Chapter 20

OUTPUT, THE INTEREST RATE AND

THE EXCHANGE RATE

In Chapter 19, we treated the exchange rate as one of the policy instruments available to the
government. But the exchange rate is not a policy instrument. Rather, it is determined in the
foreign exchange market, where, as you saw in Chapter 18, there is an enormous amount of
trading. This fact raises two obvious questions: what determines the exchange rate? How can
policymakers affect it?

These questions motivate this chapter. To answer them, we reintroduce financial markets, which
we had left aside in Chapter 19. We examine the implications of equilibrium in both the goods
market and financial markets, including the foreign exchange market. This allows us to character-
ise the joint movements of output, the interest rate and the exchange rate in an open economy.
The model we develop is an extension to the open economy of the IS-LM model you first saw
in Chapter 5 and is known as the Mundell-Fleming model – after the two economists, Robert
Mundell and Marcus Fleming, who put it together in the 1960s. (The model presented here retains
the spirit of the original Mundell-Fleming model but differs in its details.)

● Section 20.1 looks at equilibrium in the goods market.

● Section 20.2 looks at equilibrium in financial markets, including the foreign exchange market.

● Section 20.3 puts the two equilibrium conditions together and looks at the determination of
output, the interest rate and the exchange rate.

● Section 20.4 looks at the role of policy under flexible exchange rates.

● Section 20.5 looks at the role of policy under fixed exchange rates.

If you remember one basic message from this chapter, it should be: the
effects of monetary and fiscal policies differ very much depending on the
exchange rate regime.

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 425

20.1 EQUILIBRIUM IN THE GOODS MARKET

Equilibrium in the goods market was the focus of Chapter 19, where we derived the equilib-
rium condition equation (19.4):
Y = C(Y - T) + I(Y, r) + G - IM(Y, e)/e + X(Y*, e)
(+) (+, -) (+, +) (+, -)
For the goods market to be in equilibrium, output (the left side of the equation) must be equal
to the demand for domestic goods (the right side of the equation). The demand for domestic
goods is equal to consumption, C, plus investment, I, plus government spending, G, minus Goods market equilibrium (IS):
the value of imports, IM/e, plus exports, X. ➤ output = demand for domestic goods.
● Consumption, C, depends positively on disposable income Y - T.
● Investment, I, depends positively on output, Y, and negatively on the real interest rate, r.
● Government spending, G, is taken as given.
● The quantity of imports, IM, depends positively on both output, Y, and the real exchange
rate, e. The value of imports in terms of domestic goods is equal to the quantity of imports
divided by the real exchange rate.
● Exports, X, depend positively on foreign output, Y*, and negatively on the real exchange
rate, e.
It will be convenient in what follows to regroup the last two terms under net exports (NX),
defined as exports minus the value of imports:
NX (Y, Y*, e) K X (Y*, e) - IM (Y, e)>e

It follows from our assumptions about imports and exports that net exports, NX, depend on We shall assume, throughout the chap-
ter, that the Marshall-Lerner condition
domestic output, Y, foreign output, Y*, and the real exchange rate, e. An increase in domestic
holds. Under this condition, an increase
output increases imports, thus decreasing net exports. An increase in foreign output increases in the real exchange rate – a real appre-
exports, thus increasing net exports. An increase in the real exchange rate leads to a decrease ciation – leads to a decrease in net
in net exports. ➤ exports (see Chapter 19).
Using this definition of net exports, we can rewrite the equilibrium condition as:
Y = C(Y - T) + I(Y, r) + G + NX (Y, Y*, e)
(20.1)
(+) (+, -) (-, +, -)

For our purposes, the main implication of equation (20.1) is that both the real interest rate
and the real exchange rate affect demand and in turn equilibrium output.
● An increase in the real interest rate leads to a decrease in investment spending and, as a
result, to a decrease in the demand for domestic goods. This leads, through the multiplier,
to a decrease in output.
● An increase in the real exchange rate leads to a shift in demand toward foreign goods and,
as a result, to a decrease in net exports. The decrease in net exports decreases the demand
for domestic goods. This leads, through the multiplier, to a decrease in output.
For the remainder of the chapter, we shall simplify equation (20.1) in two ways:
● Given our focus on the short run, we assumed in our previous treatment of the IS-LM
model that the (domestic) price level was given. We shall make the same assumption
here and extend this assumption to the foreign price level, so the real exchange rate,
e = EP>P*, and the nominal exchange rate, E, move together. A decrease in the nominal
exchange rate – a nominal depreciation – leads, one-for-one, to a decrease in the real
exchange rate – a real depreciation. Conversely, an increase in the nominal exchange rate
– a nominal appreciation – leads, one-for-one, to an increase in the real exchange rate – a
real appreciation. If, for notational convenience, we choose P and P* so that P>P* = 1
(we can do so because both are index numbers), then e = E and we can replace e with E First simplification: P = P* = 1, so
in equation (20.1). ➤ e = E.

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 426 EXTENSIONS THE OPEN ECONOMY

● Because we take the domestic price level as given, there is no inflation, either actual or
expected. Therefore, the nominal interest rate and the real interest rate are the same,
and we can replace the real interest rate, r, in equation (19.1) with the nominal interest
rate, i.
Second simplification: Pe = 0, so
r = i. ➤ With these two simplifications, equation (20.1) becomes:

Y = C(Y - T) + I(Y, i) + G + NX(Y, Y*, E)

By now you realise that the way to ➤ (20.2)
understand various macroeconomic
(+) (+, -) (-, +, -)
mechanisms is to refine the basic In words: goods market equilibrium implies that output depends negatively on both the
model in one direction and simplify it in
nominal interest rate and the nominal exchange rate.
others (here, opening the economy but
ignoring risk). Keeping all the refine-
ments would lead to a rich model (and
this is what macroeconometric models
20.2 EQUILIBRIUM IN FINANCIAL MARKETS
do) but would make for a terrible text-
book. Things would become far too
When we looked at financial markets in the IS-LM model, we assumed that people chose
complicated.
only between two financial assets, money and bonds. Now that we look at a financially open
economy, we must also consider the fact that people have a choice between domestic bonds
Remember that we have assumed that ➤ and foreign bonds.
people only hold domestic currency and
do not hold foreign currency, so we do
not have to look at that choice. Domestic bonds versus foreign bonds
As we look at the choice between domestic and foreign bonds, we shall rely on the assump-
tion we introduced in Chapter 18: financial investors, domestic or foreign, go for the highest
expected rate of return, ignoring risk. This implies that, in equilibrium, both domestic and
foreign bonds must have the same expected rate of return; otherwise, investors would be
willing to hold only one or the other, but not both, and this could not be an equilibrium. (Like
all economic relations, this relation is only an approximation to reality and does not always
hold. For more on this, see the Focus box ‘Capital flows, sudden stops and the limits of the
interest parity condition’.)
As we saw in Chapter 18 (equation (18.2)), this assumption implies that the following
arbitrage relation – the interest parity condition – must hold:

Et
The presence of Et comes from the fact (1 + it) = (1 + it*) e (20.3)
Et + 1
that, to buy the foreign bond, you must
first exchange domestic currency for where is the domestic interest rate, it* is the foreign interest rate, E t is the current exchange
foreign currency. The presence of E et+1 rate, and E et + 1 is the expected future exchange rate. The left side of the equation gives the
comes from the fact that to bring the
funds back next period, you will have to
return, in terms of domestic currency, from holding domestic bonds. The right side of the
exchange foreign currency for domestic equation gives the expected return, also in terms of domestic currency, from holding foreign
currency. ➤ bonds. In equilibrium, the two expected returns must be equal.
Multiply both sides by E et + 1 and reorganise to get:

1 + it
Et = E et + 1 (20.4)
1 + it*
For now, we shall take the expected future exchange rate as given and denote it as E e (we shall
relax this assumption in Chapter 21). Under this assumption, and dropping time indexes, the
interest parity condition becomes:

1 + i e
E = E (20.5)
1 + i*

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 427

FOCUS
Capital flows, sudden stops and the limits to the interest parity condition

The interest parity condition assumes that financial inves- Figure 20.1, which shows the net purchases of Brazilian
tors care only about expected returns. But, as we discussed equities by foreign investors from 2000 on. Note that the
in Chapter 15, investors also care about risk and liquidity. flows turned sharply negative in the second half of 2008,
Much of the time, one can leave aside these other factors. going from nearly 30% of annual GDP to - 25%, only to
Sometimes, however, they play a big role in investors’ deci- rebound in 2009. (Negative net purchases indicate that
sions and in determining exchange rate movements. The foreign investors sold more stocks than they bought dur-
perception that risk has increased leads investors to want ing the quarter.)
to sell most or all the assets they have in a country, no mat- The sharp negative flows had major effects on Brazil
ter what the interest rate. These selling episodes, which and other emerging market countries, leading to strong
have affected many Latin American and Asian emerging downward pressure on their exchange rates and serious
economies in the past, are known as sudden stops. During problems in their financial systems. For example, domestic
these episodes, the interest parity condition fails, and the banks that had relied on foreign investors for funds found
exchange rate of these emerging market countries may fall themselves short of funds, which forced them to cut lend-
a lot without much change in domestic or foreign interest ing to domestic firms and households. This was an impor-
rates. tant channel of transmission of the crisis from the United
The start of the Great Recession was associated States to the rest of the world.
with large capital movements, which also had little to Further reading: among the countries affected by
do with expected returns. Worried about uncertainty, large capital outflows in 2008 and 2009 were several
many investors from advanced countries decided to take small advanced economies, notably Ireland and Ice-
their funds home, where they felt safer. (Ironically, even land. A number of these countries had built up the same
though the crisis originated from the United States, the financial vulnerabilities as the United States (those we
United States was still seen as a safe haven, leading many studied in Chapter 6) and suffered badly. A good and
investors to sell emerging market countries’ assets and easy read is Michael Lewis’s chapters on Ireland and Ice-
buy US assets.) The result was large capital outflows land in Boomerang: Travels in a New Third World (2011,
from several emerging countries. An example is given in Norton Books).

50

40

30
Percent of GDP

20

10

210

220
Figure 1
230
Net purchases of Brazil-
2000-01
2000-11
2001-09
2002-07
2003-05
2004-03
2005-01
2005-11
2006-09
2007-07
2008-05
2009-03
2010-01
2010-11
2011-09
2012-07
2013-05
2014-03
2015-01
2015-11
2016-09
2017-07

ian equities since 2000

Source: IMF BOP statistics.

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 428 EXTENSIONS THE OPEN ECONOMY

This relation tells us that the current exchange rate depends on the domestic interest rate,
the foreign interest rate and the expected future exchange rate:
● 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.
This relation plays a central role in the real world and will play a central role in this chapter.
Consider the following example.
Think of financial investors – investors, for short – choosing between UK bonds and
German bonds. Suppose that the one-year interest rate on both is 2%. The current exchange
rate is 1 (one pound is worth 100 euros), and the expected exchange rate a year from now is
also 1. Under these assumptions, both UK and German bonds have the same expected return
in pounds, and the interest parity condition holds.
Suppose that investors now expect the exchange rate, for whatever reason, to be 10% higher
a year from now, so E e is now equal to 1.1. At an unchanged current exchange rate, UK bonds
are now much more attractive than German bonds. Both offer an interest rate of 2%, in pounds
or euros but, a year from today, the euro is now expected to be worth 10% less in terms of
pounds. In terms of pounds, the return on German bonds is therefore 2% (the interest rate)
➤
e
An increase in E is an expected appre- - 10% (the expected depreciation of the euro relative to the pound), or - 8%.
ciation of the pound relative to the euro. What, then, will happen to the current exchange rate? At the initial exchange rate of 1,
Equivalently, it is an expected deprecia- investors will want to shift out of German bonds into UK bonds. To do so, they must first
tion of the euro relative to the pound.
sell German bonds for euros, then sell euros for pounds, and then use the pounds to buy UK
bonds. As investors sell euros and buy pounds, the pound will appreciate relative to the euro.
By how much? Equation (20.5) gives the answer: E = (1.02>1.02)1.1 = 1.1. The current
exchange rate must increase in the same proportion as the expected future exchange rate.
Put another way, the pound must appreciate today by 10%. When it has appreciated by 10%,
so E = E e = 1.1, the expected returns on UK and German bonds are again equal, and there
is equilibrium in the foreign exchange market.
Suppose instead that the Bank of England raises the domestic interest rate from 2% to 5%.
Assume that the German interest rate remains unchanged at 2%, and the expected future
exchange rate remains unchanged at 1. At an unchanged current exchange rate, UK bonds are
again more attractive than German bonds. UK bonds yield a return of 5% in pounds. German
bonds give a return of 2% in euros, and – because the exchange rate is expected to be the
same next year as it is today – an expected return of 2% in pounds as well.
Now what will happen to the current exchange rate? Again, at the initial exchange rate
of 1, investors will want to shift out of German bonds into UK bonds. As they do so, they sell
euros for pounds and the pound will appreciate. By how much? Equation (20.5) gives the
answer: E = (1.05>1.02) 1 ≈ 1.03. The current exchange rate will increase by approxi-
mately 3%.
Why 3%? Think of what happens when the pound appreciates. If, as we have assumed,
investors do not change their expectation of the future exchange rate, then the more the pound
appreciates today, the more investors expect it to depreciate in the future (as it is expected to
return to the same value in the future). When the pound has appreciated by 3% today, inves-
tors expect it to depreciate by 3% during the coming year. Equivalently, they expect the euro
to appreciate relative to the pound by 3% over the coming year. The expected rate of return
Make sure you understand the argu- in pounds from holding German bonds is therefore 2% (the interest rate in euros) + 3% (the
ment. Why doesn’t the pound appreci- expected euro appreciation), or 5%. This expected rate of return is the same as the rate of
ate by, say, 20%? ➤ return on holding UK bonds, so there is equilibrium in the foreign exchange market.
Note that our argument relies heavily on the assumption that, when the interest rate
changes, the expected exchange rate remains unchanged. This implies that an appreciation
today leads to an expected depreciation in the future because the exchange rate is expected
to return to the same, unchanged, value. We shall relax the assumption that the expected
future exchange rate is fixed in Chapter 21. But the basic conclusion will remain: an increase

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 429

Domestic interest rate, i

Interest parity relation
given (i *, E e )

A
i 5i*
Figure 20.1
The relation between
the interest rate and the
exchange rate implied by
interest parity
A higher domestic interest rate
Ee leads to a higher exchange rate – an
Exchange rate, E appreciation.

in the domestic interest rate relative to the foreign interest rate leads to an appreciation of the
domestic currency.
Figure 20.1 plots the relation between the domestic interest rate, i, and the exchange
rate, E, implied by equation (20.5) – the interest parity relation. The relation is drawn for
a given expected future exchange rate, E e, and a given foreign interest rate, i*, and is rep-
resented by an upward-sloping line. The higher the domestic interest rate, the higher the
exchange rate. Equation (20.5) also implies that, when the domestic interest rate is equal to
the foreign interest rate (i = i*), the exchange rate is equal to the expected future exchange What happens to the line if
rate (E = E e). This implies that the line corresponding to the interest parity condition goes (1) i* increases?
e
through point A (where i = i*) in the figure. (2) E increases?
➤

20.3 PUTTING GOODS AND FINANCIAL MARKETS

TOGETHER
We now have the elements we need to understand the movements of output, the interest
rate and the exchange rate.
Goods market equilibrium implies that output depends, among other factors, on the inter-
est rate and the exchange rate:
Y = C(Y - T) + I(Y, i) + G + NX(Y, Y*, E)

Let’s think of the interest rate, i, as the policy rate set by the central bank:
i = i

And the interest parity condition implies a positive relation between the domestic interest
rate and the exchange rate:
1 + i e
E = E
1 + i*
Together, these three relations determine output, the interest rate and the exchange rate.
Working with three equations and three variables is not easy. But we can easily reduce them
to two by using the interest parity condition to eliminate the exchange rate in the goods mar-
ket equilibrium relation. Doing this gives us the following two equations, the open economy
versions of the IS and LM relations:

1 + i e
IS: Y = C(Y - T) + I(Y, i) + G + NX aY, Y*, E b
1 + i*
LM: i = i

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 430 EXTENSIONS THE OPEN ECONOMY

Together, the two equations determine the interest rate and equilibrium output. Using equa-
tion (20.5) then gives us the implied exchange rate. Take the IS relation first and consider
the effects of an increase in the interest rate on output. An increase in the interest rate now
has two effects:
● The first effect, which was already present in a closed economy, is the direct effect on
investment. A higher interest rate leads to a decrease in investment, a decrease in the
demand for domestic goods, and a decrease in output.
● The second effect, which is present in the open economy, is the effect through the exchange
rate. A higher interest rate leads to an increase in the exchange rate – an appreciation. The
appreciation, which makes domestic goods more expensive relative to foreign goods, leads
to a decrease in net exports, and therefore a decrease in the demand for domestic goods
and a decrease in output.
Both effects work in the same direction. An increase in the interest rate decreases demand
directly and indirectly – through the adverse effect of the appreciation on demand.
The IS relation between the interest rate and output is drawn in Figure 20.2(a), for given
values of all the other variables in the relation – T, G, Y*, i* and E e. The IS curve is downward
An increase in the interest rate leads,
sloping: an increase in the interest rate leads to lower output. The curve looks much the same
both directly and indirectly (through the as in the closed economy, but it hides a more complex relation than before. The interest rate
➤
exchange rate), to a decrease in output. affects output not only directly but also indirectly through the exchange rate.
The LM relation is the same as in the closed economy: it is a horizontal line, at the level of
the interest rate i set by the central bank.
Equilibrium in the goods and financial markets is attained at point A in Figure 20.2(a),
with output level Y and interest rate i. The equilibrium value of the exchange rate cannot be
read directly from the graph. But it is easily obtained from Figure 20.2(b), which replicates
Figure 20.1 and gives the exchange rate associated with a given interest rate found at point
B, given the foreign interest rate i* and the expected exchange rate. The exchange rate associ-
ated with the equilibrium interest rate i is equal to E.
Let’s summarise. We have derived the IS and LM relations for an open economy:
● The IS curve is downward sloping. An increase in the interest rate leads both directly
and indirectly (through the exchange rate) to a decrease in demand and a decrease in
output.
● The LM curve is horizontal at the interest rate set by the central bank.
● Equilibrium output and the equilibrium interest rate are given by the intersection of the
IS and LM curves. Given the foreign interest rate and the expected future exchange rate,
the equilibrium interest rate determines the equilibrium exchange rate.

(a) (b)

Interest parity
relation given
Domestic interest rate, i

Domestic interest rate, i

(i *, E e )

A LM B
i i
Figure 20.2
The IS-LM model in an
open economy
An increase in the interest rate reduces
output both directly and indirectly
(through the exchange rate). The IS IS
curve is downward sloping, for both
reasons. The LM curve is horizontal, as Y E
in Chapter 6. Output, Y Exchange rate, E

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 431

20.4 THE EFFECTS OF POLICY IN AN OPEN ECONOMY

Having derived the IS-LM model for the open economy, we can now put it to use and look at
the effects of monetary and fiscal policy.

The effects of monetary policy in an open economy

Let’s start from the effects of the central bank’s decision to increase the domestic interest
rate. Look at Figure 20.3(a). At a given level of output, with a higher interest rate, the LM
curve shifts up, from LM to LM′. The IS curve does not shift (remember that the IS curve A monetary contraction shifts the LM
shifts only if G or T or Y* or i* change). The equilibrium moves from point A to point A′. In curve up. It shifts neither the IS curve
Figure 20.3(b), the increase in the interest rate leads to an appreciation. nor the interest parity curve.
➤

So, in an open economy, monetary policy works through two channels: first, as in the
closed economy, it works through the effect of the interest rate on spending; second, it works
Can you tell what happens to net
through the effect of the interest rate on the exchange rate and the effect of the exchange rate exports? (The answer is no: they can go
on exports and imports. Both effects work in the same direction. In the case of a monetary either way. Make sure you understand
contraction, the higher interest rate and the appreciation decrease both demand and output. why.)
➤

The effects of fiscal policy in an open economy

Let’s look now at a change in government spending. Suppose that, starting from a balanced
budget, the government decides to increase defence spending without raising taxes and so
runs a budget deficit. What happens to the level of output? To the composition of output?
To the interest rate? To the exchange rate?
Let us first assume that, before the increase in government spending, the level of output,
Y, was below potential. If the increase in G moves output toward potential, but not above
potential, the central bank will not be worried that inflation might increase (remember our
discussion in Chapter 9, particularly Figure 9.2) and will keep the interest rate unchanged.
What happens to the economy is described in Figure 20.4. The economy is initially at point
A. The increase in government spending, ∆G 7 0, increases output at a given interest rate,
shifting the IS curve to the right, from IS to IS′ in Figure 20.4(a). Because the central bank
does not change the policy rate, the LM curve does not shift. The new equilibrium is at point
A′, with a higher level of output, Y′. In panel (b), because the interest rate has not changed,
An increase in government spending
neither has the exchange rate. So, an increase in government spending, when the central shifts the IS curve to the right. It shifts
bank keeps the interest rate unchanged, leads to an increase in output with no change in the neither the LM curve nor the interest
exchange rate. ➤ parity line.

(a) (b)

Interest parity relation

given (i *, E e )
Domestic interest rate, i

A
Domestic interest rate, i

A LM
i i
A LM A
i i

Figure 20.3
The effects of an increase
IS in the interest rate
An increase in the interest rate
Y Y E E leads to a decrease in output and an
Output, Y Exchange rate, E appreciation.

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 432 EXTENSIONS THE OPEN ECONOMY

(a) (b)

Interest parity relation

∆G > 0 given (i *, E e )

Domestic interest rate, i

Domestic interest rate, i

A A LM A
Figure 20.4
The effects of an increase
in government spending
with an unchanged interest
rate IS
An increase in government spending
leads to an increase in output. If the IS
central bank keeps the interest rate
unchanged, the exchange rate also
Y Y Ee
remains unchanged. Output, Y Exchange rate, E

Can we tell what happens to the various components of demand?

● Clearly, both consumption and government spending increase: consumption goes up
because of the increase in income; government spending goes up by assumption.
● Investment also rises because it depends on both output and the interest rate: I = I(Y, i).
Here, output rises and the interest rate does not change, thus investment rises.
● What about net exports? Recall that net exports depend on domestic output, foreign
output and the exchange rate: NX = NX(Y, Y*, E). Foreign output is unchanged, as we
are assuming that the rest of the world does not respond to the increase in domestic gov-
ernment spending. The exchange rate is also unchanged, because the interest rate does
not change. We are left with the effect of higher domestic output; as the increase in out-
put increases imports at an unchanged exchange rate, net exports decrease. As a result,
the budget deficit leads to a deterioration of the trade balance. If trade was balanced to
start, then the budget deficit leads to a trade deficit. Note that, although an increase in
the budget deficit increases the trade deficit, the effect is far from mechanical. It works
through the effect of the budget deficit on output and, in turn, on the trade deficit.
Now assume, instead, that the increase in G happens in an economy where output is close to
potential output, Yn. The government could decide to increase government spending even
if the economy is already at potential output because, for example, it needs to pay for an
exceptional event, such as a big flood, and wants to postpone tax increases. Or it could do
it for political reasons, because it wants to increase spending but does not want to increase
taxes (more on this in Chapter 23). In this case, the central bank will worry that the increase
in G, by moving the economy above potential output, might push inflation up. It is likely to
respond by raising the interest rate. What happens then is described in Figure 20.5. At an
unchanged interest rate, output would increase from Yn to Y′ and the exchange rate would
not change. But, if the central bank accompanies the increase in government spending with
an increase in the interest rate, output will increase by less, from to Yn to Y″, and the exchange
rate will appreciate, from E to E″.
Again, can we tell what happens to the various components of demand?
● As before, both consumption and government spending increase: consumption goes up
because of the increase in income, and government spending goes up by assumption.
● What happens to investment is now ambiguous. Investment depends on both output and
the interest rate: I = I(Y, i). Here output rises, but so does the interest rate.
● Net exports decrease for two reasons: output goes up, increasing imports; the exchange
rate appreciates, increasing imports and decreasing exports. The budget deficit leads to a
trade deficit. (Whether, however, the trade deficit is larger than if the policy rate remained
constant is ambiguous. The appreciation makes it worse, but the higher interest rate leads
to a smaller increase in output and thus a smaller increase in imports.)

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 433

(a) (b)
Domestic interest rate, i

Domestic interest rate, i

∆G > 0
LM A A Figure 20.5
The effects of an increase
LM A A A in government spending
when the central bank
IS
responds by raising the
interest rate
IS An increase in government spending
leads to an increase in output. If the
central bank responds by raising the
Yn Y Y E E interest rate, the exchange rate will
Output, Y Exchange rate, E appreciate.

This version of the IS-LM model for the open economy was first put together in the 1960s by
the two economists we mentioned at the outset of the chapter, Robert Mundell, at Columbia
University, and Marcus Fleming, at the International Monetary Fund – although their model
reflected the economies of the 1960s, when central banks used to set the supply of money,
M, rather than the interest rate as they do today (remember our discussions in Chapters 4 Robert Mundell was awarded the Nobel
and 6), so their model was slightly different from the model presented here. Prize in Economics in 1999.
➤

How well does the Mundell-Fleming model fit the facts? Typically, quite well, and this
is why it is still in use. Like all simple models, it often needs to be extended. One can incor-
porate, for example, the role of risk in affecting portfolio decisions, or the implications of
the zero lower bound, two important aspects of the financial crisis. But the simple exercises
we worked through in Figures 20.3, 20.4 and 20.5 are a good starting point to organise
thoughts. How the model can be used to interpret events or think about policy is shown in
two Focus boxes. The first looks at the effects of the combination of monetary contraction
and fiscal expansion that took place in the United States in the early 1980s. The second looks
at whether we can expect the trade tariffs introduced by the Trump administration to reduce
the trade deficit.

FOCUS
Monetary contraction and fiscal expansion: the United States
in the early 1980s

The early 1980s in the United States were dominated taxation and a scaling back of the government’s role in
by sharp changes in both monetary policy and in fiscal economic activity. This commitment led to the Economic
policy. Recovery Tax Act of August 1981. Personal income taxes
In the late 1970s, the chairman of the Fed, Paul Volcker, were cut by a total of 23% in three instalments from 1981
concluded that US inflation was too high and had to be to 1983. Corporate taxes were also reduced. These tax
reduced. Starting in late 1979, he embarked on a path of cuts were not, however, accompanied by corresponding
sharp increases in interest rates, realising this might lead decreases in government spending, and the result was a
to a recession in the short run but lower inflation in the steady increase in budget deficits.
medium run. What were the Reagan administration’s motivations for
The change in fiscal policy was triggered by the elec- cutting taxes without implementing corresponding cuts in
tion of Ronald Reagan in 1980. Reagan was elected on spending? These are still being debated, but there is agree-
the promise of more conservative policies, namely lower ment that there were two main motivations.

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 434 EXTENSIONS THE OPEN ECONOMY

One motivation came from the beliefs of a fringe, but very much in line with what the Mundell-Fleming model
influential, group of economists called the supply siders, predicts. Table 1 shows the evolution of the main macro-
who argued that a cut in tax rates would cause people and economic variables from 1980 to 1984.
firms to work much harder and more productively, and that From 1980 to 1982, the evolution of the economy was
the resulting increase in activity would actually lead to an dominated by the effects of the increase in interest rates,
increase, not a decrease, in tax revenues. Using the termi- both nominal and real. They increased sharply, leading
nology of this textbook: they thought that potential output to both a large dollar appreciation and a recession. The
would substantially increase, actual output would follow, goal of lowering inflation was achieved; by 1982, infla-
and tax revenues would increase. Whatever the merits of tion was down to about 4%, down from 12.5% in 1980.
the argument appeared to be then, it proved wrong. Even if Lower output and the dollar appreciation had opposing
some people did work harder and more productively after effects on the trade balance (lower output leading to
the tax cuts, tax revenues decreased and the fiscal deficit lower imports and an improvement in the trade balance;
increased. the appreciation of the dollar leading to a deterioration in
The other motivation was more cynical. It was a bet the trade balance), resulting in little change in the trade
that the cut in taxes, and the resulting increase in defi- deficit until 1983.
cits, would scare Congress into cutting spending or, at the From 1983 on, the evolution of the economy was
least, into not increasing spending – a strategy known as dominated by the effects of the fiscal expansion. As our
‘starve the beast’. This motivation turned out to be partly model predicts, these effects were strong output growth,
right: Congress found itself under enormous pressure not high interest rates, and further dollar appreciation.
to increase spending, and the growth of spending in the High output growth and the dollar appreciation led to
1980s was surely lower than it would have been otherwise. an increase in the trade deficit to 2.7% of GDP by 1984.
Nonetheless, the adjustment of spending was not enough By the mid-1980s, the main macroeconomic policy issue
to offset the shortfall in tax revenues and avoid the rapid had become that of the twin deficits: the budget deficit
increase in deficits. and the trade deficit. The twin deficits were to remain a
Whatever the reason for the deficits, the combined central macroeconomic concern throughout the 1980s
effects of higher interest rates and a fiscal expansion were and early 1990s.

Table 1 Major US macroeconomic variables, 1980–4

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
Nominal interest rate (%) 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, normalised so that 1973 = 100.
A negative trade surplus is a trade deficit.

FOCUS
US trade deficits and Trump administration trade tariffs

One of the themes of President Trump’s 2016 campaign increased tariffs on solar panels, then on steel and alumin-
was that the US trade deficit, which stood at 2.7% of GDP ium imports, and then on a range of Chinese goods.
at the time, had to be reduced. He saw the trade deficit Most economists disagreed with both the diagnosis and
as an indication that foreign countries, China in particu- the method.
lar, were taking advantage of the United States. In 2018, About the diagnosis: most economists saw the trade
following up on this promise, the Trump administration deficits as reflecting chronically low US saving relative to

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 435

investment, together with the willingness of foreigners to the volume of imports decreases, leading again to a
lend to the United States, allowing for the deficits to be eas- decrease in the value of imports.
ily financed through foreign borrowing. Thus, they argued, In both cases, at a given nominal exchange rate, the value
trade deficits reflected a US problem and had to be solved of imports in terms of domestic goods decreases. Given
by increasing domestic saving, private or public. Some exports, this implies a smaller trade deficit. (There is a dif-
economists went further and argued that the origin of the ference, however, in terms of who pays for the tariffs. In
trade deficit was actually the attractiveness of US assets. the first case, the foreign firms pay; in the second case, the
Foreigners were eager to hold US assets, and this foreign US consumers pay.) The smaller trade deficit leads to an
demand led to dollar appreciation, decreasing, in turn, the increase in demand and an increase in output. It all seems
relative competitiveness of US goods and leading to the to work. So why were the economists sceptical that the tar-
trade deficit. (You may want to return to the discussion of iffs would not reduce the trade deficit?
the relation between trade deficits, saving and investment For four reasons:
in Section 19.5.) Thus, these economists argued, the trade
● To the extent that it triggered a tariff war, and other
deficit reflected the financial strength of the United States
countries responded by raising tariffs on US goods,
and was not particularly worrisome.
US exports might decrease in line with the decrease
About the method: economists argued that, if the origin
in US imports, leading to no change in the trade deficit.
of the trade deficit lay in low US saving or in the attractive-
And, indeed, in response to US tariffs, China increased
ness of US assets, tariffs were unlikely to work. Let’s see
tariffs on US goods in late 2018.
why.
● To the extent that the US economy was close to poten-
At a given exchange rate, an increase in tariffs increases
tial, as was indeed the case in 2018, an increase in out-
the price of imports for US consumers. How much depends
put might lead to overheating and thus force the Fed to
on what foreign firms do in reaction to the tariff:
increase the interest rate. This, in turn, would lead to a
● They can decrease their pre-tariff price, in which case dollar appreciation (remember the interest parity condi-
the price facing US consumers increases by less than the tion), partially cancelling the effects of the tariffs on net
tariff. They can even decrease the pre-tariff price enough exports.
that the price facing US consumers does not change. In ● Even if the Fed did not increase the interest rate, expec-
this case, the volume of imports may not change, but tations of a lower trade deficit and thus a smaller need
how much the United States pays for imports (the pre- for foreign borrowing, now and in the future, may lead
tariff price) goes down, so the value of imports in terms to an appreciation of the dollar, again partially offset-
of domestic goods decreases. ting the effects of the tariffs on net exports.
● Or they can, instead, keep the same pre-tariff price, in ● Finally, while it was increasing tariffs, the Trump
which case the price facing US consumers increases by administration also implemented a tax reform passed
the increase in the tariff, and the demand for imports is in 2017, which led to a large increase in the fiscal defi-
then likely to decrease. In this case, the price that the cit in 2018. As we saw in this chapter, a larger fiscal
United States pays for imports does not change, but deficit is likely to lead to a larger trade deficit: if the

125 22.0
2018
Real multilateral exchange rate 22.2
120
22.4
115 22.6

110 22.8
Net exports/GDP
23.0
105 23.2
100 23.4
23.6
95 Figure 1
23.8
90 24.0 Net exports/GDP and
the real multilateral
2010-01

2011-01

2012-01

2013-01

2014-01

2015-01

2016-01

2017-01

2018-01

exchange rate since 2010

Source: FRED: NETEXP, GDP, RBUSBIS.

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 436 EXTENSIONS THE OPEN ECONOMY

Fed did not intervene, the fiscal deficit would lead to Figure 20.7, which plots the evolution of the ratio of net
larger output and higher imports. If the Fed intervened exports to GDP and of the real exchange rate (normalised
to limit the increase in output, the increase in interest to 100 in 2010), quarterly, since 2010.
rates would lead to a dollar appreciation and, again, to The shaded area corresponds to the four quarters of
a larger trade deficit. In either case, fiscal policy was 2018. Since the beginning of 2018, the real exchange rate
likely to offset or even dominate the effects of tariffs on (left-hand vertical axis) has increased by close to 9%. The
the trade balance. trade deficit (right-hand vertical axis) is roughly the same
What happened? At the time of writing, it is too early to as it was at the beginning of 2018, around 3% of GDP. For
draw strong conclusions. Trade negotiations are still going the moment, things have not moved in the direction the
on. It takes time for exporters and importers to react to Trump administration hoped for. (What would you do if
tariffs and exchange rate movements. So far, however, the you wanted to reduce the US trade deficit while keeping
evidence is on the side of the economists. This is shown in output at potential?)

20.5 FIXED EXCHANGE RATES

We have assumed, so far, that the central bank chose the interest rate and let the exchange
rate adjust freely in whatever manner was implied by equilibrium in the foreign exchange
market. In many countries, this assumption does not reflect reality. Central banks act under
implicit or explicit exchange rate targets and use monetary policy to achieve those targets.
The targets are sometimes implicit, sometimes explicit; they are sometimes specific values,
sometimes bands or ranges. These exchange rate arrangements (or regimes, as they are
called) come under many names. Let’s first see what the names mean.

Pegs, crawling pegs, bands, the EMS and the euro

At one end of the spectrum are countries with flexible exchange rates such as the United
States, the United Kingdom, Japan and Canada. These countries have no explicit exchange
rate targets. Although their central banks do not ignore movements in the exchange rate,
they have shown themselves quite willing to let their exchange rates fluctuate considerably.
At the other end are countries that operate under fixed exchange rates. They maintain a
fixed exchange rate in terms of some foreign currency. Some peg their currency to the dollar.
For example, from 1991 to 2001, Argentina pegged its currency, the peso, at the highly sym-
bolic exchange rate of one dollar for one peso (more on this in Chapter 21). Other countries
used to peg their currency to the French franc (most of these are former French colonies in
Africa); as the French franc has been replaced by the euro, they are now pegged to the euro.
Still other countries peg their currency to a basket of foreign currencies, with the weights
reflecting the composition of their trade.
The label fixed is a bit misleading. It is not the case that the exchange rate in countries with
a fixed exchange rate never actually changes. But changes are rare. An extreme case is that of
the African countries pegged to the French franc. When their exchange rates were readjusted
in January 1994, it was the first adjustment in 45 years! Because these changes are rare,
economists use specific words to distinguish them from the daily changes that occur under
flexible exchange rates. A decrease in the exchange rate under a regime of fixed exchange
rates is called a devaluation rather than a depreciation, and an increase in the exchange rate
➤
These terms were introduced in under a regime of fixed exchange rates is called a revaluation rather than an appreciation.
Chapter 18. Between these extremes are countries with various degrees of commitment to an exchange
Recall the definition of the real rate target. For example, some countries operate under a crawling peg. The name describes
exchange rate E = EP>P*. If domestic it well. These countries typically have inflation rates that exceed the US inflation rate. If
inflation is higher than foreign inflation:
they were to peg their nominal exchange rate against the dollar, the more rapid increase in
P increases faster than P*. If E is fixed,
EP/P* steadily increases. their domestic price level above the US price level would lead to a steady real appreciation
and rapidly make their goods uncompetitive. To avoid this effect, these countries choose a
predetermined rate of depreciation against the dollar: they choose to ‘crawl’ (move slowly)
vis-à-vis the dollar.

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 437

Yet another arrangement is for a group of countries to maintain their bilateral exchange
rates (the exchange rate between each pair of countries) within some bands. Perhaps the
most prominent example was the European Monetary System (EMS), which determined
the movements of exchange rates in the European Union from 1978 to 1998. Under the EMS
rules, member countries agreed to maintain their exchange rate relative to the other curren-
cies in the system within narrow limits or bands around a central parity – a given value for
the exchange rate. Changes in the central parity and devaluations or revaluations of specific
currencies could occur, but only by common agreement among member countries. After a We shall look at the 1992 crisis in
Chapter 21.
major crisis in 1992, which led several countries to drop out of the EMS, exchange rate adjust-
You can think of countries adopting
ments became more and more infrequent, leading a number of countries to move one step
a common currency as adopting an
further and adopt a common currency, the euro. The conversion from domestic currencies extreme form of fixed exchange rates.
to the euro began on 1 January 1999, and was completed in early 2002. We shall return to Their ‘exchange rate’ is fixed at one-to-
the implications of the move to the euro in Chapter 21. one between any pair of countries.
➤

We shall discuss the pros and cons of different exchange regimes in the next chapter. But
first, we must understand how pegging (also called fixing) the exchange rate affects mon-
etary policy and fiscal policy. This is what we do in the rest of this section.

Monetary policy when the exchange rate is fixed

Suppose a country decides to peg its exchange rate at some chosen value; call it E. How does
it achieve this? The government cannot just announce the value of the exchange rate and
remain idle. Rather, it must take measures so that its chosen exchange rate will prevail in the
foreign exchange market. Let’s look at the implications and mechanics of pegging.
Pegging or no pegging, the exchange rate and the nominal interest rate must satisfy the
interest parity condition:
Et
(1 + it) = (1 + it*) ¢ e ≤ This is the trilemma right
Et + 1
here: assuming freely
When the country pegs its exchange rate at E, the current exchange rate E t = E. If financial moving capital, you have to
and foreign exchange markets believe that the exchange rate will remain pegged at this let go of monetary policy if
you are managing your
value, then their expectation of the future exchange rate, E et + 1, is also equal to E, and the
exchange rate.
interest parity relation becomes:
These results depend on the interest
(1 + it) = (1 + it*) 1 it = it* rate parity condition, which in turn
depends on the assumption of perfect
In words: if financial investors expect the exchange rate to remain unchanged, they will capital mobility – that financial inves-
require the same nominal interest rate in both countries. Under a fixed exchange rate and tors go for the highest expected rate of
perfect capital mobility, the domestic interest rate must be equal to the interest rate of the foreign return. The case of fixed exchange rates
with imperfect capital mobility, which is
country the country is pegging to.
more relevant for middle-income coun-
Let’s summarise. Under fixed exchange rates, the central bank gives up monetary policy as tries such as those in Latin America or
a policy instrument. With a fixed exchange rate, the domestic interest rate must be equal to Asia, is treated in the appendix to this
the foreign interest rate. chapter.
➤

Fiscal policy when the exchange rate is fixed

If monetary policy can no longer be used under fixed exchange rates, what about fiscal policy?
The effects of an increase in government spending when the central bank pegs the
exchange rate are identical to those we saw in Figure 20.4 for the case of flexible exchange
rates and an unchanged monetary policy. This is because, under flexible exchange rates, if the
increase in spending is not accompanied by a change in the interest rate, the exchange rate
doesn’t move. Thus, when government spending increases, it makes no difference whether
the country pegs its exchange rate. The difference between fixed and flexible exchange is the
ability of the central bank to respond. We saw in Figure 20.5 that, if the increase in govern-
ment spending pushed the economy above potential output, thus raising the possibility that
inflation might increase, the central bank could respond by raising the interest rate. This

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 438 EXTENSIONS THE OPEN ECONOMY

option is no longer available under fixed exchange rates because the interest rate must be
equal to the foreign rate.
As this chapter comes to an end, a question should have started to form in your mind:
why would a country choose to fix its exchange rate? You have seen several reasons why this
➤
Under flexible exchange rates, the cen- appears to be a bad idea:
tral bank can respond to an increase
● By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbal-
in government spending by raising
the interest rate, as in Figure 20.5. ances or changing the level of economic activity.
This option is not available under fixed ● By committing to a given exchange rate, a country also gives up control of its interest rate.
exchange rates because the interest Not only that, but the country must match movements in the foreign interest rate, at the
rate must be equal to the foreign rate. risk of unwanted effects on its own activity. This is what happened in the early 1990s in
Europe. Because of the increase in demand as a result of the reunification of West and East
Germany, Germany felt it had to increase its interest rate. To maintain their parity with the
Deutsche Mark, other countries in the European Monetary System (EMS) were forced to
increase their interest rates, something they would rather have avoided (this is the topic
of the Focus box ‘German reunification, interest rates and the EMS’.)
● Although the country retains control of fiscal policy, one policy instrument may not be
enough. As you saw in Chapter 19, a fiscal expansion can help the economy get out of
a recession, but only at the cost of a larger trade deficit. And a country that wants, for
example, to decrease its budget deficit cannot, under a fixed exchange rate, use monetary
policy to offset the contractionary effect of its fiscal policy on output.
Why, then, do some countries fix their exchange rate? Why have 19 European countries –
with perhaps more to come – adopted a common currency? To answer these questions, we
must do some more work. We must look at what happens not only in the short run – which
is what we did in this chapter – but also in the medium run, when the price level can adjust.
And we must look at the nature of exchange rate crises. Once we have done this, we shall be
able to assess the pros and cons of different exchange rate regimes. These are the topics we
take up in Chapter 21.

FOCUS
German reunification, interest rates and the EMS

Under a fixed exchange rate regime such as the European an increase in activity led it to adopt a restrictive monetary
Monetary System (EMS) – the system that prevailed before policy. The result was strong growth in Germany together
the introduction of the euro – no individual country can with a large increase in interest rates.
change its interest rate if the other countries do not change This may have been the right policy mix for Germany,
theirs as well. How, then, do interest rates actually change? but, for the other European countries, it was much less
Two arrangements are possible. One is for all the member appealing. They were not experiencing the same increase
countries to coordinate changes in their interest rates. The in demand, but to stay in the EMS they had to match
other is for one of the countries to take the lead and for the German interest rates. The net result was a sharp decrease
other countries to follow – this is, in effect, what happened in demand and output in the other countries. These results
in the EMS, with Germany as the leader. are presented in Table 1, which gives nominal interest
During the 1980s, most European central banks shared rates, real interest rates, inflation rates and GDP growth
similar goals and were happy to let the Bundesbank (the from 1990 to 1992 for Germany and two of its EMS part-
German central bank) take the lead. But, in 1990, German ners, France and Belgium.
unification led to a sharp divergence in goals between the Note, first, that the high German nominal interest rates
Bundesbank and the central banks of the other EMS coun- were matched by both France and Belgium. In fact, nominal
tries. Large budget deficits triggered by transfers to people interest rates were actually higher in France than in Ger-
and firms in Eastern Germany, together with an investment many in all three years! This is because France needed higher
boom, led to a large increase in demand in Germany. The interest rates than Germany to maintain the Deutsche Mark
Bundesbank’s fear that this shift would generate too strong (DM)/franc parity: worried about a possible devaluation of

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 CHAPTER 20 OUTPUT, THE INTEREST RATE AND THE EXCHANGE RATE 439

Table 1 Interest rates, inflation and output growth after German reunification: Germany,
France and Belgium, 1990–2
Nominal interest rates (%) Inflation (%)
1990 1991 1992 1990 1991 1992
Germany 8.5 9.2 9.5 2.7 3.7 4.7
France 10.3 9.6 10.3 2.9 3.0 2.4
Belgium 9.6 9.4 9.4 2.9 2.7 2.4
Real interest rates (%) GDP growth (%)
1990 1991 1992 1990 1991 1992
Germany 5.8 5.5 4.8 5.7 4.5 2.1
France 7.4 6.6 7.9 2.5 0.7 1.4
Belgium 6.7 6.7 7.0 3.3 2.1 0.8
The nominal interest rate is the short-term nominal interest rate. The real interest rate is the realised 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.

the franc, financial investors required a higher interest rate Union, which had been 8.7% in 1990, had increased to
on French bonds than on German bonds (more on this in the 10.3%. The effects of high real interest rates on spending
Focus box on the EMS crisis in Chapter 21). were not the only source of this slowdown, but they were
Although France and Belgium had to match – or, as we the main one.
have just seen, more than match – German nominal rates, By 1992, an increasing number of countries were won-
both countries had less inflation than Germany. The result dering whether to keep defending their EMS parity or to
was very high real interest rates, much higher than the give it up and lower their interest rates. Worried about
rate in Germany: in both France and Belgium, average real the risk of devaluations, financial markets started to ask
interest rates from 1990 to 1992 were close to 7%. And, for higher interest rates in countries where they thought
in both countries, the period 1990–2 was characterised by devaluations were more likely. The result was two major
slow growth and rising unemployment. In France, unem- exchange rate crises, one in the fall of 1992 and the other
ployment in 1992 was 10.4%, up from 8.9% in 1990; the in the summer of 1993. By the end of these two crises, two
corresponding numbers for Belgium were 12.1% and 8.7%. countries, Italy and the United Kingdom, had left the EMS.
A similar story was unfolding in the other EMS coun- We shall look at these crises, their origins, and their implica-
tries. By 1992, average unemployment in the European tions in Chapter 21.

SUMMARY
● In an open economy, the demand for domestic goods is partially offset by tighter monetary policy, it leads to an
and, in turn, output depends on both the interest rate increase in the interest rate and an appreciation.
and the exchange rate. An increase in the interest rate ● Under flexible exchange rates, a contractionary monetary
decreases the demand for domestic goods. An increase in policy leads to a decrease in output, an increase in the
the exchange rate – an appreciation – also decreases the interest rate and an appreciation.
demand for domestic goods.
● There are many types of exchange rate arrangements: fully
● The exchange rate is determined by the interest parity flexible exchange rates, crawling pegs, fixed exchange rates
condition, which states that domestic and foreign bonds (or pegs) or the adoption of a common currency. Under
must have the same expected rate of return in terms of fixed exchange rates, a country maintains a fixed exchange
domestic currency. rate in terms of a foreign currency or a basket of currencies.
● Given the expected future exchange rate and the foreign ● Under fixed exchange rates and the interest parity con-
interest rate, increases in the domestic interest rate lead dition, a country must maintain an interest rate equal to
to an increase in the exchange rate – an appreciation. the foreign interest rate. The central bank loses the use
Decreases in the domestic interest rate lead to a decrease of monetary policy as a policy instrument. Fiscal policy
in the exchange rate – a depreciation. becomes potentially more powerful than under flexible
● Under flexible exchange rates, an expansionary fiscal pol- exchange rates, because fiscal policy requires monetary
icy leads to an increase in output. If the fiscal expansion accommodation and so does not lead to offsetting changes
in the domestic interest rate and exchange rate.

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 440 EXTENSIONS THE OPEN ECONOMY

KEY TERMS
Mundell-Fleming model 424 supply siders 434 crawling peg 436 bands 437
sudden stops 427 twin deficits 434 European Monetary System central parity 437
safe haven 427 peg 436 (EMS) 437 euro 437

QUESTIONS AND PROBLEMS

QUICK CHECK b. How does the reduction in interest rates in an economy
with flexible exchange rates affect net exports?
1. Using the information in this chapter, label each of the fol-
lowing statements true, false or uncertain. Explain briefly. 4. Flexible exchange rates and foreign macroeconomic
a. The interest rate parity condition means that interest rates events
are equal across countries. Consider an open economy with flexible exchange rates. Let UIP
b. Other things being equal, the interest parity condition stand for the uncovered interest parity condition.
implies that the domestic currency will appreciate in a. In an IS-LM–UIP diagram, such as Figure 20.2, show the
response to an increase in the expected exchange rate. effect of an increase in foreign output, Y*, on domestic
c. If financial investors expect the dollar to depreciate output (Y) and the exchange rate (E), when the domestic
against the yen over the coming year, one-year interest central bank leaves the policy interest rate unchanged.
rates will be higher in the United States than in Japan. Explain in words.
d. If the expected exchange rate appreciates, the current b. In an IS-LM–UIP diagram, show the effect of an increase in
exchange rate immediately appreciates. the foreign interest rate, i*, on domestic output (Y) and the
exchange rate (E), when the domestic central bank leaves
e. The central bank influences the value of the exchange rate
the policy interest rate unchanged. Explain in words.
by changing the domestic interest rate relative to the for-
eign interest rate. 5. Flexible exchange rates and the responses to changes
f. An increase in domestic interest rates, all other factors in foreign macroeconomic policy
equal, increases exports. Suppose there is an expansionary fiscal policy in the foreign
g. A fiscal expansion, all other factors equal, tends to increase country that increases Y* and i* at the same time.
net exports. a. In an IS-LM–UIP diagram, such as Figure 20.2, show the
h. Fiscal policy has a greater effect on output in an economy effect of the increase in foreign output, Y*, and the increase
with fixed exchange rates than in an economy with flex- in the foreign interest rate, i*, on domestic output (Y) and
ible exchange rates. the exchange rate (E), when the domestic central bank
i. Under a fixed exchange rate, the central bank must keep the leaves the policy interest rate unchanged. Explain in words.
domestic interest rate equal to the foreign interest rates. b. In an IS-LM–UIP diagram, show the effect of the increase
j. One important issue with increasing tariffs on imports into in foreign output, Y*, and the increase in the foreign inter-
your country as a way of reducing your trade deficit is that est rate, i*, on domestic output (Y) and the exchange rate
other countries may retaliate by increasing their tariffs on (E), when the domestic central bank matches the increase
your exports (their imports). in the foreign interest rate with an equal increase in the
domestic interest rate. Explain in words.
2. Consider an open economy with flexible exchange rates. Sup-
c. In an IS-LM–UIP diagram, show the required domestic
pose output is at the natural level, but there is a trade deficit.
monetary policy following the increase in foreign output,
The goal of policy is to reduce the trade deficit and leave the level
Y*, and the increase in the foreign interest rate, i*, if the
of output at its natural level.
goal of domestic monetary policy is to leave domestic out-
What is the appropriate fiscal and monetary policy mix? put (Y) unchanged. Explain in words. When might such a
policy be necessary?
3. In this chapter, we showed that a reduction in the interest
rate in an economy operating under flexible exchange rates DIG DEEPER
leads to an increase in output and a depreciation of the domes-
6. Fixed exchange rates and foreign macroeconomic
tic currency.
policy
a. How does the reduction in interest rates in an economy with
Consider a fixed exchange rate system, in which a group of
flexible exchange rates affect consumption and investment?
countries (called follower countries) peg their currencies to the

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