18-20 Flashcards
When we have perfect integrated financial markets how is the real interest rate affected?
With perfect integrated financial markets the real interest rate is tied to the real interest rate of ROW.
The IP states that expected return on loans in the currency of SPE must be the same and the expected return on loans in the foreign currency.
i + △ee/e = i*
To see what the nominal exchange rate is we use the equation for real exchange rate.
ℰ = eP/P* → e = ℰP/P
Which we then, if there is no growth can rewrite as
△e/e = 𝜋 - 𝜋
Then we can substitute from the first equation and get that
i + 𝜋* - 𝜋 = i* → i - 𝜋 = i* - 𝜋*
Which can be read as: r = r*
What is the Mundell-Fleming model?
F = 0 , net claims on foreigners
D = 0 , net government debt
The model consist off:
IS, LM and IP
Since we have three equations, we have three endogenous variables.
Y: determined by AD
e: fixed exchange rate by the CB, means that i = i*
M: CB is unable to control money supply when e is fixed
If the country has a floating exchange rate the CB can control the money supply while the e is endogenous. Then production, the interest rate, and e are jointly determined. alternatively the CB can set i and adjust M so as to satisfy the de,and for money at the desired i.
What happens when central bank announces a fixed exchange rate?
The CB annonces a fixed target level for the exchange rate. In practice they cannot keep the value of the currency exactly constant. Instead the CB sets a target value, central parity, and promises to keep the exchange rate within that interval.
To fix it CB uses operations in the currency market. Meaning CB buys and sells domestic money, paying with foreign money.
When value in domestic declines, the CB buys its own currency so as to raise its value
When it rise, The CB sells domestic currency to reduce its value.
In a small economy with a fixed exchange rate, the CB is unable to control the money supply and the interest rate. The only choice concerns the target level of the exchange rate. The fixed exchange rate policy is the monetary policy of the small open economy.
What happens when central bank announces a floating exchange rate?
CB have no fixed target for exchange rate.
We rewrite IP to : e = (1+i)/(1+i*) * ee
The exchange rate now depends on three variables
interest rate
If raised it becomes more attractive to lend in SOe so there is and increased demand for the currency and the exchange rate appreciates
foreign interest rate
if raised it becomes less attractive to lend in SOE so there is reduced demand for the currency, and the exchange rate depreciates
expected future exchange rate
if increased, the value of the currency today will increase
How does a higher interest rate affect aggregated demand?
A higher interest rate affect AD through two channels
There is a direct effect of the i on domestic consumption and investment, which is the same effects as in a closed economy
A higher i leads to appreciation of the currency, which reduces net exports. We can call this the exchange rate channel
What is the effect on a Monetary policy with floating exchange rate if there is an Increase in money supply?
LM shifts down because i will be lower in the money market for a given level of Y
i falls, Y increase, currency depreciates
CB buys bonds or lends to banks, so as to increase M and reduce i. This stimulates C and I. Also reduction in i makes it less attractive to hold currency so currency depreciates, and this stimulates X. AD and production increase and there is a multiplier effect as increased income leads to further increase in C
