VIII_output_interest_exchange_rate_ho

VIII_output_interest_exchange_rate_ho - ECON110B VIII....

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147 ECON110B VIII. Output, the interest rate, and the exchange rate Motivation : What determines the exchange rate? How can policy makers affect it? To look at equilibrium in the goods market To look at equilibrium in financial markets, including the foreign exchange market To put the two equilibrium conditions together and look at the determination of output, the interest rate, and the exchange rate To look at the role of policy under flexible exchange rates To look at the role of policy under fixed exchange rates 1. Equilibrium in the Goods Market 1) Equilibrium in the goods market a. Output = the demand for domestic goods - ) , ( / ) , ( ) , ( ) ( * + + + + + + + + = ε Y X Y IM G r Y I T Y C Y b. Net exports - / ) , ( ) , ( ) , , ( * * Y IM Y X Y Y NX - Marshall-Lerner Condition holds: NX 148 c. Equilibrium: again - ) , , ( ) , ( ) ( * + + + + + + = Y Y NX G r Y I T Y C Y - The main implication: both the real interest rate and the real exchange rate affect demand and, in turn, equilibrium output: i) An increase in the real interest rate leads to a decrease in investment spending, and to a decrease in the demand for domestic goods ii) An increase in the real exchange rate leads to a shift in demand toward foreign goods, and to a decrease in net exports. d. Two simplifications i) Both the domestic and the foreign price levels are given; thus, the nominal and the real exchange rate move together - EP/P * The nominal exchange rate is one for one to the real exchange rate - P/P * = 1 = E ii) There is no inflation, neither actual nor expected - r = i
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149 To replace the real interest rate with the nominal interest rate in the equilibrium condition of goods market e. Equilibrium in the goods market with simplification - ) , , ( ) , ( ) ( * + + + + + + = E Y Y NX G i Y I T Y C Y - Output depends on both the nominal interest rate and the nominal exchange rate 2. Equilibrium in Financial Markets Choice between money, domestic bonds and foreign bonds 1) Money versus bonds a. Equilibrium in the financial markets under a closed economy - The supply of money = the demand for money - ) ( i YL P M = - The supply of real money balance is given. - The demand for real money balance depends on the level of transaction, measured by real output, Y , and on the opportunity cost of holding money rather than bonds, that is, the nominal interest rate on bonds, i . 150 b. Characterization under the open economy - The demand for domestic money is still mostly a demand by domestic residents. - The demand for money by domestic residents in any country still depends on the same factors as before: the level of transactions, which we measure by domestic real output, and the opportunity cost of holding money, which is equivalent to the nominal interest rate on bonds. -
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This note was uploaded on 09/18/2008 for the course ECON 100B taught by Professor Rauch during the Winter '07 term at UCSD.

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VIII_output_interest_exchange_rate_ho - ECON110B VIII....

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