4. The Open Economy Flashcards
What are the three dimensions of openness?
Openness in goods markets
Openness in financial markets
Openness in factor markets
What is openness in factor markets?
The ability of firms to choose where to locate production, and workers to choose where to work
What is balance of payments equal to?
BOP= current account (CA) + capital account + official reserves
What are transactions above the line?
Current account transactions
What are transactions below the line?
Capital account transactions
What does the current account record?
The exports and imports of goods and services
What is net transfers received?
The net value a country has of giving and receiving foreign aid
Equation for current account
CA= trade balance + net investment income + net transfers
Capital account
Net decrease in foreign assets
Official reserves
Foreign exchange reserves held by the CB
What is true if the foreign holdings of UK assets is greater than the UK holdings of foreign assets?
The capital account balance/ net capital flows is positive
What are imports dependent on?
Domestic income and real exchange rate
Nominal exchange rate
The price of the domestic currency in terms of foreign currency
What is an appreciation of the domestic currency
An increase in the price of the domestic currency in terms of the foreign currency
Real appreciation
An increase in the relative price of domestic goods in terms of foreign goods
Multilateral exchange rates
Exchange rates between several countries
What does openness in financial allow?
- financial investors to diversify
* countries to run trade surpluses and deficits
What does the decision to invest at home or abroad depend on?
Interest rates and expectations of nominal exchange rates
What is the interest parity condition?
The assumption that financial investors will hold only the bonds with the highest expected return
How does the multiplier of the open economy compare to the closed economy?
It is smaller in the open economy
Marshall Lerner condition
The condition under which a real depreciation (a decrease in the exchange rate) leads to an increase in net exports
How does a higher domestic interest rate effect the exchange rate
It makes the exchange rate higher
How does pegging your exchange rate to another country’s affect your monetary and fiscal policy
You can no longer control your monetary policy. The effectiveness of your fiscal policy increases
How will the same consumer confidence shock differently effect a country with a fixed exchange rate compared to one with a floating exchange rate?
- 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
What differences would an aggregate supply shock have to a country with a fixed exchange rate compared to floating exchange rate?
- no difference in shifts of AD-AS
- greater fall in output for fixed
- interest rates and exchange rates increase for floating
