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TABLE 15-1
Interest Rates, Exchange Rates, Expected Returns, and FX Market Equilibrium: A
Numerical Example
The foreign exchange (FX) market is in equilibrium when the domestic and foreign returns
are equal. In this example, the dollar interest rate is 5%, the euro interest rate is 3%, and
the expected future exchange rate (one year ahead) is = 1.224 $/. The equilibrium is
highlighted in bold type, where both returns are 5% in annual dollar terms. Figure 12-2
plots the domestic and foreign returns (columns 1 and 6) against the spot exchange rate
(column 3). Figures are rounded in this table.
Exchange Rates and Interest Rates in the Short Run:
UIP and FX Market Equilibrium
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Equilibrium in the FX Market: An Example
FIGURE 15-2
FX Market Equilibrium: A
Numerical Example
The returns calculated in
Table 15-1 are plotted in
this figure.
The dollar interest rate is
5%, the euro interest rate
is 3%, and the expected
future exchange rate is
1.224 $/.
The foreign exchange
market is in equilibrium at
point 1, where the
domestic returns DR and
expected foreign returns
FR are equal at 5% and
the spot exchange rate is
1.20 $/.
Exchange Rates and Interest Rates in the Short Run:
UIP and FX Market Equilibrium
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
FIGURE 18-8 (1 of 3)
Deriving the IS Curve
The Keynesian cross is
in panel (a), IS curve in
panel (b), and forex (FX)
market in panel (c).
The economy starts in
equilibrium with output,
Y
1
; interest rate, i
1
; and
exchange rate, E
1
.
Consider the effect of a
decrease in the interest
rate from i
1
to i
2
, all else
equal. In panel (c), a
lower interest rate
causes a depreciation;
equilibrium moves from
1 to 2.
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Equilibrium in Two Markets
FIGURE 18-8 (2 of 3)
Deriving the IS Curve
(continued)
A lower interest rate
boosts investment and a
depreciation boosts the
trade balance.
In panel (a), demand
shifts up from D
1
to D
2
,
equilibrium from 1 to 2,
output from Y
1
to Y
2
.
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
FIGURE 18-8 (3 of 3)
Deriving the IS Curve
(continued)
In panel (b), we go from
point 1 to point 2. The IS
curve is thus traced out,
a downward-sloping
relationship between the
interest rate and output.
When the interest rate
falls from i
1
to i
2
, output
rises from Y
1
to Y
2
.
The IS curve describes
all combinations of i and
Y consistent with goods
and FX market equilibria
in panels (a) and (c).
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Deriving the IS Curve
One important observation is in order:
In an open economy, lower interest rates stimulate
demand through the traditional closed-economy
investment channel and through the trade balance.
The trade balance effect occurs because lower interest
rates cause a nominal depreciation (in the short run, it
is also a real depreciation), which stimulates external
demand via the trade balance.
The IS curve is downward-sloping. It illustrates the
negative relationship between the interest rate i and
output Y.
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Factors That Shift the IS Curve
FIGURE 18-9 (1 of 2)
Exogenous Shifts in
Demand Cause the IS
Curve to Shift
In the Keynesian cross in
panel (a), when the
interest rate is held
constant at i
1
, an
exogenous increase in
demand (due to other
factors) causes the
demand curve to shift up
from D
1
to D
2
as shown,
all else equal. This
moves the equilibrium
from 1 to 2, raising
output from Y
1
to Y
2
.
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Factors That Shift the IS Curve
FIGURE 18-9 (2 of 2)
Exogenous Shifts in
Demand Cause the IS
Curve to Shift
(continued)
In the IS diagram in panel
(b), output has risen, with
no change in the interest
rate.
The IS curve has
therefore shifted right
from IS
1
to IS
2
.
The nominal interest rate
and hence the exchange
rate are unchanged in
this example, as seen in
panel (c).
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3 Goods and Forex Market Equilibria: Deriving the IS Curve
Summing Up the IS Curve
IS = IS(G,T,i
*
, E
e
, P*, P)
i
Y
i
Y
D
e
*
D
TB
I
C
P
P
E
i
G
T
rate interest home
given a at
output m equilibriu
in Increase
rate interest home
given a at and
output of level any at
demand in Increase
*
right shifts
curve IS
up shifts
curve Demand
function balance trade in the up shift Any
function investment in the up shift Any
function n consumptio in the up shift Any
prices home in Fall
prices foreign in Rise
rate exchange expected future in Rise
rate interest foreign in Rise
spending government in Rise
in taxes Fall
demand
money
Real
supply
money
Real
) ( Y i L
P
M
=
In the short-run, the price level is assumed to be sticky
at a level P, and the money market is in equilibrium
when the demand for real money balances L(i)Y equals
the real money supply M/P:
(18-2)
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4 Money Market Equilibrium: Deriving the LM Curve
Deriving the LM Curve
FIGURE 18-10 (1 of 2)
Deriving the LM Curve
If there is an increase in real income or output from Y
1
to Y
2
in panel (b), the effect
in the money market in panel (a) is to shift the demand for real money balances to
the right, all else equal.
If the real supply of money, MS, is held fixed at M/P, then the interest rate rises
from i
1
to i
2
and money market equilibrium moves from point 1 to point 2.
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4 Money Market Equilibrium: Deriving the LM Curve
Deriving the LM Curve
FIGURE 18-10 (2 of 2)
Deriving the LM Curve (continued)
The relationship thus described between the interest rate and income, all else
equal, is known as the LM curve and is depicted in panel (b) by the movement from
point 1 to point 2. The LM curve is upward-sloping: when the output level rises
from Y
1
to Y
2
, the interest rate rises from i
1
to i
2
. The LM curve describes all
combinations of i and Y that are consistent with money market equilibrium in panel
(a).
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4 Money Market Equilibrium: Deriving the LM Curve
Factors That Shift the LM Curve
FIGURE 18-11 (1 of 2)
Change in the Money Supply Shifts the LM Curve
In the money market, shown in panel (a), we hold fixed the level of real income or
output, Y, and hence real money demand, MD.
All else equal, we show the effect of an increase in money supply from M
1
to M
2
.
The real money supply curve moves out from MS
1
to MS
2
. This moves the
equilibrium from 1 to 2, lowering the interest rate from i
1
to i
2
.
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4 Money Market Equilibrium: Deriving the LM Curve
Factors That Shift the LM Curve
FIGURE 18-11 (2 of 2)
Change in the Money Supply Shifts the LM Curve (continued)
In the LM diagram, shown in panel (b), the interest rate has fallen, with no change
in the level of income or output, so the economy moves from point 1 to point 2.
The LM curve has therefore shift down from LM
1
to LM
2
.
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4 Money Market Equilibrium: Deriving the LM Curve
Summing Up the LM Curve
LM = LM(M/ P )
Y
i
L
M
output of level given at
rate interest home m equilibriu
in Decrease
right or down shifts
curve LM
function demand money in the left shift Any
supply money (nominal) in Rise
)
`