Let's uh let's start with the Mandel flaming mold now this is a mold that that I think is extremely useful H and in the short term it will be important for because probably 70% of the quiz will be related to things that to this mod meaning you know we're going to use this model for different things but but but uh if you understand it well you probably have 70% of the last quiz under control so I'm going to go very slowly over it and please stop me if there is any step you don't understand I
I put steps into myself so I don't rush because again I think it's important um to understand things so here you have uh the exchange rate two exchange rates uh the the the wide one is the the the the euro dollar exchange rate I'm quoting it the opposite of the way it's normally quoted there are some conventions in FX markets but this is as we have defined in this courses if it goes up it means an appreciation of a local currency that is the dollar that is you get more of the foreign currency per unit
of the domestic currency when it goes up and down is a depreciation and and you see there that so this is the the dollar became a gain value relative to the euro through all this period and then it has lost quite a bit of value H since sort of late 2022 for for with respect to the Japanese Yen that's a blue line it's was the whole cycle is even more dramatic no big appreciation of the dollar depreciation of the Yen H and and a reversal since late 2022 and so so what is behind this these
big fluctuations many things effects are volatile like almost any asset price but one of the main drivers of this uh of of of these fluctuations is perceptions about interest rate policy in the different parts of the world okay so uh the risk Reon we have seen a lot of this decline here so the reason for the rise here of the dollar is mostly because investors in general perceived that the US was more advanced in its business cycle it began to tighten interest rate before the rest of the world and since interest rates were rising in
in the US that led to an appreciation of the Dollar by a mechanism they describe at the end of the previous lecture but I'm going to repeat today remember when I talk about the uncover in part condition but it's related to what I'm talking about here I'm going to again go go again over that and a big reason for the decline more recently is simply that there is a sense that monetary policy is piing in the US in terms of tightness while the rest of the world is catching up ER and in the case of
Europe more than catching up because they have further Supply shocks coming from energy shocks and so on so if you look for example at the expected in policy rate path in the case of the US nowadays it looks like this so the still markets expect some hike some hikes in the US but a limited amount of hikes and then they expect quickly the FED to start undoing that okay that's what this path is telling you this is expected policy rate path what the market thinks now the policy rate will be in the next meeting two
meetings from now three meetings from now for meetings meetings of the fomc from now okay well if you look at the same picture in Europe it looks like that it's clear that there there are still there's more ahead and and and you see sort of that that's what the market perceive at this point whether that ends up being true or not doesn't matter at any point in time the exchanger is determined by what the markets think so so what actually happens is less important for an asset price an asset price is a lot about pricing
today things that you expect to happen in the future what expects what you expect is what matter not what actually happens and at this moment the the market expect a the Euro area to go through a a sort of a more prolonged periods of hiking interest rate hiking Japan hasn't had hikes in interest rates for three three decades but even now you start you begin to see some you know the scale here is very small these are a few basis points but even the point I'm trying to make is that certainly people expect interest rates
in the US to go down relative to interest rates in Japan not to say say that the interest rate in the US will be lower than the interest rate in Japan but the direction of the change isn't that way so relative to where we're at now the direction of the change is is is is towards the US loosening monetary policy H before the rest of the world does okay and and that's what is leading to this big swings as I said before you know this is a period in which the US had to start tightening
before the rest and and the currency appreciated a lot especially with respect to the Yen because again the Yen has been against the zero lower Bound for a very long time so nobody expected the yen to move to follow the US and and and while with respect to Europe well Europe was having inflationary problems and so on as well so people expected it to follow the us at some point for Japan there was nothing like that and that's what led to the massive depreciation of the Gen appreciation of the US dollar Visa gen okay so
what we the Mandel flaming model is about is about first connecting these things trying to understand what moves exchange rate how the different monetary policies in different places or different policies in different places of the world affect exchange rate and then it's about understanding how those exchange rate movements affect real activity okay in the short run that's what the Mandel flaming model is so it is really we're going to go back to our old islm model very short run we're going to even fix nominal prices and so on so back to that environment but we're
going to do in an open economy so we're going to have a new variable floating around which is the exchange rate and and and we need to understand how the exchange rate moves when you different things happen in different countries and the and and what is the impact of that on aggregate demand and hence in on output we're talking about the very short run in the different parts of the world okay so that's a plan that's what we intend to do so let's start with the this Mandel flaming model remember we we wrote down the
equilibrium in the Goods Market Market in the previous lecture and and and that's that's I'm just reproducing what I wrote in the previous lecture so it looks exactly like the close economy output is be determined by aggregate demand but it's aggregate demand for domestically produced Goods domestic produced Goods is now the is not the same as domestic demand for goods which is this because now there's a net export term so part of the things that that residents sort of demand they they demand from the rest of the world not from Dom domestic producers and at
the same time part of the amount perceived by domestic producers comes from the rest of the world from exports not from domestic producers so that's the reason we got an extra term here which is this net exports and we said this net exports is a function of three things it's a function of output okay and it's a it's a decreasing function of output why is that of domestic output domestic output domestic income why is it a decreasing function of domestic income why do net exports decline when domestic income Rises import they they import more they
consume everything more but part of that is import and so part of that energy of the extra demand goes to foreign goods and that's what deteriorates net exports okay and that's the reason with had had we just stopped there made the net export function just a function of output we would have not needed all these extra Paratus that I'm about to build because all that would have meant is that just we have a smaller multiplier it would have been exactly the same as we did in the close economy but with a smaller multiplier because you
know every time output goes up now part of the demand goes to foreign Goods rather than domestic Goods but it's not so first because we have an extra another in income that matters here which is the income of the rest of the world but more important because we also have an exchanger but let's start from this sign so net export is increasing in the income of the rest of the world why is that that this demand for domestically produced good Rises when foreign income goes up foreign output foreign income goes up why is that it's
a symmetric argument no if with with Imports well our exports are the Imports of the other country so if the income in the other country goes up then their their Imports will go up which is our exports that go up that's the reason n exports goes up and the last term remember is that says that net exports is declining on the real exchange rate why is that what happen when the real exchanger goes up it makes our Goods more expensive relative to foreign Goods exactly our Goods become more expensive relative to foreign good and that
affects us from two Dimensions first our exports will tend to decline because our goods are more expensive and also our Imports are going to tend to increase because foreign goods are cheaper okay and so that's the reason this is decreasing with respect to the exchange the big thing of the Mandel flaming model really comes from the fact that this guy is there we had we not had the exchange rate there again we could have used exactly the same apparatus as we used earlier on but we're going to have an exchange rate floating around and that
will require us that to to build more a little more we need an extra equation you know because we have an extra endogenous variable now what I'm going to assume here as we did in the first part of the course is that both the domestic and foreign prices are completely fixed so I'm going to ignore Philips curve inflation expected inflation and all that okay assume all that is zero expected inflation inflation zero when I do that the same equation the equilibrium in the goods markets changes a little bit I mean it's the same equation but
now I don't need to differentiate between real interest rate and nominal interest rate because inflation is zero so nominal interest is equal to the real interest rate so I'm going to stick in here the nominal interest rate second I really don't need to differentiate between real exchange rate and nominal exchange rate because the relative prices the prices themselves are not changing and so all that will move the the re exchang is the nominal exchanger okay so that's the reason I'm going to write here the the nominal exchange rate is because it's the only thing that
will move this variable around given that prices are fixed okay so that's my our equilibrium in the Goods Market and this is a thing you need to compare with you know lecture three or something like that and as I said this part here only lowers the multiplier so not a big change this one here is an extra parameter that shift agre demand up and down so you can treat it almost like we treated c0 remember if the consumer confident goes up then aggre demand goes up well here we have sort of the rest of the
walls output goes up it does exactly the same the same analysis the problem we have though is that we have an extra variable here which is the exchange rate and that's an endogenous variable okay so we're going to have to come up with some other equation to solve for that equation here in in lecture three or four what we did is okay we said we have two endogenous variable output and the interest rate output and the interest rate we need one more equation well the other equation was just monetary policy that set the nominal interest
rate here that's not going to be enough because we also have an exchange floting okay so and we need to bring another equation here er er to deal with this this new endogenous variable what is that extra equation well is the uncovering transparity condition remember it's the last expression we had in in in the previous lecture H that takes this form okay it says I before I simplify lots of things I wrote this down and it says that the exchange rate is um is equal to to that okay now what what is this where does
this equation come from what is it trying to do remember we talk we we talk about this in the context and say well you know when you open Goods markets then you need a relative price to decide where you're going to buy that's what what a ER the real exchange did and and and now then then we open the capital account and then you need to people need to decide where they're going to invest money and that equation was related to that expected return has to be the same like exactly it's what equalizes the Spector
rate of an equilibrium that has to happen okay again in reality there is risk adjustment there's lots of other factors that we're removing from here but absent those other factors the the returns have to be similar in both places because if one asset is given more return than the other expected return then then then people are going to invest all the portfolios in that asset and what happens is those flows that try to go to the those assets that give the highest return end up equalizing expected return in equilibrium and that's equation that does that
exactly that how do I know that well remember h i can divide this by the exchange rate on both sides and then what you get is one equal to a numerator that has the nominal exchange rate times the expected appreciation of the currency Plus and in the denominator you have the the the foreign interest rate and so you have to when you compare the two you have to compare one base interest rate either the domestic or the foreign plus expected appreciation or depreciation of that currency and that's what this term is doing here this divided
by that okay good so what do we get out of this uh one thing we're going to do for for quite a while because it will simplify things a lot but sometimes also lead to confusion in in in in in in the way we understand why Curren is depreciated or appreciate but we we'll pause and I'll remind you of this repeatedly we're going to assume for now that the expected exchange rate for t+ one is fixed okay and and until I tell you otherwise we're going to make this assumption now that's a huge simplification completely
unrealistic and so on but it will help me explain the mechanism I mean one of the things that moves exchang a lot is that people have lots of expectations about future exchange rate we'll get to that later but for now so you understand the mechanism how the Mandel flaming mod works I'm going to assume that we all know what the expected exchange rate we we all have a common expected exchange rate and it's fixed okay we may move it as a parameter but I was trying to say I'm not going to endogenize that I'm going
to take it as fixed and I I may move it around to show you what happens when that changes but I'm not going to endogenize it okay otherwise I need more equations one more I want to stop this this this sequence of equations that I would be have to build but later we'll understand more of that what I just said but but for now just take this as fixed so if I take this as fixed now I have an equation remember I was looking for an equation here for my exchange rate once I do that
then I have what I want I have an equation from my exchange today it's just function of domestic interest rate International interest rate and the expected exchange rate okay so I know the following for example I know that an increase in the domestic interest rate other things equal appreciates exchange rate you know I can see it in the equation if I move the domestic interest rate up the exchanger goes up that's an appreciation the dollar becomes more expensive even simpler suppose we start with a situation in which the domestic and the international interest rate were
the same and now I increase the international interest rate and I'm saying the exchanger will appreciate well first of all let let me start for something even simpler suppose that suppose that that this interest rate is equal to International interest rate before analyzing the change I'm about to analyze then from this equation what do I I know about the exchange rate what is it equal to if the domestic interest rate is equal to International interest rate what is the exchange rate today equal to the expected exchange next year if I have the same interest rates
I cannot expect a capital gain or loss from the currency position because I have already an equal interest rate in the two bonds okay so then I'm starting from a situation where the current exchange rate is equal to the expected exchange rate and these two are equal and now I'm going to increase the interest rate the domestic interest rate and it's very easy for you to read from here that the exchanger will go up the currency will appreciate why this is not an easy thing to answer unless you know where unless you have read the
book or something if the interest rate goes up then like money supply should go down which would generally increase the value of money no no money here that money is only related to the mechanism we use to increase interest rate but I'm saying just use that equation and the logic behind that equation the uncover parity why is it that if I you know we went to from a situation which inter were the same now I increase the domestic interest rate I'm saying the The Exchange has to appreciate no no but that's a description of yeah
that's that we know that the question is work what is the logic yeah we we have we know the result what I'm asking is for an economic explanation for that result more people want to invest in the currency like using Curren well if you go to Wall Street to do an ARR they will explain it in those terms it's not the right explanation but they will explain on those ter and there is some logic behind that because this equation assumes that the arit happens instantaneously immediately things move but but before that happens you know some
people will start buying more the the one that has more R but this equation already solve all that and that's when this assumption matters and and is a little Annoying it bothers me for a variet of reason but but we're going to use it to understand the mechanism you see if if I keep the exchange rate fixed we started with a situation where the exchange rate was equal to the expected exchange rate if I keep it fix and I appreciate the currency today then what do I expect to happen to the dollar let's talk about
the dollar from this period to the next one remember we start from a situation where the exchange rate was equal to the spected exchange rate now I increase the interest rate and I said the exchange rate appreciate then what do you expect the the exchange rate to do over the next period if I haven't move expected exchange rate and now the exchange move above the expected exchange rate what do you expect exchange rate to do exactly has to depreciate so the reason the appreciation happens here is because you need to expect to depreciate the dollar
from this period to the next one why do I need to expect the exchange rate to depreciate so I'm appreciating the currency because I need in equilibrium I need to expect to depreciate that is I need to expect to lose money money on the currency part of the trade why is that confusion is good you you learn from that and this can be very confusing I know what is it this equation trying to do we are trying to make the Spectre Returns the same that's the whole idea of this so if I now I'm now
telling you that one bond is paying a higher interest than the other one I need to offset that somehow how do I offset it by expecting a depreciation of the currency of the bond that is you know of of the bond that is denominated in the currency that expected to depreciate so what I need to do is compensate for the interest rate differential with an expected depreciation of the currency that is paying a higher interest rate so that's what in this model when I fix expected exchange rate the only way I can do that is
by appreciating the currency today so I can expect it to depreciate in the future that's the logic okay now how what is the connection with qu in wall stre they will tell you is to say well before this may happen not instantaneously it happens somewhat slowly so Traders immediately will go to the US dollar Bond because they see that they have a higher return and it will be the case until the currency really appreciates once the currency appreciates enough then that that Advantage disappeared that's what this condition is doing it's making the Spector return the
same but in the process of the exchanger going from the initial exchange rate to to to the new equilibrium exchange rate there may be an opportunity there and that's when you start seeing these flows okay that happens very very fast but that's when you can see some of those flows I mean in these markets that happens very very quickly so what is typically wrong is that then analyst comes and tells you explains the story why the changes if want to continue to appreciate well that's just way too late you're already in this environment you lost
the trade okay okay what about an increaseing the foreign interest rate I star so an increaseing the foreign interest rate let's start from the same situation we had before we start from interest rate equal to International interest rate therefore the exchange rate is equal to spected exchange rate and now the foreign interest rate goes up okay what is going on now in the US the US is sort of stabilizing here and and Europe is beginning to hike a little more than the us so we know from the equation that that means the exchange will fall
that is will drop here so that that means the exchange rate is depreciating the dollar is depreciating why is the dollar depreciating yeah that's correct I mean the the issue here in terms of the economics is that remember if we start from the same interest and now all the lines I'm giving you doesn't need to start for the same interest it just a lot simpler to start from from the same interest but suppose we start with the same interest rate and now we increase this one then that means the foreign bond is playing a high
interest rate than the domestic Bond I need to equalize expected Returns the only way I can do that is by having an expected appreciation of the dollar since the expected exchange and we fix it here the only way I can give you an expected appreciation of the dollar is to by depreciating the dollar today so it's the same mechanism the same logic is symmetric that's that's the mechanism now is this true that in the very short run when when I start goes up and and I doesn't move then lots of people go and buy foreign
bonds and that produces sort of you know demand for euros and blah blah blah blah but that's very quick machines do it for you now so it happens very quickly so this equation shows you what happens after all that mess has already clear which happens in milliseconds okay what what if I change the spect to rate so again I'm fixing it but I can move it around I'm treating as a parameter that when I say if I fix it I just don't want to endogenize I don't want to make it another endogenous variable so what
happens here if the exchange rate we start with the same situation we had before now the Spector exchanger goes up well from the equation is very clear the current exchanges immediately Rises one for one in fact okay if I have the these two interest are the same and now I move the spect change itate up then the current exchange immediately jumps so is if we expect the dollar to appreciate in the future then it appreciate today why is that expectations are very powerful in financial Assets in general this is the first time you come out
but and we'll talk a lot more about that in the next week but but you can see it here so if I move the exchange rate today up the expected exchange rate means which expect the changer to be you know today the dollar is is 90 cents on 90 Cent 9 Euros per dollar well suppose I expect one Euro for dollar in the next period what will happen to the CH today will it jumps today to one why is that the dollar will be more expensive to BU there so people okay that's that's your friend
the trader there okay but um yes that's true that's true what does it mean though it is true it's more expensive but why would why did you want to buy it to start with I mean who cares that something it's more expensive you are not planning to buy it um because the the current price is something also has to take into account future price that's what the question says yes because part of because its value at the present moment takes into account some of value I I you know whenever we we this is an Arbitrage
type relationship and what I suggest is whenever you come across an Arbitrage type argument you ask a question well suppose not suppose this didn't happen What would then happen What would look odd okay that's almost any arbitr that's a good way of thinking about this say okay the equation tells me that the exchanger has to jump right away well suppose not what goes wrong that's I think that's the way the the easiest way to think about any of this asset pricing in general by the way well suppose not suppose the expected exchange rate goes up
the interest rates haven't changed and the exchange rate today doesn't move what happens then remember we s a situation which both interest rates are the same now the spect exchanger went up by 10% say and er the current exchanger hasn't move I'm sure between the two of you can design this tra okay what do you do everyone would buy foreign Bonds in like the next period now in the first period er no no but what do you do today suppos you're a Trader and and then now you see whoops The Exchange the dollar will appreciate
10% the interest rates are the same and the CH is not moving today what do you do which Bond do you buy of course because you have a 10% expected capital gain from buying that bone if that doesn't happen the both the two bones are paying the same interest rate and now I tell you well yeah but one is on appreciate by 10% relative to the other okay so clearly that you go short massively the foreign bone and you go very long the US Bond that's what you do we all want to do the same
so it happens very quickly and exchanges appre today up to a point in which that that incentive is no longer there and that in this particular case if the interest are the same that will happen only if the exchange today jumps exactly by the same amount as expected appreciation of the as expected value of the dollar change in the future okay good think about this play with these things I know it can be confusing but and I always start with let me move some the equation tells me this is what has to happen to the
exchange rate well suppose that didn't happen to The Exchange and then you say oh then I clearly invest in this one this dominates the other one well that condition tells you no no in equilibrium you have to be different so so the only thing you can move is exchange rate and the exchange has to move until you are in different again after you have done some change some argument on the right hand side okay that's the way you need to think about it so I here I'm just plotting uh this this relationship in the space
of exchange rate in the x-axis and the domestic interest rate here okay so that's an upward sloping relationship you can see here that I move the interest rate up or the other way around but anyways if I move the interest rate up the exchange is going up so that's a positive relationship I can do it the other way around they move the chain rate up then the domestic has to go up I'm taking as parameters the foreign interest rate and and and the expected exchange if I take as parameter this and that then I have
a positive relationship between the exchange rate and the domestic interest rate okay so that's going to be the U I'm plotting the uip and covering transparity condition notice this point here is interesting this points tells you that when the domestic interest rate I is equal to the international interest rate then the exchange rate has to be equal to the expected exchange rate which is the question I asked before remember I ask you a question well suppose that we start with an interest rate that is equal to the international interest rate what the exchange what is
the exchange rate and you said the answer was well it has to be equal to the expected exchange rate that's that point here okay if the interest rate domestic interest rate is above that the intern National interest rate then the exchange rate today has to be above the expected exchange rate because that will give you expected depreciation of the currency which will compensate for the fact that the domestic bond is paying a higher interest rate than international bond okay conversely if if the domestic bond is paying a lower interest rate then the exchange rate today
is very depreciated because you have to expect it to appreciate in order to compensate for the interest rate differential okay probably not but this requires practice I tell you ER okay so but now we have a an equation for the exchange rate at least so I can go back to my is is is the is equation in the open economy and I have an equation for the exchanger so I can replace it this is nice because I I have two new parameters expected exchange rate and international interest rate but now this is also a function
of the interest rate so at this moment I have one equation in two unknowns really after I solve out for the exchang it I have one equation and two unknowns the two unknowns are output and the domestic interest rate all the rest are parameters so that's the same situation we're at in lecture three or so so then we need an extra equation the extra equation was monetary policy the LM we're going to do exactly the same here okay the Lim is the same it's a domestic Central Bank sets the interest rate so now I'm set
now we have the islm model in the open economy this is the Mandel flaming model okay that's what the Mandel flaming model is so yes some more complicated ideas with that uip um driven exchange rate and then the LM is the same as in the Clos economy so this is the Mandel flaming mod so notice that that so one thing we know already we knew from the previous lecture that that we have a smaller multiplier in the open economy because we have the inputs that are also responding to Output we have a new parameter but
now we also know that an increase in the interest rate so monetary policy in the open economy has two effects now it used to have only this effect remember it affected domestic investment so an increase in the interest rate would lead to a um a reduction in aggregate demand because investment would fall remember that was a role of the interest rate that's the way monetary policy work in the close economy was through this channel here now we have a second Channel which is this one so when the interest rate goes up it's contraction for two
reasons one for the reason we had before which is that investment Falls but there is a second reason is contractionary what is that second reason I mean it's only here it's only second yeah ra the exchange rate because appreciates the exchange rate and when you appreciate the exchange rate net exports decline okay so more of the domestic consumption is diverted to foreign goods and less of for foreign demand is is allocated to our exports okay so that's a second channel so in an open economy and the smaller is the economy the more important is this
term the more powerful is that channel okay the US cares very little about this effect most other economies care a lot about this effect okay because the US is a relatively close economy believe it or not so this is sort of the star diagram of the Mandel flaming mle so this thing here is our old islm model it's just that this is is a little thicker now it has net exports in there and so on but it looks exactly the same that is plots equilibrium in financial and and and and the Goods Market the the
combinations of output and domestic interest rate that are consistent with equilibrium in in both markets that's the case here okay this is the is which is all the combinations of domestic output and domestic interest rate that are consistent with equilibrium in Goods Market this is the interest rate that is consistent with equilibrium financial markets that's what the FED does in the US that point is where both markets are in equilibrium but we can take this interest rate so that's what will happen the interest rate will be in the US the interest rate is set by
the FED not by the ACB the FED will set the interest rate that will give us some equilibrium output and then we can go to the uip condition you see I'm plotting here and figure out what the exchange rate is because for this interest rate here there's going to be some point in the uip and that tells me exactly what the exchange rate is okay so with this set of diagrams I can determine the interest rate output and exchange rate so I can study the effects of different policies for example on output the interest rate
of course that's the policy itself and the exchange rate so this is the the new thing I can explain I can do a little bit of asset pricing here I can explain the the the behavior of the exchange rate as well so this diagram I mean you need to really control very very well let's when I'm going to play with it quite a bit monetary policy let's do monetary policy we talk about monetary policy already so suppose that for whatever reason H the domestic economy domestic Central Bank ER decides to hike the interest rate suppose
the economy was overheating output was too high ready to Natural rate of output the typical reasons why you need to raise interest rate and so suppose that the domestic interest rate goes up well as it used to be that's going to be contractionary what happens to the exchange rate well I know the interest went up I go I look into my uip for the higher interest rate and need a current exchange rate that is above the old it has to go up relative to all when when I when I increase interest rate from here to
there then my exchange has to appreciate why is that so an expansionary domestic monetary policy will lead to contraction in output which is what we get out of a monetary policy but it will also lead to an appreciation of the currency why is that that's what we just discussed uip if if I move the domestic interest rate and the rest and the rest of world does not follow me so we move interest rate they don't then now I need to compensate for this increasing the interest rate differential and the compensation will come through an expected
Capital loss through the currency so if I appreciate more the currencies and I haven't moved the expected exchange rate I expect a larger loss from the point of from the country from the currency side okay that's what what has happened here that's what is behind depreciation and of course the depreciation is already built in here which is what uh you know makes monetary policy more powerful than the close economy okay because you get the next export Channel but that's built in here um okay did here all that I did is exactly the same as we
were doing in the last 30 minutes I just used this this uip for whatever domestic reason I need to raise interest rate ER you know I have contract and monetary policy well one of the effects that you're going to get in an open economy is that your currency will tend to appreciate okay good what about fiscal policy well if the FED doesn't follow the central bank doesn't follow and you have an expansionary fiscal policy then ER that will increase output it has no effect on the interest rate therefore has absolutely no effect on the exchange
so an expansionary fiscal policy which is accommodated by the FED that means the interest rate is kept to the same level then does not lead to an appreciation of the currency doesn't move the exchange rate has no implication for the exchange rate okay now what about this change in output is it larger or smaller than the one we did in lecture three or four it's smaller why exactly because yeah it goes to import perfect okay okay good so this is smaller than it was in the close economy and but it has no impact on the
exchange rate that is the uip has nothing to do with government expenditure it's all about financial markets it's about expected returns things like that so unless the fiscal policy somehow affects interest rate H then there is no effect what may happen is that for example is that that you know treasury becomes very expansionary and this output becomes too large for what is consistent with a zero output Gap or no inflation and then the FED May react and raise interest rate and that will Le to anation of exchanges and so on and that's the reason why
in practice when countries have sort of expansionary fiscal packages they the currency tends to appreciate is because investor expect the FED to react to that or the central bank to react to that and raise interest rate but if the FED says no no we need that fiscal expansion I'm not going to move the interest rate then the exchanger won't move so let's look at let's use a little more of this model and and look at other shocks within this model so let's start with suppose that that a we increase the expected exchange rate what moves
in this diagram let's go does the L move no the LM is controlled by domestic Central Bank doesn't move that's the I move when when I ask you what moves you should always fix something so you say okay let me fix the interest rate say picked a point like this one say and now I have to ask the question what happens to Output now that I have moved the Spector exchange it if I get the same output back means that yes hasn't move if I get a different output equilibrium output then I they did move
so what is the answer if the interest rate doesn't move the forign interest doesn't move move an expected exchange rate goes up what happens to the current exchange rate appreciates what happens when when there's an appreciation net export decline that means that moves the yes to the left okay so so so this movement will move the to the left as a first effect what about the uip condition will it move or not we have taken that as a parameter will it move I mean remember I give you a clue because I said we are taking
these two as parameters here so if I move a parameter most likely I will move the curve okay but in which direction will it move to the right yes because for the same interest rate now I need the exchange rate to move one for one the current exchange to move one for one with the Spector Exchange you know so this was the exchanger before and now the speed exchanger move to the right well in order not to generate expected capital gain or loss I have to move the current exchange rate by the same amount and
so that means this this Curve will shift to the right okay what if I move for an output down what happens which curve moves well this is not a parameter here so this is not moving this is not a parameter here so this one is not moving only one can move that yes where it will move to the left because net exports will decline no for any given level of the interest rate now we're going have less net exports and therefore they just moves to the left so output false but there's no movement here unless
the FED reacts to that the Central Bank reacts to that it won't happen okay I mean and and and it may well be the case that you want to react to that if if the whole world goes into a recession the US is very likely to lower interest rates because you know it's very contraction the whole world goes into recession when the US goes into recession the rest of the world everyone wants to cut interest rates because the US is a big player so so it really drags everyone down okay good the last one and
I'm going to repeat this in the next lecture is well what happens if the if I star moves up the foreign inter moves up well the LM doesn't move this one will move which way because that was a parameter here to the right you said to the right that's right okay okay so so think what happened here if they forign interet goes up at any given interest rate now the domestic bond is doing worse than otherwise so I need to depreciate the exchange rate today in order to expect an appreciation okay that means this curve
moves to the left okay okay it moves to the left because I have to expect an appreciation to compensate for the interest rate differential so this will move to the left what about this curve here we solve it in the next lecture good
