real interest rate is equal to
the nominal rate minus the forecast of inflation by DRI, a private forecasting firm. The real exchange rate is the trade-
weighted real exchange rate, normalized so that 1973 = 100. A negative trade surplus is a trade deficit.
12
FOCUS: US Trade Deficits and Trump
Administration Trade Tariffs
• Figure 1 Net exports/GDP and the real multilateral exchange rate
since 2010
Source: FRED: NETEXP, GDP, RBUSBIS

13
19.5 Fixed Exchange Rates (1 of 2)

• Some countries peg their currency to the dollar.
• Some countries operate under a crawling peg by moving
to an exchange rate target slowly.
• The European Monetary System (E M S) determined the
movements of exchange rates within the European Union
from 1978 and 1998.
• In the E M S, member countries agreed to maintain their
exchange rate relative to the other currencies in the
system within narrow limits or bands around a central
parity—a given value for the exchange rate.
• Beginning on January 1, 1999, a number of those
European countries adopted a common currency, the
euro.
14
19.5 Fixed Exchange Rates (2 of 2)
• Recall the interest rate parity condition:
𝐸
1 𝑖 1 𝑖∗
𝐸
• If the country pegs the exchange rate so that 𝐸 𝐸,
which also is the expectation of the future exchange rate,

then the interest rate relation becomes:
1 𝑖 1 𝑖∗ ⇒ 𝑖 𝑖∗
• Under a fixed exchange rate and perfect capital mobility,

the domestic interest rate must be equal to the foreign
interest rate.
• Under fixed exchange rates, the central bank gives up
monetary policy as a policy instrument.
15
FOCUS: German Reunification, Interest

Rates, and the EMS
• German reunification in 1990 led to large increases in demand and interest
rates in Germany.
• To stay in the fixed exchange regime of the EMS, other European members
had to match German interest rates, leading to decreases in their output.
Table 1 Interest Rates, Inflation, and Output Growth after German Reunification:
Germany, France, and Belgium, 1990–1992
The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realized real interest rate over
the year—that is, the nominal interest rate minus actual inflation over the year. All rates are annual.
Source: OECD Economic Outlook.
16
APPENDIX: Fixed Exchange Rates,
Interest Rates, and Capital Mobility (1 of 3)
Figure 1 Balance Sheet of the Central Bank
Figure 2 Balance Sheet of the Central Bank after an Open Market

Operation, and the Induced Intervention in the Foreign Exchange Market
17

• Under fixed exchange rates and perfect capital mobility,
the only effect of the open market operation is to change
the composition of the central bank’s balance sheet but
not the monetary base, nor the interest rate.
• With imperfect capital mobility, the net effects of the initial
open market operation and the following foreign exchange
interventions are likely to be an increase in the monetary
base; a decrease in the domestic interest rate; an increase
in the central bank’s bond holdings; and some loss in
reserves of foreign currency.
18
• With imperfect capital mobility, a country has some
freedom to move the domestic interest rate while
maintaining its exchange rate.
• That freedom depends on:
− the degree of development of its financial markets and
the willingness of domestic and foreign investors to shift
between domestic assets and foreign assets
− the degree of capital controls
− the amount of foreign exchange reserves it holds
19

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Macroeconomics

Eighth Edition, Global Edition

– Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

19.1 Equilibrium in the Goods Market

which can be rewritten as:

• If ε = E, then goods market equilibrium implies that output

Copyright © 2021 Pearson Education Ltd.

• Assume the expected future exchange rate as given, so

which tells us that:

FOCUS: Capital Flows, Sudden Stops, and the

Figure 1 Net Purchases of Brazilian Equities since 2000

Source: IMF BOP statistics.

A higher domestic interest rate leads to a higher exchange

Copyright © 2021 Pearson Education Ltd.

19.3 Putting Goods and Financial

• An increase in the interest rate now has two effects:

Copyright © 2021 Pearson Education Ltd.

An increase in the interest rate reduces output both directly and

19.4 The Effects of Policy in an Open

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

FOCUS: Monetary Contraction and Fiscal Expansion:

Table 2 Major U.S. Macroeconomic Variables, 1980–1984

Copyright © 2021 Pearson Education Ltd.

Source: FRED: NETEXP, GDP, RBUSBIS

19.5 Fixed Exchange Rates (1 of 2)

• If the country pegs the exchange rate so that 𝐸 𝐸,

which also is the expectation of the future exchange rate,

• Under a fixed exchange rate and perfect capital mobility,

FOCUS: German Reunification, Interest

Copyright © 2021 Pearson Education Ltd.

Figure 2 Balance Sheet of the Central Bank after an Open Market

Copyright © 2021 Pearson Education Ltd.

APPENDIX: Fixed Exchange Rates,

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

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