Chapter 6 - The Open Economy

Question 1

Give 2 reasons why PPP does not hold in the real world

Answer 1

1. International arbitrage is not possible (non traded goods and transportation costs)
2. Different countries’ goods are not perfect substitutes

Question 2

Despite its flaws, why is PPP a useful theory?

Answer 2

Nominal exchange rates tend toward their PPP values over the long run.

Question 3

How can the nominal exchange rate be determined if PPP holds?

Answer 3

If PPP holds: e = P*/P

Question 4

Purchasing-power parity (PPP)

Answer 4

Goods must sell at the same price (currency-adjusted) in all countries. Thus, the nominal exchange rate adjusts to equalize the cost of a basket across countries.

Question 5

Does spending equal output and saving equal investment in an open economy?

Answer 5

No. We cannot assume spending equals output and saving equals investment in an open economy (equalitie(s) may hold, but they are not required to in an open economy)

Question 6

Perfect Capital Mobility Assumption

Answer 6

Domestic residents have full access to world financial markets. The government does not impede international borrowing or lending.

Question 7

Small Open Economy Assumption

Answer 7

The economy has a negligible impact on the world interest rate. Thus, the economy cannot change the world interest rate.

Question 8

Nominal Exchange Rate

Answer 8

The price of a country’s currency in terms of another country’s currency.

Question 9

Real Exchange Rate

Answer 9

The price of a country’s goods in terms of another country’s goods

Question 10

Trade Surplus

Answer 10

Output > Spending
X > IM

Question 11

Trade Deficit

Answer 11

Spending > Output
IM > X

Question 12

What 3 assumptions must be made to ensure that r = r* and r* is exogenous?

Answer 12

1. Domestic and foreign bonds are perfect substitutes
2. Perfect Capital Mobility
3. Small economy

Question 13

What happens to NX when real exchange rate rises?

Answer 13

Domestic good become more expensive relative to foreign goods. Therefore, exports fall and imports rise (NX falls).

Question 14

How does a large open economy behave compared to a closed economy and a small open economy?

Answer 14

A large open economy behaves somewhere in between a closed economy and a small open economy. The changes to the variables in a large open economy are not as extreme as a closed economy or a small open economy.