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6 Saving, investment and the current account balance
Chapter 18 The goods market in an open economy 383
components using the assumptions that we have made about consumption, investment,
exports and imports. That is, we need to do the complete analysis laid out in this chapter. Using only equation (18.5) can, if you are not careful, be very misleading. To see how
misleading, consider, for example, the following argument (which is so common that you
may have read something similar in the newspapers): ‘It is clear the United Kingdom cannot
reduce its large current account deficit through a depreciation.’ Look at equation (18.5). It
shows that the current account deficit is equal to investment minus saving. Why should a
depreciation affect either saving or investment? So how can a depreciation affect the current
The argument might sound convincing, but we know it is wrong. We showed that a depreciation leads to an improvement in a country’s trade position and by implication, given net
income and transfers, an improvement in the current account. So what is wrong with the
argument? A depreciation actually does affect saving and investment. It does so by affecting the demand for domestic goods, thereby increasing output. Higher output leads to an
increase in saving over investment or, equivalently, to a decrease in the current account
A good way of making sure that you understand the material in this section is to go back
and look at the various cases we have considered, from changes in government spending, to
changes in foreign output, to combinations of depreciation and fiscal contraction, and so on.
Trace what happens in each case to each of the four components of equation (18.5): private
saving, public saving (equivalently, the budget surplus), investment and the current account
balance. Make sure, as always, that you can tell the story in words.
Let us end the chapter with a challenge. Assess the following three statements about the
US trade deficit – the largest by far in the world – and decide which one(s) is (are) right:
Suppose, for example, that the government wants to reduce the current
account deficit without changing the
level of output, so it uses a combination
of depreciation and fiscal contraction.
What happens to private saving, public
saving and investment?
The US current account deficit shows that the US is no longer competitive (see Chapter 17). It is a sign of weakness. Forget saving, or investment. The United States must
urgently improve its competitiveness.
The US current account deficit shows that the United States just does not save enough to
finance its investment. It is a sign of weakness. Forget competitiveness. The United States
must urgently increase its saving rate.
The US current account deficit is just a mirror image of the US capital account surplus.
What is happening is that the rest of the world wants to put its funds in the United States.
The US capital account surplus and, by implication, the US current account deficit are in
fact a sign of strength, and there is no need to take policy measures to reduce it.
In an open economy, the demand for domestic goods is
equal to the domestic demand for goods (consumption,
plus investment, plus government spending) minus the
value of imports (in terms of domestic goods), plus exports.
In an open economy, an increase in domestic demand
leads to a smaller increase in output than it would in a
closed economy because some of the additional demand
falls on imports. For the same reason, an increase in
domestic demand also leads to a deterioration of the
An increase in foreign demand leads, as a result of
increased exports, to both an increase in domestic output
and an improvement of the trade balance.
Because increases in foreign demand improve the trade
balance and increases in domestic demand worsen the
trade balance, countries might be tempted to wait for
M18 Macroeconomics 85678.indd 383
increases in foreign demand to move them out of a recession. When a group of countries is in recession, coordination can, in principle, help their recovery.
If the Marshall–Lerner condition is satisfied – and the
empirical evidence indicates that it is – a real depreciation leads to an improvement in net exports.
A real depreciation leads first to a deterioration of the
trade balance and then to an improvement. This adjustment process is known as the J-curve.
The condition for equilibrium in the goods market can
be rewritten as the condition that saving (public and
private) minus investment must be equal to the current
account balance. A current account surplus corresponds
to an excess of saving over investment. A current account
deficit usually corresponds to an excess of investment
384 EXTENSIONS The open economy
demand for domestic
domestic demand for
policy coordination 375
import compression 379
Questions and problems
All ‘Quick check’ questions and problems are available on
1.Using the information in this chapter, label each of the following statements true, false or uncertain. Explain briefly.
a. The current US trade deficit is the result of unusually high
investment, not the result of a decline in national saving.
b. The national income identity implies that budget deficits
cause trade deficits.
c. Opening the economy to trade tends to increase the multiplier because an increase in expenditure leads to more
d.If the trade deficit is equal to zero, then the domestic
demand for goods and the demand for domestic goods are
e. A real depreciation leads to an immediate improvement in
the trade balance.
f. A small open economy can reduce its trade deficit through
fiscal contraction at a smaller cost in output than can a
large open economy.
g. The experience of the United States in the 1990s shows
that real exchange rate appreciations lead to trade deficits and real exchange rate depreciations lead to trade
h.A decline in real income can lead to a decline in imports
and thus a trade surplus.
2.Real and nominal exchange rates and inflation
Using the definition of the real exchange rate (and Propositions
7 and 8 in Appendix 2), you can show that:
(et - et - 1)
(E t - E t - 1)
+ pt - pt*
et - 1
Et - 1
b.Suppose the real exchange rate is currently at the level
required for net exports (or the current account) to equal
zero. In this case, if domestic inflation is higher than foreign inflation, what must happen over time to maintain a
trade balance of zero?
3.A European recession and the US economy
a. In 2014, EU spending on US goods accounted for 18% of
US exports (see Table 17.2) and US exports amounted to
15% of US GDP (see Table 17.1). What was the share of
EU spending on US goods relative to US GDP?
b.Assume that the multiplier in the United States is 2 and
that a major slump in Europe would reduce output and
imports from the United States by 5% (relative to its normal level). Given your answer to part (a), what is the
impact on US GDP of the European slump?
c. If the European slump also leads to a slowdown of the
other economies that import goods from the United
States, the effect could be larger. To put a bound on the
size of the effect, assume that US exports decrease by 5%
(as a result of changes in foreign output) in one year. What
is the effect of a 5% drop in exports on US GDP?
d.Comment on this statement: ‘Unless Europe can avoid a
major slump following the problems with sovereign debt
and the euro, US growth will grind to a halt.’
4.A further look at Table 18.1
Table 18.1 has four entries. Using Figure 18.5 as a guide,
draw the situations illustrated in each of the four entries in
Table 18.1. Be sure you understand why the direction of change
in government spending and the real exchange rate is labelled
as ambiguous in each entry.
In words, the percentage real appreciation equals the percentage
nominal appreciation plus the difference between domestic and
All ‘Dig deeper’ questions and problems are available on
a. If domestic inflation is higher than foreign inflation, and
the domestic country has a fixed exchange rate, what happens to the real exchange rate over time? Assume that the
Marshall–Lerner condition holds. What happens to the
trade balance over time? Explain in words.
5.Net exports and foreign demand
M18 Macroeconomics 85678.indd 384
a.Suppose there is an increase in foreign output. Show
the effect on the domestic economy (i.e. replicate
Figure 18.4). What is the effect on domestic output? And
on domestic net exports?
Chapter 18 The goods market in an open economy 385
b. If the interest rate remains constant, what will happen to
domestic investment? If taxes are fixed, what will happen
to the domestic budget deficit?
e. Suppose one of the economies is much larger than the
other. Which economy do you expect to have the larger
value of m 1? Explain.
c. Using equation (18.5), what must happen to private saving? Explain.
f. Calculate your answers to parts (b) and (c) for each economy by substituting the appropriate parameter values.
d. Foreign output does not appear in equation (18.5), yet it
evidently affects net exports. Explain how this is possible.
g. In which economy will fiscal policy have a larger effect on
output? In which economy will fiscal policy have a larger
effect on net exports?
6.Eliminating a trade deficit
a. Consider an economy with a trade deficit (NX 6 0) and
with output equal to its natural level. Suppose that, even
though output may deviate from its natural level in the
short run, it returns to its natural level in the medium run.
Assume that the natural level is unaffected by the real
exchange rate. What must happen to the real exchange
rate over the medium run to eliminate the trade deficit
(i.e. to increase NX to zero)?
8.Policy coordination and the world economy
b.Now write down the national income identity. Assume
again that output returns to its natural level in the medium
run. If NX increases to zero, what must happen to domestic
demand (C + I + G) in the medium run? What government policies are available to reduce domestic demand in
the medium run? Identify which components of domestic
demand each of these policies affects.
Imports and exports are given by:
7.Multipliers, openness and fiscal policy
Consider an open economy characterised by the following
C = c0 + c1(Y - T)
I = d 0 + d 1Y
IM = m 1Y
X = x 1Y*
The parameters m 1 and x 1 are the propensities to import and
export. Assume that the real exchange rate is fixed at a value
of 1 and treat foreign income, Y*, as fixed. Also assume that
taxes are fixed and that government purchases are exogenous
(i.e. decided by the government). We explore the effectiveness
of changes in G under alternative assumptions about the propensity to import.
a. Write the equilibrium condition in the market for domestic
goods and solve for Y.
b.Suppose government purchases increase by one
unit. What is the effect on output? (Assume that
0 6 m 1 6 c1 + d 1 6 1. Explain why.)
c. How do net exports change when government purchases
increase by one unit?
d. Now consider two economies, one with m 1 = 0.5 and the
other with m 1 = 0.1. Each economy is characterised by
(c1 + d 1) = 0.6.
M18 Macroeconomics 85678.indd 385
Consider an open economy in which the real exchange rate is
fixed and equal to one. Consumption, investment, government
spending and taxes are given by:
C = 10 + 0.8(Y - T)
I = 10, G = 10 and T = 10
IM = 0.3Y and X = 0.3Y*
where Y* denotes foreign output.
a. Solve for equilibrium output in the domestic economy,
given Y*. What is the multiplier in this economy? If we
were to close the economy – so exports and imports were
identically equal to zero – what would the multiplier
be? Why would the multiplier be different in a closed
b. Assume that the foreign economy is characterised by the
same equations as the domestic economy (with asterisks
reversed). Use the two sets of equations to solve for the
equilibrium output of each country. (Hint: Use the equations for the foreign economy to solve for Y* as a function
of Y and substitute this solution for Y* in part (a).) What
is the multiplier for each country now? Why is it different
from the open economy multiplier in part (a)?
c. Assume that the domestic government, G, has a target
level of output of 125. Assuming that the foreign government does not change G*, what is the increase in G
necessary to achieve the target output in the domestic
economy? Solve for net exports and the budget deficit in
d.Suppose each government has a target level of output
of 125 and that each government increases government
spending by the same amount. What is the common
increase in G and G* necessary to achieve the target output in both countries? Solve for net exports and the budget
deficit in each country.
e. Why is fiscal coordination, such as the common increase
in G and G* in part (d), difficult to achieve in practice?
386 EXTENSIONS The open economy
9.The US trade deficit, current account deficit and
c. The trade surplus in 1980 was roughly zero. Compute
the average percentage of GDP invested and the averaged value of the trade balance as a percentage of GDP in
three periods: 1980–1989, 1990–1999, 2000 to the latest
point. Would it appear that trade deficits have been used to
a. Define national saving as private saving plus the government surplus, that is as S + T - G. Now, using equation (18.5), describe the relation between the current
account deficit, net investment income, and the difference
between national saving and domestic investment.
d. Is a trade deficit more worrisome when not accompanied
by a corresponding increase in investment? Explain your
b.Using the FRED economic database retrieve annual
data for nominal GDP (series GDP), gross domestic
investment (series GDPIA) and net exports (series
A019RC1A027NBEA) from 1980 to the most recent
year available. Divide gross domestic investment and
net exports by GDP in each year to express their values
as a percentage of GDP. What year has the largest trade
deficit as a percentage of GDP?
e. The previous question focuses on the trade deficit rather
than the current account deficit. How does net investment
income (NI) relate to the difference between the trade deficit and the current account deficit in the United States? You
can download GDP (series GDP) and GNP (series GNP) from
the FRED database at the Federal Reserve Bank of St. Louis.
This difference is a measure of NI. Is this value rising or falling over time? What is the implication of such changes?
Log on to MyEconLab and complete the study plan exercises for this chapter to see
how much you have learnt, and where you need to revise most.
A good discussion of the relation among trade deficits, current account deficits, budget deficits, private saving and
investment is given in Barry Bosworth’s Saving and Investment in a Global Economy (Washington, DC: Brookings Institution Press, 1993).
M18 Macroeconomics 85678.indd 386
For more on the relation between the exchange rate and the
trade balance, read ‘Exchange rates and trade flows: disconnected?’, International Monetary Fund, October 2015,
Chapter 18 The goods market in an open economy 387
Derivation of the Marshall–Lerner condition
Start from the definition of net exports:
NX = X - IM/e
Assume trade to be initially balanced, so that NX = 0 and X = IM/e or, equivalently,
eX = IM.
The Marshall–Lerner condition is the condition under which a real depreciation, a decrease
in U, leads to an increase in net exports.
To derive this condition, first multiply both sides of the equation above by e to get:
eNX = eX - IM
Now consider a change in the real exchange rate of ∆e. The effect of the change in the real
exchange rate on the left side of the equation is given by (∆e)NX + e∆(NX).
Note that, if trade is initially balanced, NX = 0, so the first term in this expression is equal
to zero and the effect of the change on the left side is simply given by e∆(NX).
The effect of the change in the real exchange rate on the right side of the equation is given
by (∆e)X + e∆(X) - (∆IM). Putting the two sides together gives:
e(∆NX) = (∆e)X + e(∆X) - (∆IM)
Divide both sides by eX to get:
[(e∆NX)]/(eX) = [(e∆)X]/(eX) + [(e∆X)]/(eX) - [∆IM]/(eX)
Simplify and use the fact that, if trade is initially balanced, eX = IM to replace eX by IM
in the last term on the right. This gives:
(∆NX)/X = (∆e)/e + (∆X)/X - ∆IM/IM
The change in the trade balance (as a ratio to exports) in response to a real depreciation
is equal to the sum of three terms:
● The first term is equal to the proportional change in the real exchange rate. It is negative
if there is a real depreciation.
● The second term is equal to the proportional change in exports. It is positive if there is a
● The third term is equal to minus the proportional change in the imports. It is positive if
there is a real depreciation.
The Marshall–Lerner condition is the condition that the sum of these three terms be positive. If it is satisfied, a real depreciation leads to an improvement in the trade balance.
A numerical example will help here. Suppose that a 1% depreciation leads to a proportional increase in exports of 0.9% and to a proportional decrease in imports of 0.8%. (Econometric evidence on the relation of exports and imports to the real exchange rate suggests
that these are indeed reasonable numbers.) In this case, the right-hand side of the equation
is equal to - 1% + 0.9% - ( - 0.8%) = 0.7%. Thus, the trade balance improves and the
Marshall–Lerner condition is satisfied.
M18 Macroeconomics 85678.indd 387
Output, the interest rate
and the exchange rate
Previously, we treated the exchange rate as one of the policy instruments available to the government (see Chapter 18). But the exchange rate is not a policy instrument. Rather, it is determined
in the foreign exchange market – a market where, as we saw, there is an enormous amount of
trading (see Chapter 17). This fact raises two obvious questions: What determines the exchange
rate? And how can policy makers affect it?
These questions motivate this chapter. To answer them, we reintroduce financial markets, which
we had left aside earlier in the text. We examine the implications of equilibrium in both the goods
market and financial markets, including the foreign exchange market. This allows us to characterise the joint movements of output, the interest rate and the exchange rate in an open economy.
The model we develop is an extension to the open economy of our IS–LM model and known as
the Mundell–Fleming model – after the two economists, Robert Mundell and Marcus Fleming,
who first put it together in the 1960s. (The model presented here retains the spirit of the original
Mundell–Fleming model but differs in its details.)
Section 19.1 looks at equilibrium in the goods market.
Section 19.2 looks at equilibrium in financial markets, including the foreign exchange market.
Section 19.3 puts the two equilibrium conditions together and looks at the determination of
output, the interest rate and the exchange rate.
Section 19.4 looks at the role of policy under flexible exchange rates.
Section 19.5 looks at the role of policy under fixed exchange rates.
M19 Macroeconomics 85678.indd 388
Chapter 19 Output, the interest rate and the exchange rate 389
19.1 Equilibrium in the goods market
Equilibrium in the goods market was the focus in the previous chapter, where we derived the
equilibrium condition equation (18.4):
Y = C(Y - T) + I(Y, r) + G - IM(Y, e)/e + X(Y*, e)
We shall assume, throughout the text
here, that the Marshall–Lerner condition holds. Under this condition, an
increase in the real exchange rate – a
real appreciation – leads to a decrease
in net exports (see Chapter 18).
Goods market equilibrium (IS):
Output = demand for domestic goods.
For the goods market to be in equilibrium, output (the left side of the equation) must be
equal to the demand for domestic goods (the right side of the equation). The demand for
domestic goods is equal to consumption, C, plus investment, I, plus government spending,
G, minus the value of imports, IM/e, plus exports, X.
First simplification: P = P* = 1, so
e = E.
Consumption, C, depends positively on disposable income, Y - T.
Investment, I, depends positively on output, Y, and negatively on the real interest rate, r.
Government spending, G, is taken as given.
The quantity of imports, IM, depends positively on both output, Y, and the real exchange
rate, e. The value of imports in terms of domestic goods is equal to the quantity of imports
divided by the real exchange rate.
Exports, X, depend positively on foreign output, Y*, and negatively on the real exchange
It will be convenient in what follows to regroup the last two terms under ‘net exports’,
defined as exports minus the value of imports:
NX(Y, Y*, e) = X(Y*, e) - IM(Y, e)/e
It follows from our assumptions about imports and exports that net exports, NX, depend
on domestic output, Y, foreign output, Y*, and the real exchange rate, e. An increase in
domestic output increases imports, thus decreasing net exports. An increase in foreign output
increases exports, thus increasing net exports. An increase in the real exchange rate leads to
a decrease in net exports.
Using this definition of net exports, we can rewrite the equilibrium condition as:
Y = C(Y - T) + I(Y, r) + G - NX(Y, Y*, e)
(-, +, -)
For our purposes, the main implication of equation (19.1) is that both the real interest rate
and the real exchange rate affect demand, and in turn equilibrium output:
An increase in the real interest rate leads to a decrease in investment spending and, as a
result, to a decrease in the demand for domestic goods. This leads, through the multiplier,
to a decrease in output.
An increase in the real exchange rate leads to a shift in demand towards foreign goods and,
as a result, to a decrease in net exports. The decrease in net exports decreases the demand
for domestic goods. This leads, through the multiplier, to a decrease in output.
For the remainder of our discussion here we shall simplify equation (19.1) in two ways:
Given our focus on the short run, we assumed in our previous treatment of the IS–LM
model that the (domestic) price level was given. We shall make the same assumption
here and extend this assumption to the foreign price level, so the real exchange rate
e = EP/P* and the nominal exchange rate E move together. A decrease in the nominal exchange rate – a nominal depreciation – leads, one for one, to a decrease in
the real exchange rate – a real depreciation. Conversely, an increase in the nominal
exchange rate – a nominal appreciation – leads, one for one, to an increase in the
real exchange rate – a real appreciation. If, for notational convenience, we choose P
and P* so that P/P* = 1 (and we can do so because both are index numbers), then
e = E and we can replace e by E in equation (19.1).
M19 Macroeconomics 85678.indd 389
390 EXTENSIONS The open economy
Second simplification: pe = 0, so
r = i.
With these two simplifications, equation (19.1) becomes:
By now, you know that the way to
understand various macroeconomic
mechanisms is to refine the basic
model in one direction and simplify it
in others (here, opening the economy
but ignoring risk). Keeping all the
refinements would lead to a rich model
(and this is what macroeconometric
models do), but would make for a terrible text. Things would become far too
Because we take the domestic price level as given, there is no inflation, neither actual
nor expected. Therefore, the nominal interest rate and the real interest rate are the
same, and we can replace the real interest rate, r, in equation (19.1) by the nominal
interest rate, i.
Y = C(Y - T) + I(Y, i) + G + NX(Y, Y*, E)
(-, +, -)
In words, goods-market equilibrium implies that output depends negatively on both the
nominal interest rate and the nominal exchange rate.
19.2 Equilibrium in financial markets
When we looked at financial markets in the IS–LM model, we assumed that people chose
only between two financial assets, money and bonds. Now that we look at a financially open
economy, we must also take into account the fact that people have a choice between domestic
bonds and foreign bonds.
Domestic bonds versus foreign bonds
As we look at the choice between domestic bonds and foreign bonds, we shall rely on the
assumption we introduced earlier: that financial investors, domestic or foreign, go for the
highest expected rate of return, ignoring risk (see Chapter 17). This implies that, in equilibrium, both domestic bonds and foreign bonds must have the same expected rate of return;
otherwise, investors would be willing to hold only one or the other, but not both, and this
could not be an equilibrium. (Like all economic relations, this relation is only an approximation to reality and does not always hold. More on this in the first Focus box below.)
As we saw in equation (17.2), this assumption implies that the following arbitrage relation – the interest parity condition – must hold:
(1 + it) = (1 + i t*) a e b [19.3]
Et + 1
where it is the domestic interest rate, i t* is the foreign interest rate, E t is the current
exchange rate and E et + 1 is the future expected exchange rate. The left side of the equation
gives the return, in terms of domestic currency, from holding domestic bonds. The right
side of the equation gives the expected return, also in terms of domestic currency, from
The presence of Et comes from the fact
holding foreign bonds. In equilibrium, the two expected returns must be equal.
that, to buy the foreign bond, you must
Multiply both sides by E et + 1 and rearrange to get:
first exchange domestic currency for
foreign currency. The presence of E et + 1
comes from the fact that, to bring the
funds back next period, you will have to
exchange foreign currency for domestic
1 + i t*
E et + 1[19.4]
1 + i e
1 + i*
This relation tells us that the current exchange rate depends on the domestic interest rate,
on the foreign interest rate and on the expected future exchange rate:
M19 Macroeconomics 85678.indd 390
1 + it
For now, we shall take the expected future exchange rate as given and denote it as E e (we
shall relax this assumption later (see Chapter 20)). Under this assumption, and dropping
time indexes, the interest parity condition becomes:
Remember that we have assumed that
people are not willing to hold domestic
or foreign currency on its own.
An increase in the domestic interest rate leads to an increase in the exchange rate.
An increase in the foreign interest rate leads to a decrease in the exchange rate.
Chapter 19 Output, the interest rate and the exchange rate 391
An increase in the expected future exchange rate leads to an increase in the current
This relation plays a central role in the real world and will play a central role in this chapter. To understand the relation further, consider the following example.
Consider financial investors – investors, for short – choosing between UK bonds and German bonds. Suppose that the one-year interest rate on UK bonds is 2% and the one-year
interest rate on German bonds is also 2%. Suppose that the current exchange rate is 1 (one
pound is worth 1 euro) and the expected exchange rate a year from now is also 1. Under
these assumptions, both UK and German bonds have the same expected return in dollars,
and the interest parity condition holds.
Suppose that investors now expect the exchange rate to be 10% higher a year from now,
so E e is now equal to 1.1. At an unchanged current exchange rate, UK bonds are now much
more attractive than German bonds. UK bonds offer an interest rate of 2% in dollars. German bonds still offer an interest rate of 2% in yen, but the yen a year from today is expected
to be worth 10% less in terms of dollars. In terms of pounds, the return on German bonds is
therefore 2% (the interest rate) - 10% (the expected depreciation of the euro relative to the
pound), or - 8%.
So what will happen to the current exchange rate? At the initial exchange rate of 1, investors want to shift out of German bonds into UK bonds. To do so, they must first sell German
bonds for yen, then sell euros for pounds and then use the pounds to buy UK bonds. As
investors sell euros and buy pounds, the pound appreciates relative to the euro. By how
much? Equation (19.5) gives us the answer: E = (1.02/1.02)110 = 110. The current
exchange rate must increase in the same proportion as the expected future exchange rate.
Put another way, the pound must appreciate today by 10%. When it has appreciated by 10%,
so E = E e = 110, the expected returns on UK and German bonds are again equal, and there
is equilibrium in the foreign exchange market.
Suppose instead that the Bank of England raises the domestic interest rate in the UK
from 2 to 5%. Assume that the German interest rate remains unchanged at 2% and that the
expected future exchange rate remains unchanged at 1. At an unchanged current exchange
rate, UK bonds are now again much more attractive than German bonds. UK bonds yield
a return of 5% in pounds. German bonds give a return of 2% in euros and – because the
exchange rate is expected to be the same next year as it is today – an expected return of 5%
in pounds as well.
So what will happen to the current exchange rate? Again, at the initial exchange rate of
1, investors want to shift out of German bonds into UK bonds. As they do so, they sell euros
for pounds, and the pound appreciates. By how much? Equation (19.5) gives the answer:
E = (1.05/1.02)100 ≈ 103. The current exchange rate increases by approximately 3%.
Why 3%? Think of what happens when the pound appreciates. If, as we have assumed,
investors do not change their expectation of the future exchange rate, then the more the
pound appreciates today, the more investors expect it to depreciate in the future (as it is
expected to return to the same value in the future). When the pound has appreciated by
3% today, investors expect it to depreciate by 3% during the coming year. Equivalently,
they expect the euro to appreciate relative to the pound by 3% over the coming year. The
expected rate of return in pounds from holding German bonds is therefore 2% (the interest
rate in euros) + 3% (the expected euro appreciation), or 5%. This expected rate of return
is the same as the rate of return on holding UK bonds, so there is equilibrium in the foreign ➤ Make sure you understand the argument. Why does the pound not appreciexchange market.
Note that our argument relies heavily on the assumption that, when the interest rate ate by, say, 20%?
changes, the expected exchange rate remains unchanged. This implies that an appreciation today leads to an expected depreciation in the future because the exchange rate is
expected to return to the same, unchanged, value. We shall later relax the assumption that
the future expected exchange rate is fixed (see Chapter 20). But the basic conclusion will
remain: An increase in the domestic interest rate relative to the foreign interest rate leads to
M19 Macroeconomics 85678.indd 391
392 EXTENSIONS The open economy
Figure 19.1 plots the relation between the domestic interest rate, i, and the exchange rate,
E, implied by equation (19.5) – the interest parity relation. The relation is drawn for a given
expected future exchange rate, E e, and a given foreign interest rate, i*, and is represented by
an upward-sloping line. The higher the domestic interest rate, the higher the exchange rate.
Equation (19.5) also implies that when the domestic interest rate is equal to the foreign interest rate (i = i*), the exchange rate is equal to the expected future exchange rate (E = E e).
This implies that the line corresponding to the interest parity condition goes through point
What happens to the line if: (1) i*
A (where i = i*) in the figure.
increases; and (2) Ee increases?
The relation between
the interest rate and the
exchange rate implied by
Domestic interest rate, i
Interest parity relation
(given i *, E e )
A higher domestic interest rate
leads to a higher exchange rate – an
Exchange rate, E
Sudden stops, safe havens and the limits to the interest parity condition
The interest parity condition assumes that financial investors care only about expected returns. As we discussed
previously (in Chapter 14), investors care not only about
expected returns, but also about risk and liquidity. Much
of the time, one can ignore these other factors. Sometimes,
however, these factors play a big role in investors’ decisions
and in determining exchange rate movements.
As shown in Figure 19.2, capital flows, captured here
by equity inflows – purchases of emerging market firms’
stocks by foreigners – to emerging market countries, have
been volatile since the beginning of the crisis. Volatile capital flows are an issue that many emerging countries know
well and often reflect changes in investors’ perceptions of
risk rather than changes in relative interest rates.
Perceptions of risk play an important role in the decision
of foreign investors, such as pension funds, to invest or not
invest in their country. Sometimes, the perception that risk
has increased leads investors to want to sell all the assets
they have in the country, no matter what the interest rate.
These selling episodes, which have affected many Latin
American and Asian emerging economies in the past, are
known as sudden stops. During these episodes, the interest parity condition fails, and the exchange rate of these
M19 Macroeconomics 85678.indd 392
emerging market countries may decrease a lot, without
much change in domestic or foreign interest rates.
Indeed, the start of the crisis was associated with large
capital movements which had little to do with expected
returns. Worried about uncertainty, many investors from
advanced countries decided to take their funds home,
where they felt safer. The result was large capital outflows
from a number of emerging countries, leading to strong
downward pressure on their exchange rates and serious
financial problems. For example, some domestic banks that
had relied on foreign investors for funds found themselves
short of funds, which forced them in turn to cut lending
to domestic firms and households. This was an important
channel of transmission of the crisis from the United States
to the rest of the world.
A symmetrical phenomenon is at play in some
advanced countries. Because of their characteristics,
some countries are seen as particularly attractive by
investors when uncertainty is high. This is the case for
the United States. Even in normal times, there is a large
foreign demand for US T-bills. The reason is the size and
liquidity of the US T-bill market. One can sell or buy
large quantities of T-bills quickly and without moving
Chapter 19 Output, the interest rate and the exchange rate 393
Billions of dollars (weekly flows)
Bond fund flows
Billions of dollars (weekly flows)
The equity flows to emerging countries since June 2008
Source: International Monetary Fund.
the price very much. Going back to the long-standing US
trade deficit we saw earlier, one reason why the United
States has been able to run such a trade deficit, and thus
to borrow from the rest of the world for such a long time,
is the high foreign demand for T-bills (this is a partial
answer to the challenge stated at the end of the previous
In crisis times, the preference for US T-bills becomes
even stronger. The United States is widely seen by investors as being a safe haven, a country in which it is safe to
move funds. The result is that times of higher uncertainty
are often associated with a stronger demand for US assets
and thus some upward pressure on the dollar. Interestingly, the beginning of the recent crisis was associated
M19 Macroeconomics 85678.indd 393
with a strong dollar appreciation. There is some irony here,
given that the crisis originated in the United States. Indeed,
some economists wonder how long the United States will
continue to be perceived as a safe haven. If this were to
change, the dollar would depreciate.
Further reading: Among the countries affected by large
capital outflows in 2008 and 2009 were also a number of
small advanced economies, notably Ireland and Iceland. A
number of these countries had built up the same financial
vulnerabilities as the United States (those we studied earlier (in Chapter 6)), and some of them suffered badly. A
good and easy read is Michael Lewis’s chapters on Ireland
and Iceland in Boomerang: Travels in a New Third World
(New York: W.W. Norton, 2011).