WEBVTT 00:00:00.000 --> 00:00:02.480 align:middle line:90% [SQUEAKING] 00:00:02.480 --> 00:00:04.960 align:middle line:90% [RUSTLING] 00:00:04.960 --> 00:00:07.936 align:middle line:90% [CLICKING] 00:00:07.936 --> 00:00:17.390 align:middle line:90% 00:00:17.390 --> 00:00:20.970 align:middle line:84% RICARDO CABALLERO: Let's start with the Mundell-Fleming model. 00:00:20.970 --> 00:00:26.660 align:middle line:84% Now, this is a model that I think is extremely useful. 00:00:26.660 --> 00:00:30.140 align:middle line:84% And in the short term it will be important for you 00:00:30.140 --> 00:00:33.500 align:middle line:84% because probably 70% of the quiz will be related 00:00:33.500 --> 00:00:35.910 align:middle line:90% to things, to this model. 00:00:35.910 --> 00:00:38.970 align:middle line:84% Meaning, we're going to use this model for different things. 00:00:38.970 --> 00:00:43.070 align:middle line:84% But if you understand it well, you probably 00:00:43.070 --> 00:00:46.520 align:middle line:84% have 70% of the last quiz under control. 00:00:46.520 --> 00:00:48.750 align:middle line:84% So I'm going to go very slowly over it. 00:00:48.750 --> 00:00:51.860 align:middle line:84% And please stop me if there is any step you don't understand. 00:00:51.860 --> 00:00:55.310 align:middle line:84% I put steps into myself so I don't rush. 00:00:55.310 --> 00:01:00.480 align:middle line:84% Because again, I think it's important to understand things. 00:01:00.480 --> 00:01:05.180 align:middle line:84% So here you have the exchange rate, two exchange rates. 00:01:05.180 --> 00:01:14.420 align:middle line:84% The white one is the euro dollar exchange rate. 00:01:14.420 --> 00:01:17.663 align:middle line:84% I'm quoting it the opposite of the way it's normally quoted. 00:01:17.663 --> 00:01:19.580 align:middle line:84% There are some conventions in effects markets. 00:01:19.580 --> 00:01:23.660 align:middle line:84% But this is, as we have defined in this course, if it goes up, 00:01:23.660 --> 00:01:26.130 align:middle line:84% it means an appreciation of a local currency. 00:01:26.130 --> 00:01:28.280 align:middle line:90% That is the dollar. 00:01:28.280 --> 00:01:31.910 align:middle line:84% That is, you get more of the foreign currency per unit 00:01:31.910 --> 00:01:35.000 align:middle line:84% of the domestic currency when it goes up, and down 00:01:35.000 --> 00:01:36.710 align:middle line:90% is a depreciation. 00:01:36.710 --> 00:01:38.900 align:middle line:90% And you see there that-- 00:01:38.900 --> 00:01:43.610 align:middle line:84% this is the dollar became a gain value relative to the euro 00:01:43.610 --> 00:01:45.030 align:middle line:90% through all this period. 00:01:45.030 --> 00:01:47.870 align:middle line:84% And then it has lost quite a bit of value 00:01:47.870 --> 00:01:53.700 align:middle line:84% since sort of late 2022, with respect to the Japanese yen. 00:01:53.700 --> 00:01:55.460 align:middle line:90% That's the blue line. 00:01:55.460 --> 00:01:57.590 align:middle line:84% The whole cycle is even more dramatic. 00:01:57.590 --> 00:01:59.720 align:middle line:90% Big appreciation of the dollar. 00:01:59.720 --> 00:02:02.830 align:middle line:90% Depreciation of the yen. 00:02:02.830 --> 00:02:09.370 align:middle line:84% And a reversal since late 2022 and so. 00:02:09.370 --> 00:02:13.840 align:middle line:84% So what is behind this big fluctuations? 00:02:13.840 --> 00:02:14.410 align:middle line:90% Many things. 00:02:14.410 --> 00:02:17.510 align:middle line:84% Effects are volatile, like almost any asset price. 00:02:17.510 --> 00:02:22.390 align:middle line:84% But one of the main drivers of these fluctuations 00:02:22.390 --> 00:02:24.640 align:middle line:84% is perceptions about interest rate 00:02:24.640 --> 00:02:26.630 align:middle line:84% policy in the different parts of the world. 00:02:26.630 --> 00:02:33.340 align:middle line:84% So the reason we have seen a lot of this decline here-- 00:02:33.340 --> 00:02:36.010 align:middle line:84% the reason for the rise here of the dollar 00:02:36.010 --> 00:02:39.070 align:middle line:84% is mostly because investors in general 00:02:39.070 --> 00:02:42.603 align:middle line:84% perceive that the US was more advanced in its business cycle. 00:02:42.603 --> 00:02:44.020 align:middle line:84% It began to tighten interest rates 00:02:44.020 --> 00:02:45.830 align:middle line:90% before the rest of the world. 00:02:45.830 --> 00:02:49.240 align:middle line:84% And since interest rates were rising in the US, 00:02:49.240 --> 00:02:52.960 align:middle line:84% that led to an appreciation of the dollar by a mechanism 00:02:52.960 --> 00:02:55.790 align:middle line:84% that I describe at the end of the previous lecture., 00:02:55.790 --> 00:02:57.700 align:middle line:90% but I'm going to repeat today. 00:02:57.700 --> 00:02:59.950 align:middle line:84% Remember when I talk about the uncover interest parity 00:02:59.950 --> 00:03:00.890 align:middle line:90% condition. 00:03:00.890 --> 00:03:03.130 align:middle line:84% Well, it's related to what I'm talking about here. 00:03:03.130 --> 00:03:05.810 align:middle line:84% And when I, again, go again over that. 00:03:05.810 --> 00:03:09.110 align:middle line:84% And a big reason for the decline more recently 00:03:09.110 --> 00:03:13.250 align:middle line:84% is simply that there is a sense that monetary policy is peaking 00:03:13.250 --> 00:03:16.340 align:middle line:84% in the US in terms of tightness while the rest of the world 00:03:16.340 --> 00:03:18.050 align:middle line:90% is catching up. 00:03:18.050 --> 00:03:21.410 align:middle line:84% And in the case of Europe, more than catching up 00:03:21.410 --> 00:03:24.860 align:middle line:84% because they have further supply shocks coming from energy shocks 00:03:24.860 --> 00:03:25.820 align:middle line:90% and so on. 00:03:25.820 --> 00:03:30.500 align:middle line:84% So if you look, for example, at the expected policy rate path, 00:03:30.500 --> 00:03:34.530 align:middle line:84% in the case of the US, nowadays it looks like this. 00:03:34.530 --> 00:03:38.420 align:middle line:84% So the steel markets expect some hikes in the US, 00:03:38.420 --> 00:03:40.610 align:middle line:84% but a limited amount of hikes and then 00:03:40.610 --> 00:03:44.000 align:middle line:84% they expect quickly the Fed to start undoing that. 00:03:44.000 --> 00:03:45.900 align:middle line:84% That's what this path is telling you. 00:03:45.900 --> 00:03:48.140 align:middle line:84% This is expected policy rate path. 00:03:48.140 --> 00:03:50.270 align:middle line:84% What the market thinks now, the policy rate 00:03:50.270 --> 00:03:53.000 align:middle line:84% will be in the next meeting, two meetings from now, 00:03:53.000 --> 00:03:57.290 align:middle line:84% three meetings from now, four meetings, meetings of the FOMC 00:03:57.290 --> 00:03:58.080 align:middle line:90% from now. 00:03:58.080 --> 00:04:00.428 align:middle line:84% OK, well, if you look at the same picture in Europe, 00:04:00.428 --> 00:04:01.220 align:middle line:90% it looks like that. 00:04:01.220 --> 00:04:04.790 align:middle line:84% It's clear that there still is more ahead. 00:04:04.790 --> 00:04:06.950 align:middle line:90% And you see that. 00:04:06.950 --> 00:04:09.620 align:middle line:84% That's what the market perceives at this point. 00:04:09.620 --> 00:04:12.117 align:middle line:84% Whether that ends up being true or not doesn't matter. 00:04:12.117 --> 00:04:13.700 align:middle line:84% At any point in time the exchange rate 00:04:13.700 --> 00:04:15.540 align:middle line:84% is determined by what the markets think. 00:04:15.540 --> 00:04:19.890 align:middle line:84% So what actually happens is less important for an asset price. 00:04:19.890 --> 00:04:23.030 align:middle line:84% An asset price is a lot about pricing today things 00:04:23.030 --> 00:04:25.370 align:middle line:84% that you expect to happen in the future. 00:04:25.370 --> 00:04:27.417 align:middle line:84% But what you expect is what matters, 00:04:27.417 --> 00:04:28.500 align:middle line:90% not what actually happens. 00:04:28.500 --> 00:04:33.380 align:middle line:84% And at this moment, the market expect the Euro area 00:04:33.380 --> 00:04:36.950 align:middle line:84% to go through a more prolonged period of hiking, 00:04:36.950 --> 00:04:38.360 align:middle line:90% interest rate, hiking. 00:04:38.360 --> 00:04:40.520 align:middle line:84% Japan hasn't had hikes in interest rates 00:04:40.520 --> 00:04:42.240 align:middle line:90% for three decades. 00:04:42.240 --> 00:04:46.490 align:middle line:84% But even now, you begin to see some-- 00:04:46.490 --> 00:04:48.090 align:middle line:90% the scale here is very small. 00:04:48.090 --> 00:04:49.620 align:middle line:90% These are a few basis points. 00:04:49.620 --> 00:04:51.680 align:middle line:84% But even the point I'm trying to make 00:04:51.680 --> 00:04:55.670 align:middle line:84% is that certainly people expect interest rates in the US 00:04:55.670 --> 00:04:58.820 align:middle line:84% to go down relative to interest rates in Japan. 00:04:58.820 --> 00:05:01.010 align:middle line:84% Not to say that the interest rate in the US 00:05:01.010 --> 00:05:02.930 align:middle line:84% will be lower than the interest rate in Japan, 00:05:02.930 --> 00:05:05.100 align:middle line:84% but the direction of the change is in that way. 00:05:05.100 --> 00:05:09.660 align:middle line:84% So relative to where we're at now, the direction of the change 00:05:09.660 --> 00:05:14.430 align:middle line:84% is towards the US loosening monetary policy 00:05:14.430 --> 00:05:17.150 align:middle line:84% before the rest of the world does 00:05:17.150 --> 00:05:21.440 align:middle line:84% And that's what is leading to these big swings. 00:05:21.440 --> 00:05:24.410 align:middle line:84% I said before, this is a period in which the US have 00:05:24.410 --> 00:05:27.440 align:middle line:84% to start tightening before the rest and the currency 00:05:27.440 --> 00:05:30.230 align:middle line:84% appreciated a lot, especially with respect to the yen. 00:05:30.230 --> 00:05:32.990 align:middle line:84% Because again, the yen has been against the zero lower bound 00:05:32.990 --> 00:05:34.350 align:middle line:90% for a very long time. 00:05:34.350 --> 00:05:37.410 align:middle line:84% So nobody expected the yen to move, to follow the US. 00:05:37.410 --> 00:05:40.580 align:middle line:84% And with respect to Europe, well, Europe 00:05:40.580 --> 00:05:42.930 align:middle line:84% was having inflationary problems and so on, as well. 00:05:42.930 --> 00:05:45.900 align:middle line:84% So people expected it to follow the US at some point. 00:05:45.900 --> 00:05:47.940 align:middle line:84% For Japan, there was nothing like that. 00:05:47.940 --> 00:05:50.090 align:middle line:84% And that's what led to a massive depreciation 00:05:50.090 --> 00:05:54.650 align:middle line:84% of the yen, appreciation of the US dollar vis a vis the yen. 00:05:54.650 --> 00:05:58.220 align:middle line:84% So what the Mundell-Fleming model is about 00:05:58.220 --> 00:06:00.397 align:middle line:84% is about first connecting these things, 00:06:00.397 --> 00:06:02.480 align:middle line:84% trying to understand what moves the exchange rate, 00:06:02.480 --> 00:06:04.970 align:middle line:84% how the different monetary policies in different places 00:06:04.970 --> 00:06:07.670 align:middle line:84% or different policies in different places of the world 00:06:07.670 --> 00:06:09.180 align:middle line:90% affect the exchange rate. 00:06:09.180 --> 00:06:12.230 align:middle line:84% And then it's about understanding how those exchange 00:06:12.230 --> 00:06:17.240 align:middle line:84% rate movements affect real activity in the short run that's 00:06:17.240 --> 00:06:19.290 align:middle line:84% what the Mundell-Fleming model is. 00:06:19.290 --> 00:06:23.730 align:middle line:84% So it is really, we're going to go back to our old IS-LM model, 00:06:23.730 --> 00:06:24.700 align:middle line:90% very short run. 00:06:24.700 --> 00:06:27.070 align:middle line:84% We're going to even fix nominal prices and so on. 00:06:27.070 --> 00:06:28.890 align:middle line:90% So back to that environment. 00:06:28.890 --> 00:06:30.760 align:middle line:84% But we're going to do it in an open economy. 00:06:30.760 --> 00:06:33.010 align:middle line:84% So we're going to have a new variable floating around, 00:06:33.010 --> 00:06:34.150 align:middle line:90% which is the exchange rate. 00:06:34.150 --> 00:06:36.660 align:middle line:84% And we need to understand how the exchange rate moves 00:06:36.660 --> 00:06:39.900 align:middle line:84% when different things happen in different countries 00:06:39.900 --> 00:06:43.290 align:middle line:84% and what is the impact of that on aggregate demand, 00:06:43.290 --> 00:06:44.860 align:middle line:90% and hence, on output-- 00:06:44.860 --> 00:06:47.940 align:middle line:84% we're talking about a very short run in the different parts 00:06:47.940 --> 00:06:48.700 align:middle line:90% of the world. 00:06:48.700 --> 00:06:49.930 align:middle line:90% So that's the plan. 00:06:49.930 --> 00:06:52.020 align:middle line:90% That's what we intend to do. 00:06:52.020 --> 00:06:54.610 align:middle line:84% So let's start with the Mundell-Fleming model. 00:06:54.610 --> 00:07:00.210 align:middle line:84% Remember, we wrote down the equilibrium in the goods market 00:07:00.210 --> 00:07:01.660 align:middle line:90% in the previous lecture. 00:07:01.660 --> 00:07:06.190 align:middle line:84% And I'm just reproducing what I wrote in the previous lecture. 00:07:06.190 --> 00:07:08.100 align:middle line:84% So it looks exactly like the closed economy. 00:07:08.100 --> 00:07:10.350 align:middle line:84% Output is being determined by aggregate demand. 00:07:10.350 --> 00:07:13.300 align:middle line:84% But it's aggregate demand for domestically produced goods. 00:07:13.300 --> 00:07:18.180 align:middle line:84% Domestically produced goods is not the same as domestic demand 00:07:18.180 --> 00:07:20.910 align:middle line:84% for goods, which is this, because now there 00:07:20.910 --> 00:07:22.090 align:middle line:90% is a net export term. 00:07:22.090 --> 00:07:27.030 align:middle line:84% So part of the things that residents demand, 00:07:27.030 --> 00:07:29.010 align:middle line:84% they demand from the rest of the world, 00:07:29.010 --> 00:07:30.610 align:middle line:90% not from domestic producers. 00:07:30.610 --> 00:07:32.748 align:middle line:84% And at the same time, part of the demand perceived 00:07:32.748 --> 00:07:35.040 align:middle line:84% by domestic producers comes from the rest of the world, 00:07:35.040 --> 00:07:37.582 align:middle line:84% from exports, not from domestic producers. 00:07:37.582 --> 00:07:39.540 align:middle line:84% So that's the reason we got an extra term here, 00:07:39.540 --> 00:07:41.590 align:middle line:90% which is this net exports. 00:07:41.590 --> 00:07:44.620 align:middle line:84% And we said this net exports is a function of three things. 00:07:44.620 --> 00:07:46.250 align:middle line:90% It's a function of output. 00:07:46.250 --> 00:07:49.790 align:middle line:90% 00:07:49.790 --> 00:07:51.750 align:middle line:84% So it's a decreasing function of output. 00:07:51.750 --> 00:07:54.530 align:middle line:84% Why is that-- of domestic output? 00:07:54.530 --> 00:07:57.450 align:middle line:90% 00:07:57.450 --> 00:07:58.560 align:middle line:90% Domestic output. 00:07:58.560 --> 00:07:59.910 align:middle line:90% Domestic income. 00:07:59.910 --> 00:08:02.420 align:middle line:84% Why is it a decreasing function of domestic income? 00:08:02.420 --> 00:08:08.440 align:middle line:90% 00:08:08.440 --> 00:08:11.385 align:middle line:84% Why do net exports decline when domestic income rises? 00:08:11.385 --> 00:08:14.880 align:middle line:90% 00:08:14.880 --> 00:08:17.540 align:middle line:84% AUDIENCE: People might be more inclined to buy imports. 00:08:17.540 --> 00:08:18.640 align:middle line:84% RICARDO CABALLERO: They import more. 00:08:18.640 --> 00:08:19.848 align:middle line:90% They consume everything more. 00:08:19.848 --> 00:08:21.520 align:middle line:90% But part of that is import. 00:08:21.520 --> 00:08:24.360 align:middle line:84% And so part of that energy of the extra demand 00:08:24.360 --> 00:08:25.720 align:middle line:90% goes to foreign goods. 00:08:25.720 --> 00:08:28.030 align:middle line:84% And that's what deteriorates net exports. 00:08:28.030 --> 00:08:31.095 align:middle line:84% And that's the reason, had we just stopped there, 00:08:31.095 --> 00:08:34.150 align:middle line:84% made the net export function just a function of output, 00:08:34.150 --> 00:08:36.960 align:middle line:84% we would have not needed all these extra parameters 00:08:36.960 --> 00:08:39.720 align:middle line:84% that I'm about to build because all that would have meant 00:08:39.720 --> 00:08:42.162 align:middle line:84% is that just we have a smaller multiplier. 00:08:42.162 --> 00:08:43.620 align:middle line:84% It would have been exactly the same 00:08:43.620 --> 00:08:46.860 align:middle line:84% as we did in the closed economy, but with a smaller multiplier, 00:08:46.860 --> 00:08:49.890 align:middle line:84% because every time an output goes up, now part of that demand 00:08:49.890 --> 00:08:54.090 align:middle line:84% goes to foreign goods rather than domestic goods. 00:08:54.090 --> 00:08:56.770 align:middle line:90% But it's not so-- 00:08:56.770 --> 00:08:59.620 align:middle line:84% first, because we have an extra another income 00:08:59.620 --> 00:09:03.430 align:middle line:84% that matters here, which is the income of the rest of the world. 00:09:03.430 --> 00:09:06.260 align:middle line:84% But more importantly, because we also have an exchange. 00:09:06.260 --> 00:09:07.770 align:middle line:90% But let's start from this side. 00:09:07.770 --> 00:09:11.150 align:middle line:84% So net exports is increasing the income of the rest of the world. 00:09:11.150 --> 00:09:11.670 align:middle line:90% Why is that? 00:09:11.670 --> 00:09:15.270 align:middle line:90% 00:09:15.270 --> 00:09:17.670 align:middle line:84% That is, demand for domestically produced goods 00:09:17.670 --> 00:09:22.090 align:middle line:84% rises when foreign income goes up. 00:09:22.090 --> 00:09:23.800 align:middle line:84% For an output, for income goes up. 00:09:23.800 --> 00:09:24.375 align:middle line:90% Why is that? 00:09:24.375 --> 00:09:29.370 align:middle line:90% 00:09:29.370 --> 00:09:33.640 align:middle line:84% The symmetric argument with inputs. 00:09:33.640 --> 00:09:37.360 align:middle line:84% Well, our exports are the imports of the other country. 00:09:37.360 --> 00:09:40.290 align:middle line:84% So if the income in the other country goes up, 00:09:40.290 --> 00:09:45.430 align:middle line:84% then their imports will go up, which is our exports that go up. 00:09:45.430 --> 00:09:49.810 align:middle line:84% That's the reason net exports goes up. 00:09:49.810 --> 00:09:53.980 align:middle line:84% And the last term, remember, says 00:09:53.980 --> 00:09:59.930 align:middle line:84% that net exports is declining on the real exchange rate. 00:09:59.930 --> 00:10:00.640 align:middle line:90% Why is that? 00:10:00.640 --> 00:10:05.080 align:middle line:90% 00:10:05.080 --> 00:10:07.608 align:middle line:84% What happened when the real exchange rate goes up? 00:10:07.608 --> 00:10:09.400 align:middle line:84% AUDIENCE: It makes our goods more expensive 00:10:09.400 --> 00:10:10.520 align:middle line:90% relative to foreign goods. 00:10:10.520 --> 00:10:10.930 align:middle line:90% RICARDO CABALLERO: Exactly. 00:10:10.930 --> 00:10:13.540 align:middle line:84% Our goods become more expensive relative to foreign goods, 00:10:13.540 --> 00:10:15.350 align:middle line:84% and that affects us from two dimensions. 00:10:15.350 --> 00:10:18.490 align:middle line:84% First, our exports will tend to decline because our goods are 00:10:18.490 --> 00:10:19.600 align:middle line:90% more expensive. 00:10:19.600 --> 00:10:21.760 align:middle line:84% And also, our imports are going to tend 00:10:21.760 --> 00:10:23.900 align:middle line:84% to increase because foreign goods are cheaper. 00:10:23.900 --> 00:10:28.690 align:middle line:84% And so that's the reason this is decreasing with respect 00:10:28.690 --> 00:10:30.250 align:middle line:90% to the exchange rate. 00:10:30.250 --> 00:10:32.290 align:middle line:84% The big thing of the Mundell-Fleming model 00:10:32.290 --> 00:10:35.050 align:middle line:84% really comes from the fact that this guy is there. 00:10:35.050 --> 00:10:36.723 align:middle line:84% Had we not had the exchange rate there, 00:10:36.723 --> 00:10:38.890 align:middle line:84% again, we could have used exactly the same apparatus 00:10:38.890 --> 00:10:40.805 align:middle line:90% as we used earlier on. 00:10:40.805 --> 00:10:43.180 align:middle line:84% But we're going to have an exchange rate floating around. 00:10:43.180 --> 00:10:48.140 align:middle line:84% And that will require us to build more, a little more. 00:10:48.140 --> 00:10:50.590 align:middle line:84% We need an extra equation, because we have 00:10:50.590 --> 00:10:52.090 align:middle line:90% an extra endogenous variable. 00:10:52.090 --> 00:10:54.490 align:middle line:84% Now, what I'm going to assume here, 00:10:54.490 --> 00:10:56.950 align:middle line:84% as we did in the first part of the course, 00:10:56.950 --> 00:10:59.740 align:middle line:84% is that both the domestic and foreign prices 00:10:59.740 --> 00:11:00.680 align:middle line:90% are completely fixed. 00:11:00.680 --> 00:11:02.740 align:middle line:84% So I'm going to ignore Phillips curve, inflation, 00:11:02.740 --> 00:11:06.370 align:middle line:84% expected inflation, and all that, and assume all that is 0. 00:11:06.370 --> 00:11:09.190 align:middle line:84% Expected inflation, inflation, zero. 00:11:09.190 --> 00:11:12.370 align:middle line:84% When I do that, the same equation, 00:11:12.370 --> 00:11:15.910 align:middle line:84% the equilibrium in the goods markets changes a little bit. 00:11:15.910 --> 00:11:17.210 align:middle line:90% I mean, it's the same equation. 00:11:17.210 --> 00:11:18.752 align:middle line:84% But now I don't need to differentiate 00:11:18.752 --> 00:11:21.250 align:middle line:84% between real interest rate and nominal interest rate 00:11:21.250 --> 00:11:22.550 align:middle line:90% because inflation is zero. 00:11:22.550 --> 00:11:25.160 align:middle line:84% So nominal interest rate is equal to the real interest rate. 00:11:25.160 --> 00:11:27.730 align:middle line:84% So I'm going to stick in here the nominal interest rate. 00:11:27.730 --> 00:11:31.270 align:middle line:84% Second, I really don't need to differentiate 00:11:31.270 --> 00:11:34.150 align:middle line:84% between real exchange rate and nominal exchange rate 00:11:34.150 --> 00:11:36.940 align:middle line:84% because the relative prices, the prices themselves are not 00:11:36.940 --> 00:11:37.730 align:middle line:90% changing. 00:11:37.730 --> 00:11:40.360 align:middle line:84% And so all that will move the real exchange rate 00:11:40.360 --> 00:11:41.810 align:middle line:90% is the nominal exchange rate. 00:11:41.810 --> 00:11:44.410 align:middle line:84% So that's the reason I'm going to write 00:11:44.410 --> 00:11:48.460 align:middle line:84% here the nominal exchange rate is because it's 00:11:48.460 --> 00:11:50.950 align:middle line:84% the only thing that will move this variable around given 00:11:50.950 --> 00:11:53.060 align:middle line:90% that prices are fixed. 00:11:53.060 --> 00:11:57.510 align:middle line:84% So our equilibrium in the goods market. 00:11:57.510 --> 00:11:59.930 align:middle line:84% And this is the thing you need to compare with lecture 00:11:59.930 --> 00:12:01.410 align:middle line:90% three or something like that. 00:12:01.410 --> 00:12:05.420 align:middle line:84% And as I said, this part here only lowers the multiplier, so 00:12:05.420 --> 00:12:06.630 align:middle line:90% not a big change. 00:12:06.630 --> 00:12:08.270 align:middle line:84% This one here is an extra parameter 00:12:08.270 --> 00:12:10.700 align:middle line:84% that shifts aggregate demand up and down. 00:12:10.700 --> 00:12:13.710 align:middle line:84% So you can treat it almost like we treated [INAUDIBLE].. 00:12:13.710 --> 00:12:16.130 align:middle line:84% Remember, as the consumer confidence goes up, 00:12:16.130 --> 00:12:17.760 align:middle line:90% then aggregate demand goes up. 00:12:17.760 --> 00:12:21.120 align:middle line:84% Well, here we have the rest of the world's output goes up. 00:12:21.120 --> 00:12:23.210 align:middle line:84% It does exactly the same, the same analysis. 00:12:23.210 --> 00:12:26.185 align:middle line:84% The problem we have, though, is that we have an extra variable 00:12:26.185 --> 00:12:27.560 align:middle line:84% here, which is the exchange rate. 00:12:27.560 --> 00:12:29.330 align:middle line:84% And that's an endogenous variable. 00:12:29.330 --> 00:12:33.140 align:middle line:84% So we're going to have to come up with some other equation 00:12:33.140 --> 00:12:35.960 align:middle line:90% to solve for that equation here. 00:12:35.960 --> 00:12:39.110 align:middle line:84% In lecture 3 or 4, what we did is, 00:12:39.110 --> 00:12:42.590 align:middle line:84% OK, we said we have two endogenous variable, output 00:12:42.590 --> 00:12:44.270 align:middle line:90% and the interest rate-- 00:12:44.270 --> 00:12:45.560 align:middle line:90% output and the interest rate. 00:12:45.560 --> 00:12:46.850 align:middle line:90% We need one more equation. 00:12:46.850 --> 00:12:49.100 align:middle line:84% Well, the other equation was just monetary policy that 00:12:49.100 --> 00:12:51.050 align:middle line:90% set the nominal interest rate. 00:12:51.050 --> 00:12:53.370 align:middle line:84% Here, that's not going to be enough 00:12:53.370 --> 00:12:56.250 align:middle line:84% because we also have an exchange rate floating around. 00:12:56.250 --> 00:13:01.200 align:middle line:84% So we need to bring another equation here 00:13:01.200 --> 00:13:04.980 align:middle line:84% to deal with this new endogenous variable. 00:13:04.980 --> 00:13:07.350 align:middle line:90% What is that extra equation? 00:13:07.350 --> 00:13:09.893 align:middle line:84% Well, it's the uncovered interest parity condition. 00:13:09.893 --> 00:13:11.310 align:middle line:84% Remember, it's the last expression 00:13:11.310 --> 00:13:16.873 align:middle line:84% we had in the previous lecture that takes this form. 00:13:16.873 --> 00:13:20.990 align:middle line:90% 00:13:20.990 --> 00:13:24.060 align:middle line:84% Before I simplify lots of things, I wrote this down. 00:13:24.060 --> 00:13:31.520 align:middle line:84% And it says that the exchange rate is equal to that. 00:13:31.520 --> 00:13:33.360 align:middle line:90% Now, what is this? 00:13:33.360 --> 00:13:36.410 align:middle line:84% Where does this equation come from? 00:13:36.410 --> 00:13:39.310 align:middle line:90% What is it trying to do? 00:13:39.310 --> 00:13:42.610 align:middle line:84% Remember, we talked about this in the context of say, 00:13:42.610 --> 00:13:44.723 align:middle line:84% well, you know, when you open goods markets, 00:13:44.723 --> 00:13:46.390 align:middle line:84% then you need a relative price to decide 00:13:46.390 --> 00:13:47.560 align:middle line:90% what you're going to buy. 00:13:47.560 --> 00:13:53.010 align:middle line:84% That's what the real exchange did. 00:13:53.010 --> 00:13:55.870 align:middle line:84% And then we open the capital account. 00:13:55.870 --> 00:13:58.180 align:middle line:84% And then people need to decide where are they 00:13:58.180 --> 00:13:59.810 align:middle line:90% going to invest their money. 00:13:59.810 --> 00:14:03.455 align:middle line:84% And that equation was related to that. 00:14:03.455 --> 00:14:04.830 align:middle line:84% AUDIENCE: Expected rate of return 00:14:04.830 --> 00:14:06.240 align:middle line:90% has to be the same for domestic. 00:14:06.240 --> 00:14:06.780 align:middle line:90% RICARDO CABALLERO: Exactly. 00:14:06.780 --> 00:14:08.613 align:middle line:84% It's what equalizes expected rate of return. 00:14:08.613 --> 00:14:11.280 align:middle line:84% In equilibrium, that has to happen. 00:14:11.280 --> 00:14:13.840 align:middle line:84% Again, in reality, there is risk adjustment. 00:14:13.840 --> 00:14:16.690 align:middle line:84% There is lots of other factors that we're removing from here. 00:14:16.690 --> 00:14:19.860 align:middle line:84% But absent those other factors, the returns 00:14:19.860 --> 00:14:21.240 align:middle line:84% have to be similar in both places 00:14:21.240 --> 00:14:22.698 align:middle line:84% because if one asset is giving more 00:14:22.698 --> 00:14:24.420 align:middle line:84% return than the other expected return, 00:14:24.420 --> 00:14:26.528 align:middle line:84% then people are going to invest all 00:14:26.528 --> 00:14:27.820 align:middle line:90% their portfolios in that asset. 00:14:27.820 --> 00:14:30.270 align:middle line:84% And what happens is those flows that 00:14:30.270 --> 00:14:34.020 align:middle line:84% try to go to those assets that give the highest return end up 00:14:34.020 --> 00:14:36.790 align:middle line:84% equalizing expected return in equilibrium. 00:14:36.790 --> 00:14:40.660 align:middle line:84% And that's the equation that does that, exactly that. 00:14:40.660 --> 00:14:41.890 align:middle line:90% How do I know that? 00:14:41.890 --> 00:14:45.230 align:middle line:84% Well, remember, I can divide this 00:14:45.230 --> 00:14:47.850 align:middle line:84% by the exchange rate on both sides. 00:14:47.850 --> 00:14:52.430 align:middle line:84% And then what you get is 1 equal to a numerator that 00:14:52.430 --> 00:14:56.690 align:middle line:84% has the nominal exchange rate times the expected 00:14:56.690 --> 00:14:59.600 align:middle line:90% appreciation of the currency. 00:14:59.600 --> 00:15:02.960 align:middle line:84% And in the denominator, you have the foreign interest rate. 00:15:02.960 --> 00:15:05.180 align:middle line:84% And so when you compare the two, you 00:15:05.180 --> 00:15:09.560 align:middle line:84% have to compare one base interest rate, the domestic 00:15:09.560 --> 00:15:11.718 align:middle line:84% or the foreign, plus the expected appreciation 00:15:11.718 --> 00:15:13.260 align:middle line:84% of the appreciation of that currency. 00:15:13.260 --> 00:15:15.170 align:middle line:84% And that's what this term is doing here, 00:15:15.170 --> 00:15:16.790 align:middle line:90% this divided by that. 00:15:16.790 --> 00:15:19.280 align:middle line:90% 00:15:19.280 --> 00:15:19.780 align:middle line:90% Good. 00:15:19.780 --> 00:15:21.360 align:middle line:90% So what do we get out of this? 00:15:21.360 --> 00:15:23.790 align:middle line:84% One thing we're going to do for quite a while, 00:15:23.790 --> 00:15:26.460 align:middle line:84% because it will simplify things a lot, but sometimes 00:15:26.460 --> 00:15:32.910 align:middle line:84% also lead to confusion in the way we understand why currencies 00:15:32.910 --> 00:15:34.420 align:middle line:90% depreciate or appreciate. 00:15:34.420 --> 00:15:38.530 align:middle line:84% But we'll pause and I'll remind you of this repeatedly. 00:15:38.530 --> 00:15:42.750 align:middle line:84% We're going to assume for now that the expected exchange 00:15:42.750 --> 00:15:45.590 align:middle line:90% rate for t plus 1 is fixed. 00:15:45.590 --> 00:15:49.350 align:middle line:84% And until I tell you otherwise, we're 00:15:49.350 --> 00:15:53.190 align:middle line:90% going to make this assumption. 00:15:53.190 --> 00:15:56.430 align:middle line:84% Now, that's a huge simplification, completely 00:15:56.430 --> 00:15:58.300 align:middle line:90% unrealistic, and so on. 00:15:58.300 --> 00:16:01.313 align:middle line:84% But it will help me explain the mechanism. 00:16:01.313 --> 00:16:03.480 align:middle line:84% I mean, one of the things that moves exchanges a lot 00:16:03.480 --> 00:16:05.147 align:middle line:84% is that people have lots of expectations 00:16:05.147 --> 00:16:06.490 align:middle line:90% about future exchange rates. 00:16:06.490 --> 00:16:08.260 align:middle line:90% We'll get to that later. 00:16:08.260 --> 00:16:10.830 align:middle line:84% But for now, so you understand the mechanism, 00:16:10.830 --> 00:16:13.380 align:middle line:84% how the Mundell-Fleming model works, 00:16:13.380 --> 00:16:16.460 align:middle line:84% I'm going to assume that we all know what the expected exchange 00:16:16.460 --> 00:16:18.630 align:middle line:84% rate-- we all have a common expected exchange rate 00:16:18.630 --> 00:16:19.340 align:middle line:90% and it's fixed. 00:16:19.340 --> 00:16:22.480 align:middle line:90% 00:16:22.480 --> 00:16:24.310 align:middle line:90% We may move it as a parameter. 00:16:24.310 --> 00:16:27.040 align:middle line:84% But I'm trying to say, I'm not going to endogenize that. 00:16:27.040 --> 00:16:28.630 align:middle line:90% I'm going to take it as fixed. 00:16:28.630 --> 00:16:31.150 align:middle line:84% And I may move it around to show you 00:16:31.150 --> 00:16:32.800 align:middle line:90% what happens when that changes. 00:16:32.800 --> 00:16:35.020 align:middle line:84% But I'm not going to endogenize it. 00:16:35.020 --> 00:16:40.480 align:middle line:84% Otherwise, I need more equations, one more. 00:16:40.480 --> 00:16:44.400 align:middle line:84% I want to stop this sequence of equations 00:16:44.400 --> 00:16:47.500 align:middle line:90% that I would have to build. 00:16:47.500 --> 00:16:50.000 align:middle line:84% Later we'll understand more that, what I just said. 00:16:50.000 --> 00:16:52.220 align:middle line:84% But for now, just take this as fixed. 00:16:52.220 --> 00:16:54.620 align:middle line:84% So if I take this as fixed, now I have an equation. 00:16:54.620 --> 00:16:56.770 align:middle line:84% Remember, I was looking for an equation 00:16:56.770 --> 00:17:00.080 align:middle line:90% here for my exchange rate. 00:17:00.080 --> 00:17:02.750 align:middle line:84% Once I do that, then I have what I want. 00:17:02.750 --> 00:17:05.230 align:middle line:84% I have an equation for my exchange rate today. 00:17:05.230 --> 00:17:08.480 align:middle line:84% It's just a function of domestic interest rate, 00:17:08.480 --> 00:17:13.130 align:middle line:84% international interest rate, and the expected exchange rate. 00:17:13.130 --> 00:17:15.230 align:middle line:84% So I know the following, for example. 00:17:15.230 --> 00:17:18.740 align:middle line:84% I know that an increase in the domestic interest rate, 00:17:18.740 --> 00:17:22.252 align:middle line:84% other things equal, appreciates exchange rate. 00:17:22.252 --> 00:17:23.460 align:middle line:90% I can see it in the equation. 00:17:23.460 --> 00:17:25.339 align:middle line:84% If I move the domestic interest rate up, 00:17:25.339 --> 00:17:26.792 align:middle line:90% the exchange rate goes up. 00:17:26.792 --> 00:17:27.750 align:middle line:90% That's an appreciation. 00:17:27.750 --> 00:17:31.090 align:middle line:84% The dollar becomes more expensive. 00:17:31.090 --> 00:17:32.380 align:middle line:90% Even simpler. 00:17:32.380 --> 00:17:34.180 align:middle line:84% Suppose we start with a situation 00:17:34.180 --> 00:17:37.090 align:middle line:84% in which the domestic and the international interest rate 00:17:37.090 --> 00:17:38.790 align:middle line:90% were the same. 00:17:38.790 --> 00:17:41.200 align:middle line:84% And now I increase the international interest rate. 00:17:41.200 --> 00:17:44.930 align:middle line:84% And I'm saying the exchange rate will appreciate. 00:17:44.930 --> 00:17:50.080 align:middle line:84% Well, first of all, let me start with something even simpler. 00:17:50.080 --> 00:17:53.420 align:middle line:84% Suppose that this interest rate is 00:17:53.420 --> 00:17:54.920 align:middle line:84% equal to international interest rate 00:17:54.920 --> 00:17:58.300 align:middle line:84% before analyzing the change I'm about to analyze. 00:17:58.300 --> 00:18:01.700 align:middle line:84% Then from this equation, what do I know about exchange rate? 00:18:01.700 --> 00:18:03.563 align:middle line:90% What is it equal to? 00:18:03.563 --> 00:18:06.230 align:middle line:84% If the domestic interest rate is equal to international interest 00:18:06.230 --> 00:18:09.535 align:middle line:84% rate, what is the exchange rate today equal to? 00:18:09.535 --> 00:18:12.910 align:middle line:90% 00:18:12.910 --> 00:18:14.420 align:middle line:84% The expected exchange of next year. 00:18:14.420 --> 00:18:15.910 align:middle line:84% If I have the same interest rates, 00:18:15.910 --> 00:18:19.000 align:middle line:84% I cannot expect a capital gain or loss on the currency position 00:18:19.000 --> 00:18:22.670 align:middle line:84% because I have already an equal interest rate in the two bonds. 00:18:22.670 --> 00:18:25.240 align:middle line:84% So then I'm starting from a situation 00:18:25.240 --> 00:18:26.920 align:middle line:84% where the current exchange rate is 00:18:26.920 --> 00:18:29.420 align:middle line:84% equal to the expected exchange rate and these two are equal. 00:18:29.420 --> 00:18:31.810 align:middle line:84% And now I'm going to increase the interest rate, 00:18:31.810 --> 00:18:33.410 align:middle line:90% the domestic interest rate. 00:18:33.410 --> 00:18:36.160 align:middle line:84% And it's very easy for you to read from here 00:18:36.160 --> 00:18:37.930 align:middle line:84% that the exchange rate will go up. 00:18:37.930 --> 00:18:40.150 align:middle line:90% The currency will appreciate. 00:18:40.150 --> 00:18:42.170 align:middle line:90% Why? 00:18:42.170 --> 00:18:46.610 align:middle line:84% This is not an easy thing to answer unless you have 00:18:46.610 --> 00:18:48.211 align:middle line:90% read the book or something. 00:18:48.211 --> 00:18:50.830 align:middle line:90% 00:18:50.830 --> 00:18:52.330 align:middle line:84% AUDIENCE: The interest rate goes up, 00:18:52.330 --> 00:18:55.450 align:middle line:84% then money supply should go down, which would generally 00:18:55.450 --> 00:18:56.870 align:middle line:90% increase the value of money. 00:18:56.870 --> 00:18:57.870 align:middle line:90% RICARDO CABALLERO: Nope. 00:18:57.870 --> 00:18:59.400 align:middle line:90% No money here. 00:18:59.400 --> 00:19:01.590 align:middle line:84% That money is only related to the mechanism we 00:19:01.590 --> 00:19:03.730 align:middle line:90% use to increase interest rate. 00:19:03.730 --> 00:19:08.050 align:middle line:84% But I'm saying just use that equation and the logic 00:19:08.050 --> 00:19:10.640 align:middle line:84% behind that equation, the uncovered interest parity. 00:19:10.640 --> 00:19:13.900 align:middle line:84% Why is it that if we went to financial situation 00:19:13.900 --> 00:19:15.687 align:middle line:84% which interest were the same, now 00:19:15.687 --> 00:19:17.270 align:middle line:84% I increase the domestic interest rate. 00:19:17.270 --> 00:19:22.015 align:middle line:84% I'm saying the exchange rate has to appreciate. 00:19:22.015 --> 00:19:23.307 align:middle line:90% AUDIENCE: [INAUDIBLE] 00:19:23.307 --> 00:19:25.640 align:middle line:84% RICARDO CABALLERO: No, no, but that's a description of-- 00:19:25.640 --> 00:19:27.850 align:middle line:90% yeah, we know that. 00:19:27.850 --> 00:19:29.640 align:middle line:84% The question is, what is the logic? 00:19:29.640 --> 00:19:32.860 align:middle line:90% 00:19:32.860 --> 00:19:35.380 align:middle line:84% Yeah, we know the result. What I'm 00:19:35.380 --> 00:19:40.780 align:middle line:84% asking is for an economic explanation for that result. 00:19:40.780 --> 00:19:44.190 align:middle line:84% AUDIENCE: More people will want to invest in the currency, 00:19:44.190 --> 00:19:46.398 align:middle line:84% using currency, so the demand go up and [INAUDIBLE].. 00:19:46.398 --> 00:19:48.982 align:middle line:84% RICARDO CABALLERO: Well, if you go to Wall Street, [INAUDIBLE] 00:19:48.982 --> 00:19:50.640 align:middle line:84% they will explain it in those terms. 00:19:50.640 --> 00:19:51.990 align:middle line:90% It's not the right explanation. 00:19:51.990 --> 00:19:53.770 align:middle line:84% But they will explain it on those terms. 00:19:53.770 --> 00:19:55.890 align:middle line:84% And there is some logic behind that 00:19:55.890 --> 00:19:59.130 align:middle line:84% because this equation assumes that the arbitrage happens 00:19:59.130 --> 00:19:59.950 align:middle line:90% instantaneously. 00:19:59.950 --> 00:20:01.110 align:middle line:90% Immediately things move. 00:20:01.110 --> 00:20:03.840 align:middle line:84% But before that happens, some people 00:20:03.840 --> 00:20:07.180 align:middle line:84% will start buying more of the one that has more return. 00:20:07.180 --> 00:20:10.650 align:middle line:84% But this equation already solves all that. 00:20:10.650 --> 00:20:14.080 align:middle line:84% And that's when this assumption matters. 00:20:14.080 --> 00:20:15.990 align:middle line:90% And it's a little annoying. 00:20:15.990 --> 00:20:17.790 align:middle line:84% It bothers me for a variety of reasons. 00:20:17.790 --> 00:20:20.820 align:middle line:84% But we're going to use it to understand the mechanism. 00:20:20.820 --> 00:20:24.600 align:middle line:84% You see, if I keep the changes fixed, we start with a situation 00:20:24.600 --> 00:20:27.720 align:middle line:84% where the exchange rate was equal to expected exchange rate. 00:20:27.720 --> 00:20:32.070 align:middle line:84% If I keep it fixed and I appreciate the currency today, 00:20:32.070 --> 00:20:36.562 align:middle line:84% then what do I expect to happen to the dollar-- 00:20:36.562 --> 00:20:37.770 align:middle line:90% let's talk about the dollar-- 00:20:37.770 --> 00:20:39.810 align:middle line:84% from this period to the next one. 00:20:39.810 --> 00:20:41.413 align:middle line:84% Remember, we start from a situation 00:20:41.413 --> 00:20:43.830 align:middle line:84% where the exchange rate was equal to the expected exchange 00:20:43.830 --> 00:20:44.080 align:middle line:90% rate. 00:20:44.080 --> 00:20:46.050 align:middle line:84% Now I increase the interest rate and I said 00:20:46.050 --> 00:20:48.740 align:middle line:90% the exchange rate appreciates. 00:20:48.740 --> 00:20:51.620 align:middle line:84% Then what do you expect the exchange rate to do over 00:20:51.620 --> 00:20:53.420 align:middle line:90% the next period? 00:20:53.420 --> 00:20:55.340 align:middle line:84% If I have a move expected exchanger, now 00:20:55.340 --> 00:20:57.980 align:middle line:84% the exchanger moves above the expected exchange rate, 00:20:57.980 --> 00:21:00.000 align:middle line:84% what do you expect the exchange rate to do? 00:21:00.000 --> 00:21:03.480 align:middle line:90% 00:21:03.480 --> 00:21:04.000 align:middle line:90% Exactly. 00:21:04.000 --> 00:21:05.730 align:middle line:90% It has to depreciate. 00:21:05.730 --> 00:21:09.210 align:middle line:84% So the reason the depreciation happens here 00:21:09.210 --> 00:21:12.990 align:middle line:84% is because you need to expect depreciate the dollar 00:21:12.990 --> 00:21:14.780 align:middle line:84% from this period to the next one. 00:21:14.780 --> 00:21:20.180 align:middle line:84% Why do I need to expect the exchange rate to depreciate? 00:21:20.180 --> 00:21:22.220 align:middle line:84% So not appreciating the currency, 00:21:22.220 --> 00:21:24.600 align:middle line:84% in equilibrium, I need to expect to depreciate. 00:21:24.600 --> 00:21:28.130 align:middle line:84% That is, I need to expect to lose money on the currency 00:21:28.130 --> 00:21:30.090 align:middle line:90% part of the trade. 00:21:30.090 --> 00:21:31.070 align:middle line:90% Why is that? 00:21:31.070 --> 00:21:32.310 align:middle line:90% Confusion is good. 00:21:32.310 --> 00:21:34.560 align:middle line:90% You learn from that. 00:21:34.560 --> 00:21:36.530 align:middle line:84% And this can be very confusing, I know. 00:21:36.530 --> 00:21:40.260 align:middle line:90% 00:21:40.260 --> 00:21:42.095 align:middle line:84% What is this equation trying to do? 00:21:42.095 --> 00:21:46.140 align:middle line:90% 00:21:46.140 --> 00:21:48.850 align:middle line:84% We are trying to make the specter returns the same. 00:21:48.850 --> 00:21:50.400 align:middle line:90% That's the whole idea of this. 00:21:50.400 --> 00:21:54.720 align:middle line:84% So if I am now telling you that one bond is paying a higher 00:21:54.720 --> 00:21:56.610 align:middle line:84% interest rate than the other one, 00:21:56.610 --> 00:21:59.580 align:middle line:90% I need to offset that somehow. 00:21:59.580 --> 00:22:04.140 align:middle line:84% How do I offset it by expecting a depreciation of the currency 00:22:04.140 --> 00:22:08.370 align:middle line:84% of the bond, that is, the bond that 00:22:08.370 --> 00:22:12.040 align:middle line:84% is denominated in the currency that is expected to depreciate? 00:22:12.040 --> 00:22:16.020 align:middle line:84% So what I need to do is compensate for the interest rate 00:22:16.020 --> 00:22:18.000 align:middle line:84% differential with an expected depreciation 00:22:18.000 --> 00:22:22.060 align:middle line:84% of the currency that is paying a higher interest rate. 00:22:22.060 --> 00:22:25.273 align:middle line:84% So that's what, in this model, when I fix the expected exchange 00:22:25.273 --> 00:22:27.940 align:middle line:84% rate, the only way I can do that is by appreciating the currency 00:22:27.940 --> 00:22:32.240 align:middle line:84% today so I can expect it to depreciate in the future. 00:22:32.240 --> 00:22:34.880 align:middle line:90% That's the logic. 00:22:34.880 --> 00:22:38.100 align:middle line:84% Now, what is the connection with Wall Street? 00:22:38.100 --> 00:22:40.850 align:middle line:84% They will tell you, well, before this 00:22:40.850 --> 00:22:42.680 align:middle line:90% may happen not instantaneously. 00:22:42.680 --> 00:22:44.640 align:middle line:90% It happens somewhat slowly. 00:22:44.640 --> 00:22:49.050 align:middle line:84% So traders immediately will go to the US dollar bond 00:22:49.050 --> 00:22:51.960 align:middle line:84% because they see that they have a higher return. 00:22:51.960 --> 00:22:56.350 align:middle line:84% And it will be the case until the currency really appreciates. 00:22:56.350 --> 00:22:58.240 align:middle line:84% Once the currency appreciates enough, 00:22:58.240 --> 00:23:00.290 align:middle line:90% then that advantage disappear. 00:23:00.290 --> 00:23:01.790 align:middle line:84% That's what this condition is doing. 00:23:01.790 --> 00:23:03.530 align:middle line:84% It's making the spectral return the same. 00:23:03.530 --> 00:23:05.500 align:middle line:84% But in the process of the exchange 00:23:05.500 --> 00:23:07.000 align:middle line:84% going from the initial exchange rate 00:23:07.000 --> 00:23:10.000 align:middle line:84% to the new equilibrium exchange rate, 00:23:10.000 --> 00:23:11.600 align:middle line:84% there may be an opportunity there. 00:23:11.600 --> 00:23:14.140 align:middle line:84% And that's when you start seeing these flows. 00:23:14.140 --> 00:23:15.790 align:middle line:90% That happens very, very fast. 00:23:15.790 --> 00:23:18.110 align:middle line:84% But that's when you can see some of those flows. 00:23:18.110 --> 00:23:24.050 align:middle line:90% 00:23:24.050 --> 00:23:26.580 align:middle line:84% I mean, in this market, that happens very, very quickly. 00:23:26.580 --> 00:23:28.933 align:middle line:84% So what is typically wrong is that then an analyst comes 00:23:28.933 --> 00:23:30.350 align:middle line:84% and tells you, explains the story, 00:23:30.350 --> 00:23:32.370 align:middle line:84% why the exchange rate is going to continue to appreciate. 00:23:32.370 --> 00:23:33.860 align:middle line:90% Well, that's just way too late. 00:23:33.860 --> 00:23:35.400 align:middle line:84% You're already in this environment. 00:23:35.400 --> 00:23:36.192 align:middle line:90% You lost the trade. 00:23:36.192 --> 00:23:42.580 align:middle line:90% 00:23:42.580 --> 00:23:47.400 align:middle line:84% What about an increase in the foreign interest rate, I star? 00:23:47.400 --> 00:23:48.990 align:middle line:84% So an increase in the foreign interest 00:23:48.990 --> 00:23:51.360 align:middle line:84% rate, let's start from the same situation we had before. 00:23:51.360 --> 00:23:53.670 align:middle line:84% We start from interest rate equal to international interest 00:23:53.670 --> 00:23:54.182 align:middle line:90% rate. 00:23:54.182 --> 00:23:56.640 align:middle line:84% Therefore, the exchange rate is equal to the exchange rate. 00:23:56.640 --> 00:24:02.270 align:middle line:84% And now the foreign interest rate goes up. 00:24:02.270 --> 00:24:03.990 align:middle line:90% What is going on now in the US. 00:24:03.990 --> 00:24:05.870 align:middle line:84% The US is sort of stabilizing here. 00:24:05.870 --> 00:24:10.180 align:middle line:84% And Europe is beginning to hike a little more than the US. 00:24:10.180 --> 00:24:14.230 align:middle line:84% So we know from the equation that means 00:24:14.230 --> 00:24:16.790 align:middle line:90% the exchange rate will fall. 00:24:16.790 --> 00:24:18.080 align:middle line:90% That is will drop here. 00:24:18.080 --> 00:24:21.050 align:middle line:84% So that means the exchange rate is depreciated 00:24:21.050 --> 00:24:23.510 align:middle line:90% and the dollar is depreciating. 00:24:23.510 --> 00:24:25.230 align:middle line:90% Why is the dollar depreciating? 00:24:25.230 --> 00:24:31.070 align:middle line:90% 00:24:31.070 --> 00:24:32.960 align:middle line:84% AUDIENCE: Needs the same mechanism 00:24:32.960 --> 00:24:35.960 align:middle line:84% that you described previously, except replacing Et with 1 00:24:35.960 --> 00:24:37.080 align:middle line:90% over star key. 00:24:37.080 --> 00:24:39.690 align:middle line:84% RICARDO CABALLERO: Yeah, that's correct. 00:24:39.690 --> 00:24:42.060 align:middle line:84% I mean, the issue here in terms of the economics 00:24:42.060 --> 00:24:45.010 align:middle line:84% is that, remember, if we start from the same interest 00:24:45.010 --> 00:24:46.788 align:middle line:84% rate and now all the [INAUDIBLE] I'm 00:24:46.788 --> 00:24:49.330 align:middle line:84% giving you doesn't need to start with the same interest rate. 00:24:49.330 --> 00:24:52.148 align:middle line:84% It's just simpler to start from the same interest. 00:24:52.148 --> 00:24:54.190 align:middle line:84% But suppose we start with the same interest rate. 00:24:54.190 --> 00:24:55.770 align:middle line:90% And now we increase this one. 00:24:55.770 --> 00:24:58.650 align:middle line:84% Then that means the foreign bond is paying a higher interest 00:24:58.650 --> 00:25:00.570 align:middle line:90% rate than the domestic bond. 00:25:00.570 --> 00:25:02.560 align:middle line:84% I need to equalize the spectral returns. 00:25:02.560 --> 00:25:06.240 align:middle line:84% The only way I can do that is by having an expected appreciation 00:25:06.240 --> 00:25:08.280 align:middle line:90% of the dollar. 00:25:08.280 --> 00:25:10.135 align:middle line:84% Since the expected exchange, we fix it here. 00:25:10.135 --> 00:25:11.760 align:middle line:84% The only way I can give you an expected 00:25:11.760 --> 00:25:14.630 align:middle line:84% appreciation of the dollar is by depreciating the dollar today. 00:25:14.630 --> 00:25:18.120 align:middle line:90% 00:25:18.120 --> 00:25:19.390 align:middle line:90% So this is the same mechanism. 00:25:19.390 --> 00:25:21.660 align:middle line:90% The same logic is symmetric. 00:25:21.660 --> 00:25:24.180 align:middle line:90% That's the mechanism. 00:25:24.180 --> 00:25:27.720 align:middle line:84% Now, is this true that in the very short run, when I star 00:25:27.720 --> 00:25:30.938 align:middle line:84% goes up and I doesn't move, then lots of people 00:25:30.938 --> 00:25:31.980 align:middle line:90% go and buy foreign bonds. 00:25:31.980 --> 00:25:34.545 align:middle line:84% And that produces sort of demand for euros 00:25:34.545 --> 00:25:35.670 align:middle line:90% and blah, blah, blah, blah. 00:25:35.670 --> 00:25:37.740 align:middle line:90% But that's very quick. 00:25:37.740 --> 00:25:39.120 align:middle line:90% Machines do it for you now. 00:25:39.120 --> 00:25:43.370 align:middle line:90% So it happens very quickly. 00:25:43.370 --> 00:25:45.050 align:middle line:84% So this equation shows you what happens 00:25:45.050 --> 00:25:47.480 align:middle line:84% after all that mess has already cleared, 00:25:47.480 --> 00:25:49.230 align:middle line:90% which happens in milliseconds. 00:25:49.230 --> 00:25:53.890 align:middle line:90% 00:25:53.890 --> 00:25:59.020 align:middle line:84% OK, what if I change expected exchange rate? 00:25:59.020 --> 00:26:00.720 align:middle line:90% So again, I'm fixing it. 00:26:00.720 --> 00:26:02.188 align:middle line:90% But I can move it around. 00:26:02.188 --> 00:26:03.480 align:middle line:90% I'm treating it as a parameter. 00:26:03.480 --> 00:26:07.330 align:middle line:84% When I say I fix it, I just don't want to endogenize it. 00:26:07.330 --> 00:26:09.930 align:middle line:84% I don't want to make it another endogenous variable. 00:26:09.930 --> 00:26:11.962 align:middle line:84% So what happens here is the exchange rate, 00:26:11.962 --> 00:26:13.920 align:middle line:84% we start with the same situation we had before. 00:26:13.920 --> 00:26:15.750 align:middle line:84% Now the expected exchange rate goes up. 00:26:15.750 --> 00:26:17.730 align:middle line:84% Well, from the equation it's very clear. 00:26:17.730 --> 00:26:21.070 align:middle line:84% The current exchange rate immediately rises-- 00:26:21.070 --> 00:26:23.110 align:middle line:90% one for one, in fact. 00:26:23.110 --> 00:26:25.760 align:middle line:84% If I have these two interest rate at the same. 00:26:25.760 --> 00:26:27.730 align:middle line:84% And now I move the expected exchange rate up, 00:26:27.730 --> 00:26:31.740 align:middle line:84% then the current exchange rate immediately jumps. 00:26:31.740 --> 00:26:35.760 align:middle line:84% So if we expect the dollar to appreciate in the future, 00:26:35.760 --> 00:26:37.650 align:middle line:90% then it depreciates today. 00:26:37.650 --> 00:26:40.910 align:middle line:90% Why is that? 00:26:40.910 --> 00:26:44.540 align:middle line:84% Expectations are very powerful in financial assets in general. 00:26:44.540 --> 00:26:46.340 align:middle line:90% This is the first time you come. 00:26:46.340 --> 00:26:50.400 align:middle line:84% And we'll talk a lot more about that in the next week. 00:26:50.400 --> 00:26:53.060 align:middle line:90% But you can see it here. 00:26:53.060 --> 00:26:56.715 align:middle line:84% So if I move the exchange rate today up, 00:26:56.715 --> 00:26:57.840 align:middle line:90% the expected exchange rate. 00:26:57.840 --> 00:26:59.370 align:middle line:84% It means expect the exchange to be-- 00:26:59.370 --> 00:27:05.940 align:middle line:84% we know today the dollar is $0.90-- 00:27:05.940 --> 00:27:07.810 align:middle line:90% 0.9 euros per dollar. 00:27:07.810 --> 00:27:12.143 align:middle line:84% Well, suppose I expect 1 euro per dollar in the next period. 00:27:12.143 --> 00:27:13.810 align:middle line:84% What will happen to exchange rate today? 00:27:13.810 --> 00:27:16.390 align:middle line:90% Well, it jumps today to 1. 00:27:16.390 --> 00:27:17.130 align:middle line:90% Why is that? 00:27:17.130 --> 00:27:24.605 align:middle line:90% 00:27:24.605 --> 00:27:26.980 align:middle line:84% AUDIENCE: The dollar will be more expensive to buy later. 00:27:26.980 --> 00:27:28.560 align:middle line:90% So people are-- 00:27:28.560 --> 00:27:29.480 align:middle line:90% RICARDO CABALLERO: OK. 00:27:29.480 --> 00:27:31.190 align:middle line:84% That's your friend, the trader there. 00:27:31.190 --> 00:27:36.120 align:middle line:90% 00:27:36.120 --> 00:27:39.790 align:middle line:90% Yes, that's true. 00:27:39.790 --> 00:27:42.730 align:middle line:90% 00:27:42.730 --> 00:27:43.430 align:middle line:90% That's true. 00:27:43.430 --> 00:27:47.980 align:middle line:90% What does that mean, though? 00:27:47.980 --> 00:27:48.567 align:middle line:90% It is true. 00:27:48.567 --> 00:27:49.400 align:middle line:90% It's more expensive. 00:27:49.400 --> 00:27:52.340 align:middle line:84% But why did you want to buy it to start with? 00:27:52.340 --> 00:27:54.590 align:middle line:84% I mean, who cares that something is more expensive. 00:27:54.590 --> 00:27:55.940 align:middle line:90% You are not planning to buy it. 00:27:55.940 --> 00:28:00.070 align:middle line:90% 00:28:00.070 --> 00:28:02.560 align:middle line:84% AUDIENCE: Because the current price or something also 00:28:02.560 --> 00:28:05.120 align:middle line:84% has to take into account the future price. 00:28:05.120 --> 00:28:07.750 align:middle line:84% RICARDO CABALLERO: That's what the equation says, yes. 00:28:07.750 --> 00:28:09.700 align:middle line:84% AUDIENCE: Because it's part of it. 00:28:09.700 --> 00:28:12.130 align:middle line:84% Because its value, at the present moment, 00:28:12.130 --> 00:28:16.450 align:middle line:84% takes into account some of its value in the future. 00:28:16.450 --> 00:28:19.100 align:middle line:84% RICARDO CABALLERO: This is an arbitrage type relationship. 00:28:19.100 --> 00:28:22.360 align:middle line:84% And what I suggest is whenever you come across an arbitrage 00:28:22.360 --> 00:28:26.920 align:middle line:84% type argument, you ask the question, well, suppose not. 00:28:26.920 --> 00:28:28.960 align:middle line:90% Suppose this didn't happen. 00:28:28.960 --> 00:28:30.440 align:middle line:90% What would then happen? 00:28:30.440 --> 00:28:33.645 align:middle line:90% What would look odd? 00:28:33.645 --> 00:28:36.270 align:middle line:84% Almost any arbitrary, that's a good way of thinking about this. 00:28:36.270 --> 00:28:38.460 align:middle line:84% The equation tells me that the exchange rate 00:28:38.460 --> 00:28:40.660 align:middle line:90% has to jump right away. 00:28:40.660 --> 00:28:41.780 align:middle line:90% But suppose not. 00:28:41.780 --> 00:28:44.450 align:middle line:90% What goes wrong? 00:28:44.450 --> 00:28:47.420 align:middle line:84% Well, I think that's the way, the easiest 00:28:47.420 --> 00:28:49.430 align:middle line:84% way to think about any of these asset pricing 00:28:49.430 --> 00:28:52.040 align:middle line:90% in general, by the way. 00:28:52.040 --> 00:28:53.123 align:middle line:90% Well, suppose not. 00:28:53.123 --> 00:28:55.040 align:middle line:84% Suppose that the expected change that goes up. 00:28:55.040 --> 00:28:56.600 align:middle line:84% The interest rates haven't changed. 00:28:56.600 --> 00:28:58.770 align:middle line:84% And the exchange rate today doesn't move. 00:28:58.770 --> 00:29:00.940 align:middle line:90% What happens then? 00:29:00.940 --> 00:29:03.970 align:middle line:84% Remember, we're in a situation with both interest rates 00:29:03.970 --> 00:29:05.140 align:middle line:90% are the same. 00:29:05.140 --> 00:29:10.250 align:middle line:84% Now, the expected changes went up by 10%, say. 00:29:10.250 --> 00:29:16.090 align:middle line:84% And the current exchange rate hasn't moved. 00:29:16.090 --> 00:29:19.510 align:middle line:84% I'm sure between the two of you, you can design this trade. 00:29:19.510 --> 00:29:20.355 align:middle line:90% What do you do? 00:29:20.355 --> 00:29:25.530 align:middle line:90% 00:29:25.530 --> 00:29:27.280 align:middle line:84% AUDIENCE: Everyone would buy foreign bonds 00:29:27.280 --> 00:29:28.930 align:middle line:90% in the next period. 00:29:28.930 --> 00:29:30.825 align:middle line:84% And no one would in the first period. 00:29:30.825 --> 00:29:33.467 align:middle line:90% 00:29:33.467 --> 00:29:34.550 align:middle line:90% RICARDO CABALLERO: No, no. 00:29:34.550 --> 00:29:35.633 align:middle line:90% But what did you do today? 00:29:35.633 --> 00:29:38.790 align:middle line:90% 00:29:38.790 --> 00:29:40.740 align:middle line:90% Suppose you're a trader. 00:29:40.740 --> 00:29:43.680 align:middle line:84% And now you see, whoops, the exchange, the dollar 00:29:43.680 --> 00:29:44.717 align:middle line:90% will appreciate 10%. 00:29:44.717 --> 00:29:46.050 align:middle line:90% The interest rates are the same. 00:29:46.050 --> 00:29:47.680 align:middle line:84% And the exchange is not moving today. 00:29:47.680 --> 00:29:48.305 align:middle line:90% What do you do? 00:29:48.305 --> 00:29:58.790 align:middle line:90% 00:29:58.790 --> 00:29:59.905 align:middle line:90% Which bond do you buy? 00:29:59.905 --> 00:30:03.897 align:middle line:90% 00:30:03.897 --> 00:30:05.480 align:middle line:84% AUDIENCE: Buy a lot of American bonds. 00:30:05.480 --> 00:30:06.350 align:middle line:84% RICARDO CABALLERO: Of course, because you 00:30:06.350 --> 00:30:09.390 align:middle line:84% have a 10% expected capital gain from buying that bond 00:30:09.390 --> 00:30:10.490 align:middle line:90% if that doesn't happen. 00:30:10.490 --> 00:30:12.660 align:middle line:84% The two bonds are paying the same interest rate. 00:30:12.660 --> 00:30:14.390 align:middle line:84% And now I tell you, well, yeah, but one 00:30:14.390 --> 00:30:17.730 align:middle line:84% is going to appreciate by 10% relative to the other. 00:30:17.730 --> 00:30:21.290 align:middle line:84% So clearly, you go short massively the foreign bond. 00:30:21.290 --> 00:30:23.190 align:middle line:84% And you go very long the US bond. 00:30:23.190 --> 00:30:25.310 align:middle line:90% That's what you do. 00:30:25.310 --> 00:30:26.490 align:middle line:90% We all want to do the same. 00:30:26.490 --> 00:30:28.460 align:middle line:90% So it happens very quickly. 00:30:28.460 --> 00:30:31.460 align:middle line:84% And the changes appreciated today up 00:30:31.460 --> 00:30:35.390 align:middle line:84% to a point in which that incentive is no longer there. 00:30:35.390 --> 00:30:38.190 align:middle line:84% And in this particular case, if the interest rate are the same, 00:30:38.190 --> 00:30:40.760 align:middle line:84% that will happen only if the exchange rate jumps exactly 00:30:40.760 --> 00:30:44.960 align:middle line:84% by the same amount as expected appreciation of the-- 00:30:44.960 --> 00:30:48.665 align:middle line:84% expected value of the dollar change in the future. 00:30:48.665 --> 00:30:51.740 align:middle line:90% 00:30:51.740 --> 00:30:52.460 align:middle line:90% Think about this. 00:30:52.460 --> 00:30:53.418 align:middle line:90% Play with these things. 00:30:53.418 --> 00:30:54.740 align:middle line:90% I know it can be confusing. 00:30:54.740 --> 00:30:58.850 align:middle line:84% And I always start with let me move something. 00:30:58.850 --> 00:31:00.858 align:middle line:84% The equation tells me this is what has 00:31:00.858 --> 00:31:02.150 align:middle line:90% to happen to the exchange rate. 00:31:02.150 --> 00:31:04.790 align:middle line:84% Well, suppose that didn't happen to the exchange rate. 00:31:04.790 --> 00:31:08.130 align:middle line:84% And then you say, then I clearly invest in this bond. 00:31:08.130 --> 00:31:09.340 align:middle line:90% This dominates the other one. 00:31:09.340 --> 00:31:12.620 align:middle line:84% Well, that condition tells you no, no, in equilibrium 00:31:12.620 --> 00:31:14.010 align:middle line:90% you have to be indifferent. 00:31:14.010 --> 00:31:16.760 align:middle line:84% So the only thing you can move is exchange rate. 00:31:16.760 --> 00:31:19.100 align:middle line:84% And the exchange has to move until you are indifferent 00:31:19.100 --> 00:31:22.760 align:middle line:84% again after you have done some change, some argument 00:31:22.760 --> 00:31:23.880 align:middle line:90% on the right hand side. 00:31:23.880 --> 00:31:27.810 align:middle line:84% That's the way you need to think about it. 00:31:27.810 --> 00:31:35.570 align:middle line:84% So here I'm just plotting this relationship 00:31:35.570 --> 00:31:38.330 align:middle line:84% in the space of exchange rate in the x-axis 00:31:38.330 --> 00:31:42.240 align:middle line:84% and the domestic interest rate here. 00:31:42.240 --> 00:31:44.820 align:middle line:84% So that's an upward sloping relationship. 00:31:44.820 --> 00:31:47.580 align:middle line:84% You can see here that as I move the interest rate up 00:31:47.580 --> 00:31:48.580 align:middle line:90% or the other way around. 00:31:48.580 --> 00:31:50.970 align:middle line:84% But anyways, if I move the interest rate up, 00:31:50.970 --> 00:31:52.420 align:middle line:90% the exchange is going up. 00:31:52.420 --> 00:31:54.600 align:middle line:84% So that's a positive relationship. 00:31:54.600 --> 00:31:56.020 align:middle line:84% I can do it the other way around. 00:31:56.020 --> 00:31:58.645 align:middle line:84% As I move the exchange rate up, then the domestic interest rate 00:31:58.645 --> 00:31:59.220 align:middle line:90% has to go up. 00:31:59.220 --> 00:32:02.730 align:middle line:84% I'm taking as parameters, the foreign interest rate 00:32:02.730 --> 00:32:05.780 align:middle line:90% and the expected exchange rate. 00:32:05.780 --> 00:32:07.740 align:middle line:84% If I take as parameter this and that, 00:32:07.740 --> 00:32:09.270 align:middle line:84% then I have a positive relationship 00:32:09.270 --> 00:32:12.690 align:middle line:84% between the exchange rate and the domestic interest rate. 00:32:12.690 --> 00:32:14.880 align:middle line:90% So that's going to be-- 00:32:14.880 --> 00:32:19.050 align:middle line:84% I'm plotting the UIP and covering parity condition. 00:32:19.050 --> 00:32:21.560 align:middle line:84% Notice this point here is interesting. 00:32:21.560 --> 00:32:25.860 align:middle line:84% This point tells you that when the domestic interest rate, I, 00:32:25.860 --> 00:32:28.380 align:middle line:84% is equal to the International interest rate, 00:32:28.380 --> 00:32:32.790 align:middle line:84% then the exchange rate has to be equal to the expected exchange 00:32:32.790 --> 00:32:35.205 align:middle line:84% rate, which is the question I asked before. 00:32:35.205 --> 00:32:36.580 align:middle line:84% Remember, I asked you a question, 00:32:36.580 --> 00:32:38.413 align:middle line:84% let's suppose that we start with an interest 00:32:38.413 --> 00:32:41.265 align:middle line:84% rate that is equal to the International interest rate. 00:32:41.265 --> 00:32:44.660 align:middle line:90% 00:32:44.660 --> 00:32:45.870 align:middle line:90% What is the exchange rate? 00:32:45.870 --> 00:32:47.728 align:middle line:84% And you said the answer was, well, 00:32:47.728 --> 00:32:49.770 align:middle line:84% it has to be equal to the expected exchange rate. 00:32:49.770 --> 00:32:50.980 align:middle line:90% That's that point here. 00:32:50.980 --> 00:32:53.500 align:middle line:90% 00:32:53.500 --> 00:32:57.150 align:middle line:84% If the interest rate, domestic interest rate, is above that, 00:32:57.150 --> 00:33:01.050 align:middle line:84% the international interest rate, then the exchange rate 00:33:01.050 --> 00:33:04.020 align:middle line:84% today has to be above the expected exchange rate 00:33:04.020 --> 00:33:06.485 align:middle line:84% because that will give you a expected depreciation 00:33:06.485 --> 00:33:08.610 align:middle line:84% of the currency, which will compensate for the fact 00:33:08.610 --> 00:33:11.880 align:middle line:84% that the domestic bond is paying a higher interest 00:33:11.880 --> 00:33:15.290 align:middle line:90% rate than international bond. 00:33:15.290 --> 00:33:19.340 align:middle line:84% Conversely, if the domestic bond is paying a lower interest rate, 00:33:19.340 --> 00:33:21.710 align:middle line:84% then the exchange rate today is very depreciated 00:33:21.710 --> 00:33:24.260 align:middle line:84% because you have to expect it to appreciate in order 00:33:24.260 --> 00:33:29.550 align:middle line:84% to compensate for the interest rate differential. 00:33:29.550 --> 00:33:30.220 align:middle line:90% Probably not. 00:33:30.220 --> 00:33:34.480 align:middle line:84% But this requires practice, I tell you. 00:33:34.480 --> 00:33:40.690 align:middle line:90% 00:33:40.690 --> 00:33:46.150 align:middle line:84% OK, so now we have an equation for the exchange rate at least. 00:33:46.150 --> 00:33:52.340 align:middle line:84% So I can go back to my IS equation in the open economy. 00:33:52.340 --> 00:33:54.290 align:middle line:84% And I have an equation for the exchange rate. 00:33:54.290 --> 00:33:55.900 align:middle line:90% So I replace it. 00:33:55.900 --> 00:33:59.840 align:middle line:84% This is nice because I have two new parameters, 00:33:59.840 --> 00:34:02.372 align:middle line:84% expected exchange rate and international interest rate. 00:34:02.372 --> 00:34:04.580 align:middle line:84% But now this is also a function of the interest rate. 00:34:04.580 --> 00:34:07.610 align:middle line:84% So at this moment, I have one equation and two unknowns, 00:34:07.610 --> 00:34:09.909 align:middle line:84% really, after I solve out for the exchange rate. 00:34:09.909 --> 00:34:11.750 align:middle line:84% I have one equation and two unknowns. 00:34:11.750 --> 00:34:15.790 align:middle line:84% The two unknowns are output and the domestic interest rate. 00:34:15.790 --> 00:34:17.380 align:middle line:90% All the rest are parameters. 00:34:17.380 --> 00:34:21.560 align:middle line:84% So that's the same situation we're at in lecture 3 or so. 00:34:21.560 --> 00:34:24.699 align:middle line:84% So then we need an extra equation. 00:34:24.699 --> 00:34:28.560 align:middle line:84% The extra equation was monetary policy, the LM. 00:34:28.560 --> 00:34:31.040 align:middle line:84% We're going to do exactly the same here. 00:34:31.040 --> 00:34:32.070 align:middle line:90% LM is the same. 00:34:32.070 --> 00:34:35.330 align:middle line:84% It's the domestic central bank sets the interest rate. 00:34:35.330 --> 00:34:37.540 align:middle line:90% So now I'm set. 00:34:37.540 --> 00:34:41.030 align:middle line:84% Now we have the IS-LM model in the open economy. 00:34:41.030 --> 00:34:43.210 align:middle line:84% This is the Mundell-Fleming model. 00:34:43.210 --> 00:34:44.935 align:middle line:84% That's what the Mundell-Fleming model is. 00:34:44.935 --> 00:34:48.300 align:middle line:90% 00:34:48.300 --> 00:34:59.080 align:middle line:84% A more complicated IS with a UIP, a driven exchange rate. 00:34:59.080 --> 00:35:03.210 align:middle line:84% And then the LM is the same as in the closed economy. 00:35:03.210 --> 00:35:07.290 align:middle line:84% So this is the Mundell-Fleming model. 00:35:07.290 --> 00:35:11.730 align:middle line:90% 00:35:11.730 --> 00:35:15.180 align:middle line:84% So one thing we know already, we knew from the previous lecture, 00:35:15.180 --> 00:35:18.420 align:middle line:84% that we have a small multiplier in the open economy 00:35:18.420 --> 00:35:21.010 align:middle line:84% because we have the inputs that are also responding to output. 00:35:21.010 --> 00:35:22.480 align:middle line:90% We have a new parameter. 00:35:22.480 --> 00:35:25.710 align:middle line:84% But now we also know that an increase in the interest 00:35:25.710 --> 00:35:28.170 align:middle line:84% rate-- so monetary policy in the open economy-- 00:35:28.170 --> 00:35:30.030 align:middle line:90% has two effects now. 00:35:30.030 --> 00:35:31.550 align:middle line:84% It used to have only this effect. 00:35:31.550 --> 00:35:33.300 align:middle line:84% Remember, it affected domestic investment. 00:35:33.300 --> 00:35:35.100 align:middle line:84% So an increase in the interest rate 00:35:35.100 --> 00:35:39.900 align:middle line:84% would lead to a reduction in aggregate demand 00:35:39.900 --> 00:35:42.150 align:middle line:90% because investment would fall. 00:35:42.150 --> 00:35:44.430 align:middle line:84% Remember that was the role of the interest rate. 00:35:44.430 --> 00:35:47.590 align:middle line:84% That's the way monetary policy works in the closed economy, 00:35:47.590 --> 00:35:50.240 align:middle line:90% was through this channel here. 00:35:50.240 --> 00:35:54.690 align:middle line:84% Now we have a second channel, which is this one. 00:35:54.690 --> 00:35:56.760 align:middle line:84% So when the interest rate goes up, 00:35:56.760 --> 00:35:58.660 align:middle line:84% it's contractionary for two reasons. 00:35:58.660 --> 00:36:01.740 align:middle line:84% One, for the reason we had before, which is that investment 00:36:01.740 --> 00:36:02.500 align:middle line:90% falls. 00:36:02.500 --> 00:36:06.810 align:middle line:84% But there is a second reason it's contractionary. 00:36:06.810 --> 00:36:07.935 align:middle line:90% What is that second reason? 00:36:07.935 --> 00:36:18.800 align:middle line:90% 00:36:18.800 --> 00:36:20.220 align:middle line:90% I mean, there's only here. 00:36:20.220 --> 00:36:21.710 align:middle line:90% It's only second-- yeah. 00:36:21.710 --> 00:36:23.360 align:middle line:84% AUDIENCE: Raise the exchange rate. 00:36:23.360 --> 00:36:24.870 align:middle line:84% RICARDO CABALLERO: Because appreciates the exchange rate. 00:36:24.870 --> 00:36:26.620 align:middle line:84% And when you appreciate the exchange rate, 00:36:26.620 --> 00:36:27.830 align:middle line:90% net exports decline. 00:36:27.830 --> 00:36:31.100 align:middle line:84% So more domestic consumption is diverted to foreign goods. 00:36:31.100 --> 00:36:36.540 align:middle line:84% And less foreign demand is allocated to our exports. 00:36:36.540 --> 00:36:38.618 align:middle line:90% So that's the second channel. 00:36:38.618 --> 00:36:40.910 align:middle line:84% So in an open economy-- and the smaller is the economy, 00:36:40.910 --> 00:36:43.188 align:middle line:84% the more important is this term, the more powerful 00:36:43.188 --> 00:36:43.855 align:middle line:90% is that channel. 00:36:43.855 --> 00:36:52.342 align:middle line:90% 00:36:52.342 --> 00:36:56.590 align:middle line:84% The US cares very little about this effect. 00:36:56.590 --> 00:36:58.755 align:middle line:84% Most other economies care a lot about this effect. 00:36:58.755 --> 00:37:01.610 align:middle line:90% 00:37:01.610 --> 00:37:03.620 align:middle line:84% Because the US is a relatively closed economy, 00:37:03.620 --> 00:37:04.790 align:middle line:90% believe it or not. 00:37:04.790 --> 00:37:11.130 align:middle line:84% So this is the start diagram of the Mundell-Fleming model. 00:37:11.130 --> 00:37:15.610 align:middle line:84% So this thing here is our old IS-LM model. 00:37:15.610 --> 00:37:17.890 align:middle line:84% It's just that this IS is a little thicker now. 00:37:17.890 --> 00:37:19.620 align:middle line:84% It has net exports in there and so on, 00:37:19.620 --> 00:37:21.370 align:middle line:90% but it looks exactly the same. 00:37:21.370 --> 00:37:27.210 align:middle line:84% That is, plot equilibrium in financial and goods market, 00:37:27.210 --> 00:37:30.060 align:middle line:84% the combinations of output and domestic interest 00:37:30.060 --> 00:37:34.360 align:middle line:84% rate that are consistent with equilibrium in both markets. 00:37:34.360 --> 00:37:36.030 align:middle line:90% That's the case here. 00:37:36.030 --> 00:37:39.923 align:middle line:84% This is IS, which is all the combinations of domestic output 00:37:39.923 --> 00:37:42.590 align:middle line:84% and domestic interest rates that are consistent with equilibrium 00:37:42.590 --> 00:37:43.708 align:middle line:90% in goods market. 00:37:43.708 --> 00:37:46.250 align:middle line:84% This is the interest rate that is consistent with equilibrium 00:37:46.250 --> 00:37:47.220 align:middle line:90% in financial markets. 00:37:47.220 --> 00:37:49.970 align:middle line:84% That's what the Fed does in the US. 00:37:49.970 --> 00:37:54.290 align:middle line:84% That point is where both markets are in equilibrium. 00:37:54.290 --> 00:37:55.850 align:middle line:84% But we can take this interest rate. 00:37:55.850 --> 00:37:56.975 align:middle line:90% So that's what will happen. 00:37:56.975 --> 00:37:58.560 align:middle line:84% The interest rate will be, in the US, 00:37:58.560 --> 00:38:00.810 align:middle line:84% the interest rate is set by the Fed, not by the ECB. 00:38:00.810 --> 00:38:02.750 align:middle line:84% The Fed will set the interest rate. 00:38:02.750 --> 00:38:06.350 align:middle line:84% That will give us some equilibrium output. 00:38:06.350 --> 00:38:08.760 align:middle line:84% And then we can go to the UIP condition, 00:38:08.760 --> 00:38:10.880 align:middle line:84% you see, I'm plotting here, and figure out 00:38:10.880 --> 00:38:13.110 align:middle line:90% what the exchange rate is. 00:38:13.110 --> 00:38:15.360 align:middle line:84% Because for this interest rate here, 00:38:15.360 --> 00:38:17.640 align:middle line:84% there's going to be some point in the UIP. 00:38:17.640 --> 00:38:21.820 align:middle line:84% And that tells me exactly what the exchange rate is. 00:38:21.820 --> 00:38:26.230 align:middle line:84% So with this set of diagrams, I can determine the interest rate 00:38:26.230 --> 00:38:27.345 align:middle line:90% output and exchange rate. 00:38:27.345 --> 00:38:31.140 align:middle line:90% 00:38:31.140 --> 00:38:33.630 align:middle line:84% So I can study the effects of different policies, 00:38:33.630 --> 00:38:37.410 align:middle line:84% for example, on output, the interest rate, of course-- 00:38:37.410 --> 00:38:38.890 align:middle line:90% that's the policy itself-- 00:38:38.890 --> 00:38:39.970 align:middle line:90% and the exchange rate. 00:38:39.970 --> 00:38:41.977 align:middle line:84% So this is the new thing I can explain. 00:38:41.977 --> 00:38:43.810 align:middle line:84% I can do a little bit of asset pricing here. 00:38:43.810 --> 00:38:48.350 align:middle line:84% I can explain the behavior of the exchange rate, as well. 00:38:48.350 --> 00:38:51.950 align:middle line:90% 00:38:51.950 --> 00:38:53.060 align:middle line:90% So this diagram-- 00:38:53.060 --> 00:38:55.700 align:middle line:84% I mean, you need to really control very, very well. 00:38:55.700 --> 00:38:59.870 align:middle line:84% So I'm going to play with it quite a bit. 00:38:59.870 --> 00:39:01.088 align:middle line:90% Monetary policy. 00:39:01.088 --> 00:39:02.130 align:middle line:90% Let's do monetary policy. 00:39:02.130 --> 00:39:03.950 align:middle line:84% We talk about monetary policy already. 00:39:03.950 --> 00:39:06.650 align:middle line:84% So suppose that for whatever reason, 00:39:06.650 --> 00:39:11.750 align:middle line:84% the domestic economy, domestic central bank, 00:39:11.750 --> 00:39:13.470 align:middle line:90% decides to hike interest rate. 00:39:13.470 --> 00:39:15.200 align:middle line:84% Suppose the economy was overheating, 00:39:15.200 --> 00:39:17.330 align:middle line:84% output was too high relative to natural rate 00:39:17.330 --> 00:39:19.490 align:middle line:84% of output, the typical reasons why you 00:39:19.490 --> 00:39:20.990 align:middle line:90% need to raise interest rates. 00:39:20.990 --> 00:39:24.080 align:middle line:84% And so suppose that the domestic interest rate goes up. 00:39:24.080 --> 00:39:28.330 align:middle line:84% Well, as it used to be, that's going to be contractionary. 00:39:28.330 --> 00:39:31.400 align:middle line:84% What happens to the exchange rate? 00:39:31.400 --> 00:39:36.230 align:middle line:84% Well, I know the interest went up. 00:39:36.230 --> 00:39:38.390 align:middle line:90% I look into my UIP. 00:39:38.390 --> 00:39:40.800 align:middle line:84% For the high interest rate and a current exchange rate 00:39:40.800 --> 00:39:43.430 align:middle line:90% that is above-- 00:39:43.430 --> 00:39:44.970 align:middle line:84% that has to go up relative to all. 00:39:44.970 --> 00:39:47.990 align:middle line:84% When I increase interest rate from here to there, 00:39:47.990 --> 00:39:50.600 align:middle line:84% then my exchange rate has to appreciate. 00:39:50.600 --> 00:39:52.500 align:middle line:90% Why is that? 00:39:52.500 --> 00:39:55.980 align:middle line:84% So an expansionary domestic monetary policy 00:39:55.980 --> 00:40:00.480 align:middle line:84% will lead to a contraction in output, which is what we get out 00:40:00.480 --> 00:40:03.970 align:middle line:90% of a monetary policy. 00:40:03.970 --> 00:40:07.420 align:middle line:84% But it will also lead to an appreciation of the currency. 00:40:07.420 --> 00:40:08.135 align:middle line:90% Why is that? 00:40:08.135 --> 00:40:13.190 align:middle line:90% 00:40:13.190 --> 00:40:15.650 align:middle line:84% That's what we just discussed, UIP. 00:40:15.650 --> 00:40:19.310 align:middle line:84% If I move the domestic interest rate and the rest 00:40:19.310 --> 00:40:21.360 align:middle line:84% and the rest of the world does not follow me, 00:40:21.360 --> 00:40:23.943 align:middle line:84% so we move interest rates, they don't, then 00:40:23.943 --> 00:40:26.360 align:middle line:84% now I need to compensate for this increase in the interest 00:40:26.360 --> 00:40:27.260 align:middle line:90% rate differential. 00:40:27.260 --> 00:40:31.430 align:middle line:84% And the compensation will come through an expected capital loss 00:40:31.430 --> 00:40:32.660 align:middle line:90% through the currency. 00:40:32.660 --> 00:40:34.310 align:middle line:84% So if I appreciate more the currency, 00:40:34.310 --> 00:40:36.560 align:middle line:84% since I haven't moved the expected exchange rate, 00:40:36.560 --> 00:40:38.990 align:middle line:84% I expect a larger loss from the point of, 00:40:38.990 --> 00:40:43.430 align:middle line:84% from the countries from the currency side. 00:40:43.430 --> 00:40:45.180 align:middle line:90% That's what has happened here. 00:40:45.180 --> 00:40:47.270 align:middle line:84% So that's what is behind depreciation. 00:40:47.270 --> 00:40:49.130 align:middle line:84% And, of course, the depreciation is already 00:40:49.130 --> 00:40:56.570 align:middle line:84% built in here, which is what makes monetary policy more 00:40:56.570 --> 00:41:00.190 align:middle line:84% powerful than the closed economy because you get the next export 00:41:00.190 --> 00:41:00.690 align:middle line:90% channel. 00:41:00.690 --> 00:41:01.765 align:middle line:90% But that's built in here. 00:41:01.765 --> 00:41:06.300 align:middle line:90% 00:41:06.300 --> 00:41:08.910 align:middle line:84% OK, here all that I did is exactly the same 00:41:08.910 --> 00:41:10.930 align:middle line:84% as we were doing in the last 30 minutes. 00:41:10.930 --> 00:41:13.140 align:middle line:90% I just use this UIP. 00:41:13.140 --> 00:41:17.330 align:middle line:84% For whatever domestic reason, I need to raise interest rate. 00:41:17.330 --> 00:41:19.970 align:middle line:84% And have contractionary monetary policy. 00:41:19.970 --> 00:41:21.470 align:middle line:84% Well, one of the effects that you're 00:41:21.470 --> 00:41:24.230 align:middle line:84% going to get in an open economy is that your currency 00:41:24.230 --> 00:41:25.880 align:middle line:90% will tend to appreciate. 00:41:25.880 --> 00:41:26.605 align:middle line:90% OK, good. 00:41:26.605 --> 00:41:31.500 align:middle line:90% 00:41:31.500 --> 00:41:35.140 align:middle line:90% What about fiscal policy? 00:41:35.140 --> 00:41:39.710 align:middle line:84% Well, if the Fed doesn't follow, the central bank doesn't follow, 00:41:39.710 --> 00:41:42.460 align:middle line:84% and you have an expansionary fiscal policy, 00:41:42.460 --> 00:41:47.560 align:middle line:90% then that will increase output. 00:41:47.560 --> 00:41:49.270 align:middle line:84% It has no effect on the interest rate. 00:41:49.270 --> 00:41:51.770 align:middle line:84% Therefore, it has absolutely no effect on the exchange rate. 00:41:51.770 --> 00:41:54.020 align:middle line:84% So an expansionary fiscal policy, 00:41:54.020 --> 00:41:55.580 align:middle line:84% which is accommodated by the Fed-- 00:41:55.580 --> 00:41:58.720 align:middle line:84% that means the interest rate is kept at the same level-- 00:41:58.720 --> 00:42:01.140 align:middle line:84% then does not lead to an appreciation of the currency. 00:42:01.140 --> 00:42:02.100 align:middle line:84% It doesn't move the exchange rate. 00:42:02.100 --> 00:42:03.767 align:middle line:84% It no implication for the exchange rate. 00:42:03.767 --> 00:42:08.750 align:middle line:90% 00:42:08.750 --> 00:42:10.670 align:middle line:84% Now, what about this change in output? 00:42:10.670 --> 00:42:13.980 align:middle line:84% Is it larger or smaller than the one we did in lecture 3 or 4? 00:42:13.980 --> 00:42:17.192 align:middle line:90% 00:42:17.192 --> 00:42:18.650 align:middle line:84% AUDIENCE: It's going to be smaller. 00:42:18.650 --> 00:42:19.140 align:middle line:90% RICARDO CABALLERO: Smaller. 00:42:19.140 --> 00:42:19.850 align:middle line:90% Why? 00:42:19.850 --> 00:42:22.550 align:middle line:84% AUDIENCE: Because it's part of the increase in [INAUDIBLE] 00:42:22.550 --> 00:42:23.593 align:middle line:90% falls on [INAUDIBLE]. 00:42:23.593 --> 00:42:25.260 align:middle line:84% RICARDO CABALLERO: Exactly because yeah, 00:42:25.260 --> 00:42:26.100 align:middle line:90% it goes to imports. 00:42:26.100 --> 00:42:26.990 align:middle line:90% Perfect. 00:42:26.990 --> 00:42:27.600 align:middle line:90% OK, good. 00:42:27.600 --> 00:42:29.808 align:middle line:84% So this is smaller than it was in the closed economy. 00:42:29.808 --> 00:42:35.220 align:middle line:84% And it has no impact on the exchange rate. 00:42:35.220 --> 00:42:39.800 align:middle line:84% That is, the UIP has nothing to do with government expenditure. 00:42:39.800 --> 00:42:41.460 align:middle line:84% It's all about financial markets. 00:42:41.460 --> 00:42:44.080 align:middle line:84% It's about expected returns, things like that. 00:42:44.080 --> 00:42:50.160 align:middle line:84% So unless the fiscal policy somehow affects interest rate, 00:42:50.160 --> 00:42:51.640 align:middle line:90% then there is no effect. 00:42:51.640 --> 00:42:56.910 align:middle line:84% What may happen is that, for example, is that treasury 00:42:56.910 --> 00:42:58.410 align:middle line:90% becomes very expansionary. 00:42:58.410 --> 00:43:01.170 align:middle line:84% And this output becomes too large for what 00:43:01.170 --> 00:43:05.980 align:middle line:84% is consistent with a zero output gap or no inflation. 00:43:05.980 --> 00:43:09.090 align:middle line:84% And then the Fed may react and raise interest rate. 00:43:09.090 --> 00:43:11.830 align:middle line:84% And that will lead to inflation of the exchange rate and so on. 00:43:11.830 --> 00:43:15.540 align:middle line:84% And that's the reason why, in practice, when countries have 00:43:15.540 --> 00:43:17.910 align:middle line:84% sort of expansionary fiscal packages, 00:43:17.910 --> 00:43:19.710 align:middle line:84% the currency tends to appreciate, 00:43:19.710 --> 00:43:23.190 align:middle line:84% is because investors expect the Fed to react 00:43:23.190 --> 00:43:25.710 align:middle line:84% to that or the central bank to react to that 00:43:25.710 --> 00:43:26.950 align:middle line:90% and raise interest rates. 00:43:26.950 --> 00:43:29.460 align:middle line:84% But if the Fed says, no, no, we need that fiscal expansion, 00:43:29.460 --> 00:43:30.960 align:middle line:84% I'm not going to move the interest rate, 00:43:30.960 --> 00:43:32.377 align:middle line:84% then the exchange rate won't move. 00:43:32.377 --> 00:43:39.570 align:middle line:90% 00:43:39.570 --> 00:43:42.480 align:middle line:84% So let's use a little more of this model 00:43:42.480 --> 00:43:47.010 align:middle line:84% and look at other shocks within this model. 00:43:47.010 --> 00:43:51.840 align:middle line:84% So let's start with-- suppose that we increase 00:43:51.840 --> 00:43:53.790 align:middle line:90% the expected exchange rate. 00:43:53.790 --> 00:44:00.140 align:middle line:90% What moves in this diagram? 00:44:00.140 --> 00:44:04.550 align:middle line:90% 00:44:04.550 --> 00:44:06.660 align:middle line:90% Let's go-- does LM move? 00:44:06.660 --> 00:44:16.320 align:middle line:90% 00:44:16.320 --> 00:44:19.370 align:middle line:84% No, the LM is controlled by domestic central bank. 00:44:19.370 --> 00:44:20.640 align:middle line:90% Doesn't move. 00:44:20.640 --> 00:44:22.120 align:middle line:90% Does the IS move? 00:44:22.120 --> 00:44:25.700 align:middle line:90% 00:44:25.700 --> 00:44:27.740 align:middle line:84% When I asked you whether it moves, 00:44:27.740 --> 00:44:29.130 align:middle line:90% you should always fix something. 00:44:29.130 --> 00:44:31.140 align:middle line:84% So you say, OK, let me fix the interest rate, 00:44:31.140 --> 00:44:34.720 align:middle line:90% say, pick a point like this one. 00:44:34.720 --> 00:44:36.340 align:middle line:84% And now I have to ask the question, 00:44:36.340 --> 00:44:38.290 align:middle line:84% what happens to output now that I have 00:44:38.290 --> 00:44:39.580 align:middle line:90% moved the expected exchange? 00:44:39.580 --> 00:44:42.670 align:middle line:84% If I get the same output back, means that IS doesn't move. 00:44:42.670 --> 00:44:45.460 align:middle line:84% If I get a different output, equilibrium output, then I 00:44:45.460 --> 00:44:48.840 align:middle line:90% know that the IS did move. 00:44:48.840 --> 00:44:50.015 align:middle line:90% So what is the answer? 00:44:50.015 --> 00:44:54.270 align:middle line:90% 00:44:54.270 --> 00:44:55.830 align:middle line:84% If the interest rate doesn't move, 00:44:55.830 --> 00:44:57.620 align:middle line:84% the foreign interest doesn't move, 00:44:57.620 --> 00:44:59.380 align:middle line:84% and expected change rate goes up, 00:44:59.380 --> 00:45:02.520 align:middle line:84% what happens to the current exchange rate? 00:45:02.520 --> 00:45:04.360 align:middle line:90% Appreciate. 00:45:04.360 --> 00:45:07.090 align:middle line:84% What happens when there is an opposition? 00:45:07.090 --> 00:45:09.280 align:middle line:90% Net exports decline. 00:45:09.280 --> 00:45:12.470 align:middle line:84% That means that moves the IS to the left. 00:45:12.470 --> 00:45:16.280 align:middle line:84% So this movement will move the IS to the left. 00:45:16.280 --> 00:45:18.730 align:middle line:90% That's the first effect. 00:45:18.730 --> 00:45:20.630 align:middle line:90% What about the UIP condition? 00:45:20.630 --> 00:45:21.560 align:middle line:90% Will it move or not? 00:45:21.560 --> 00:45:23.500 align:middle line:84% We have taken that as a parameter. 00:45:23.500 --> 00:45:26.090 align:middle line:90% Will it move? 00:45:26.090 --> 00:45:29.190 align:middle line:84% I mean, remember, I give you a clue because I said, 00:45:29.190 --> 00:45:32.540 align:middle line:84% we are taking these two as parameters here. 00:45:32.540 --> 00:45:37.790 align:middle line:84% So if I move a parameter, most likely I will move the curve. 00:45:37.790 --> 00:45:39.710 align:middle line:84% But in which direction will it move? 00:45:39.710 --> 00:45:46.820 align:middle line:90% 00:45:46.820 --> 00:45:47.710 align:middle line:90% To the right. 00:45:47.710 --> 00:45:51.390 align:middle line:84% Yes, because for the same interest rate, 00:45:51.390 --> 00:45:53.833 align:middle line:84% now I need the exchange rate to move one for one, 00:45:53.833 --> 00:45:55.500 align:middle line:84% the current exchange to move one for one 00:45:55.500 --> 00:45:57.930 align:middle line:90% with the expected exchange rate. 00:45:57.930 --> 00:46:01.350 align:middle line:84% So this was the exchange rate before. 00:46:01.350 --> 00:46:03.520 align:middle line:84% And now the expected exchange moved to the right. 00:46:03.520 --> 00:46:05.790 align:middle line:84% Well, in order not to generate the expected capital 00:46:05.790 --> 00:46:08.430 align:middle line:84% gain or loss, I have to move the current exchange 00:46:08.430 --> 00:46:10.230 align:middle line:90% rate by the same amount. 00:46:10.230 --> 00:46:14.430 align:middle line:84% And so that means this curve will shift to the right. 00:46:14.430 --> 00:46:18.560 align:middle line:84% What if I move foreign output down? 00:46:18.560 --> 00:46:20.940 align:middle line:90% What happens? 00:46:20.940 --> 00:46:22.380 align:middle line:90% Which curve moves? 00:46:22.380 --> 00:46:24.900 align:middle line:84% Well, this is not a parameter here. 00:46:24.900 --> 00:46:27.250 align:middle line:90% So this is not moving. 00:46:27.250 --> 00:46:28.970 align:middle line:90% This is not a parameter here. 00:46:28.970 --> 00:46:30.940 align:middle line:90% So this one is not moving. 00:46:30.940 --> 00:46:32.270 align:middle line:90% Only one can move. 00:46:32.270 --> 00:46:33.390 align:middle line:90% The IS, where? 00:46:33.390 --> 00:46:34.890 align:middle line:84% AUDIENCE: It would move to the left. 00:46:34.890 --> 00:46:36.682 align:middle line:84% RICARDO CABALLERO: It will move to the left 00:46:36.682 --> 00:46:38.183 align:middle line:84% because net exports will decline. 00:46:38.183 --> 00:46:40.100 align:middle line:84% Now, for any given level of the interest rate, 00:46:40.100 --> 00:46:41.860 align:middle line:90% now we have less net exports. 00:46:41.860 --> 00:46:44.720 align:middle line:84% And therefore the IS move to the left, so output falls. 00:46:44.720 --> 00:46:46.900 align:middle line:90% But there is no movement here. 00:46:46.900 --> 00:46:51.150 align:middle line:84% Unless the Fed reacts to that, the central bank reacts to that, 00:46:51.150 --> 00:46:51.870 align:middle line:90% it won't happen. 00:46:51.870 --> 00:47:00.030 align:middle line:90% 00:47:00.030 --> 00:47:02.038 align:middle line:84% I mean, and it may well be the case 00:47:02.038 --> 00:47:03.330 align:middle line:90% that you want to react to that. 00:47:03.330 --> 00:47:06.550 align:middle line:84% If the whole world goes into recession, 00:47:06.550 --> 00:47:08.980 align:middle line:84% the US is very likely to lower interest rates 00:47:08.980 --> 00:47:13.130 align:middle line:84% because it's very contractionary. 00:47:13.130 --> 00:47:15.760 align:middle line:84% The whole world goes into recession. 00:47:15.760 --> 00:47:18.880 align:middle line:84% When the US goes into recession, the rest of the world, everyone 00:47:18.880 --> 00:47:21.920 align:middle line:84% wants to cut interest rates because the US is a big player. 00:47:21.920 --> 00:47:23.790 align:middle line:84% So it really drags everyone down. 00:47:23.790 --> 00:47:30.790 align:middle line:90% 00:47:30.790 --> 00:47:33.520 align:middle line:84% The last one, I'm going to repeat this in the next lecture 00:47:33.520 --> 00:47:37.750 align:middle line:84% is, well, what happens if I star moves up, the foreign interest 00:47:37.750 --> 00:47:39.340 align:middle line:90% rate moves up? 00:47:39.340 --> 00:47:42.570 align:middle line:90% Well, the LM doesn't move. 00:47:42.570 --> 00:47:45.870 align:middle line:90% This one will move which way? 00:47:45.870 --> 00:47:47.460 align:middle line:84% Because that was a parameter here. 00:47:47.460 --> 00:47:51.785 align:middle line:90% To the right. 00:47:51.785 --> 00:47:54.403 align:middle line:90% 00:47:54.403 --> 00:47:55.320 align:middle line:90% You said to the right. 00:47:55.320 --> 00:47:55.862 align:middle line:90% That's right. 00:47:55.862 --> 00:47:59.340 align:middle line:90% 00:47:59.340 --> 00:48:03.090 align:middle line:90% So think what happened here. 00:48:03.090 --> 00:48:04.710 align:middle line:84% If the foreign interest rate goes, 00:48:04.710 --> 00:48:09.720 align:middle line:84% up at any given interest rate, now the domestic bond 00:48:09.720 --> 00:48:12.030 align:middle line:90% is doing worse than otherwise. 00:48:12.030 --> 00:48:17.050 align:middle line:84% So I need to depreciate the exchange rate today in order 00:48:17.050 --> 00:48:22.030 align:middle line:90% to expect an appreciation. 00:48:22.030 --> 00:48:26.025 align:middle line:84% That means this curve moves to the left. 00:48:26.025 --> 00:48:30.132 align:middle line:90% 00:48:30.132 --> 00:48:31.590 align:middle line:84% It moves to the left because I have 00:48:31.590 --> 00:48:34.890 align:middle line:84% to expect an appreciation to compensate for the interest rate 00:48:34.890 --> 00:48:37.050 align:middle line:90% differential. 00:48:37.050 --> 00:48:38.640 align:middle line:90% So these will move to the left. 00:48:38.640 --> 00:48:40.535 align:middle line:90% What about this curve here? 00:48:40.535 --> 00:48:43.960 align:middle line:90% 00:48:43.960 --> 00:48:47.320 align:middle line:90% We solve it in the next lecture. 00:48:47.320 --> 00:48:49.050 align:middle line:90% Very good. 00:48:49.050 --> 00:49:03.000 align:middle line:90%