4. The Open Economy

Question 1

What are the three dimensions of openness?

Answer 1

Openness in goods markets
Openness in financial markets
Openness in factor markets

Question 2

What is openness in factor markets?

Answer 2

The ability of firms to choose where to locate production, and workers to choose where to work

Question 3

What is balance of payments equal to?

Answer 3

BOP= current account (CA) + capital account + official reserves

Question 4

What are transactions above the line?

Answer 4

Current account transactions

Question 5

What are transactions below the line?

Answer 5

Capital account transactions

Question 6

What does the current account record?

Answer 6

The exports and imports of goods and services

Question 7

What is net transfers received?

Answer 7

The net value a country has of giving and receiving foreign aid

Question 8

Equation for current account

Answer 8

CA= trade balance + net investment income + net transfers

Question 9

Capital account

Answer 9

Net decrease in foreign assets

Question 10

Official reserves

Answer 10

Foreign exchange reserves held by the CB

Question 11

What is true if the foreign holdings of UK assets is greater than the UK holdings of foreign assets?

Answer 11

The capital account balance/ net capital flows is positive

Question 12

What are imports dependent on?

Answer 12

Domestic income and real exchange rate

Question 13

Nominal exchange rate

Answer 13

The price of the domestic currency in terms of foreign currency

Question 14

What is an appreciation of the domestic currency

Answer 14

An increase in the price of the domestic currency in terms of the foreign currency

Question 15

Real appreciation

Answer 15

An increase in the relative price of domestic goods in terms of foreign goods

Question 16

Multilateral exchange rates

Answer 16

Exchange rates between several countries

Question 17

What does openness in financial allow?

Answer 17

• financial investors to diversify

* countries to run trade surpluses and deficits

Question 18

What does the decision to invest at home or abroad depend on?

Answer 18

Interest rates and expectations of nominal exchange rates

Question 19

What is the interest parity condition?

Answer 19

The assumption that financial investors will hold only the bonds with the highest expected return

Question 20

How does the multiplier of the open economy compare to the closed economy?

Answer 20

It is smaller in the open economy

Question 21

Marshall Lerner condition

Answer 21

The condition under which a real depreciation (a decrease in the exchange rate) leads to an increase in net exports

Question 22

How does a higher domestic interest rate effect the exchange rate

Answer 22

It makes the exchange rate higher

Question 23

How does pegging your exchange rate to another country’s affect your monetary and fiscal policy

Answer 23

You can no longer control your monetary policy. The effectiveness of your fiscal policy increases

Question 24

How will the same consumer confidence shock differently effect a country with a fixed exchange rate compared to one with a floating exchange rate?

Answer 24

• large fall in output and price for fixed
• investment increases in floating but not in fixed
• NX increase more in fixed
• real exchange rate falls more in fixed due to price falling

Question 25

What differences would an aggregate supply shock have to a country with a fixed exchange rate compared to floating exchange rate?

Answer 25

• no difference in shifts of AD-AS
• greater fall in output for fixed
• interest rates and exchange rates increase for floating