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Chapter 13 National Income Accounting and the Balance of Payments 63
Overview of Section III:
Exchange Rates and Open-Economy
Macroeconomics
Section III of the textbook consists of six chapters:
Chapter 13 National Income Accounting and the Balance of Payments
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach
Chapter 15 Money, Interest Rates, and Exchange Rates
Chapter 16 Price Levels and the Exchange Rate in the Long Run
Chapter 17 Output and the Exchange Rate in the Short Run
Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention
.1 nSection III Overview
The presentation of international finance theory proceeds by building up an integrated model of
exchange rate and output determination. Successive chapters in Section III construct this model step by
step so students acquire a firm understanding of each component as well as the manner in which these
components fit together. The resulting model presents a single unifying framework admitting the entire
range of exchange rate regimes from pure float to managed float to fixed rates. The model may be used
to analyze both comparative static and dynamic time path results arising from temporary or permanent
policy or exogenous shocks in an open economy.
The primacy given to asset markets in the model is reflected in the discussion of national income and
balance of payments accounting in the first chapter of this section. Chapter 13 begins with a discussion
of the focus of international finance. The discussion then proceeds to national income accounting in an
open economy. The chapter points out, in the discussion on the balance of payments account, that
current account transactions must be financed by financial account flows from either central bank or
non-central bank transactions. A case study uses national income accounting identities to consider the
link between government budget deficits and the current account.
Observed behavior of the exchange rate favors modeling it as an asset price rather than as a goods
price. Thus, the core relationship for short-run exchange-rate determination in the model developed in
Section III is uncovered interest parity. Chapter 14 presents a model in which the exchange rate adjusts
to equate expected returns on interest-bearing assets denominated in different currencies given
expectations about exchange rates, and the domestic and foreign interest rate. This first building block
of the model lays the foundation for subsequent chapters that explore the determination of domestic
interest rates and output, the basis for expectations of future exchange rates, and richer specifications of
the foreign-exchange market that include risk. An Appendix to this chapter explains the determination
of forward exchange rates.
Chapter 15 introduces the domestic money market, linking monetary factors to short-run exchange-
rate determination through the domestic interest rate. The chapter begins with a discussion of the
determination of the domestic interest rate. Interest parity links the domestic interest rate to the
exchange rate, a relationship captured in a two-quadrant diagram. Comparative statistics employing this
diagram demonstrate the effects of monetary expansion and contraction on the exchange rate in the
short run. Dynamic considerations are introduced through an appeal to the long-run neutrality of money
that identifies a long-run steady-state value toward which the exchange rate evolves. The dynamic time
path of the model exhibits overshooting of the exchange rate in response to monetary changes.
Chapter 16 develops a model of the long-run exchange rate. The long-run exchange rate plays a role
in a complete short-run macroeconomic model since one variable in that model is the expected future
exchange rate. The chapter begins with a discussion of the law of one price and purchasing power
parity. A model of the exchange rate in the long run based upon purchasing power parity is developed. A
review of the empirical evidence, however, casts doubt on this model. The chapter then goes on to
develop a general model of exchange rates in the long run in which the neutrality of monetary shocks
emerges as a special case. In contrast, shocks to the output market or changes in fiscal policy alter the
long-run real exchange rate. This chapter also discusses the real interest parity relationship that links
the real interest rate differential to the expected change in the real exchange rate. An Appendix
examines the relationship
of the interest rate and exchange rate under a flexible-price monetary approach.
Chapter 17 presents a macroeconomic model of output and exchange-rate determination in the short run.
The chapter introduces aggregate demand in a setting of short-run price stickiness to construct a model
of the goods market. The exchange-rate analysis presented in previous chapters provides a model of the
asset market. The resulting model is, in spirit, very close to the classic Mundell-Fleming model. This
model is used to examine the effects of a variety of policies. The analysis allows a distinction to be
drawn between permanent and temporary policy shifts through the pedagogic device that permanent
policy
shifts alter long-run expectations, while temporary policy shifts do not. This distinction highlights the
importance of exchange-rate expectations on macroeconomic outcomes. A case study of U.S. fiscal and
monetary policy between 1979 and 1983 utilizes the model to explain notable historical events. The
chapter concludes with a discussion of the links between exchange rate and import price movements
which focuses on the J-curve and exchange-rate pass-through. An online Appendix to the chapter
compares the IS-LM model to the model developed in this chapter. The first printed Appendix considers
intertemporal trade and consumption demand. A second printed Appendix discusses the Marshall-Lerner
condition and estimates of trade elasticities.
The final chapter of this section discusses intervention by the central bank and the relationship of
this policy to the money supply. This analysis is blended with the previous chapter’s short-run
macroeconomic model to analyze policy under fixed rates. The balance sheet of the central bank is used
to keep track of the effects of foreign exchange intervention on the money supply. The model developed
in previous chapters is extended by relaxing the interest parity condition and allowing exchange-rate
risk to influence agents’ decisions. This allows a discussion of sterilized intervention. Another topic
discussed in this chapter is capital flight and balance of payments crises with an introduction to
different models of how a balance of payments or currency crisis can occur. The analysis also is
extended to a two-country framework to discuss alternative systems for fixing the exchange rate as a
prelude to Section IV. The first Appendix to Chapter 18 develops a model of the foreign-exchange
market in which risk factors make domestic-currency and foreign-currency assets imperfect substitutes.
The second Appendix discusses
the timing of a balance of payments crisis. An online Appendix explores the monetary approach to the
balance of payments.
