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Intermediate Macroeconomics Ch20 notes

Intermediate Macroeconomics Ch20 notes - Chapter 20 Output...

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Chapter 20: Output, the Interest Rate and the Exchange Rate Equilibrium in the Goods Market Y = C(Y-T) + 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(Y-T) + 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(Y-T) + 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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