Chapter 20: Output, the Interest Rate and the Exchange Rate
Equilibrium in the Goods Market
Y = C(YT) + I (Y, r) + G – IM(Y, є)/ є + X(Y
*
, є)
(
+
)
( +,  )
( +, + )
( +,  )
Given NX = X – IM = X(Y
*
, є) – IM(Y, є)/ є, then NX depends on Y, Y
*
and є
or NX (Y, Y
*
, є), Y can be rewritten as
Y = C(YT) + I (Y, r) + G + NX (Y, Y
*
, є)
(
+
)
(+, )
(,
+,
)
This output/income identity implies that:
•
Real interest rate, r, increases, then private investment, I, decreases, then both
aggregate demand and output decrease.
•
Given a fixed price level, an increase in real exchange rate, є, (which implies home
currency appreciation and price at home becomes more expensive) leads to a shift in
demand toward foreign goods and it reduces local net exports, NX. A drop in net
exports then reduces aggregate demand and output.
Given є = EP/P* in which E is nominal exchange rate, P is local price level and P* is
foreign price level. If we assume P = P*, then real exchange rate will be equal to the
nominal exchange rate, or є = E.
In addition, given a fixed price level, we expect no inflation and nominal interest rate
will be the same as real interest rate, i = r, then output/income identity can be stated as:
Y = C(YT) + I (Y, i) + G + NX (Y, Y
*
, E)
(
+
)
( +, )
(,
+,
)
This equation implies that output depends on both the nominal interest rate and the
nominal exchange rate.
Equilibrium in Financial Markets
Money versus Bonds
In the financial market equilibrium in the close economy, the supply of money equals to
the demand for money:
M/P = YL(i)
In the open economy, the above equilibrium will still hold.
Domestic Bonds versus Foreign Bonds
In the last chapter, the interest parity condition is given as:
(
29
+
=
+
+
e
t
t
t
t
E
E
i
i
1
*
)
1
(
1
in which i
t
is local interest rate at time t, * represents foreign factor, E
t
is the current
exchange rate, and e represent future expected exchange rate. The left hand side must
1
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equal to the right hand side since the return from domestic bonds should be the same as
the expected return from foreign bonds in local currency. Or there will be arbitrary
condition and the local and foreign interest rate will adjust. The interest parity condition
can be rewritten into:
e
t
t
t
t
E
i
i
E
1
*
1
1
+
+
+
=
If we take the expected future exchange rate as given, then
e
t
E
1
+
becomes
e
E
, after
removing the time index, the interest parity condition becomes:
e
E
i
i
E
*
1
1
+
+
=
This equation implies that the current nominal exchange rate depends on both the local
and foreign interest rate level, as well as the expected future exchange rate.
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 Spring '09
 henry
 Exchange Rate, Inflation, Monetary Policy, Foreign exchange market, USD

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