Macroeconomics (1)

Output, the Interest Rate,
and the Exchange Rate
In Chapter 19, we treated the exchange rate as one of the policy instruments available to the
government. But the exchange rate is not a policy instrument. Rather, it is determined in the foreign
exchange market—a market where, as you saw in Chapter 18, there is an enormous amount
of trading. This fact raises two obvious questions: What determines the exchange rate? How can
policy makers affect it?
These questions motivate this chapter. More generally, we examine the implications of
equilibrium in both the goods market and financial markets, including the foreign exchange
market. This allows us to characterize 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 the IS–LM model you first saw in Chapter 5 and is 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 20-1 looks at equilibrium in the goods market.
Section 20-2 looks at equilibrium in financial markets, including the foreign exchange market.
Section 20-3 puts the two equilibrium conditions together and looks at the determination of
output, the interest rate, and the exchange rate.
Section 20-4 looks at the role of policy under flexible exchange rates.
Section 20-5 looks at the role of policy under fixed exchange rates.
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