Economic Policies

Question 1

What is the Law of One Price (LOP)

Answer 1

-In two countries, with the absence of transportation costs, two identical goods must be sold at the same price
-Pi € = E. Pi $

Question 2

What is Purchasing Power Parity (PPP)

Answer 2

-The purchasing power of a domestic currency
-An increase in the general level of prices –> reduces purchasing power of domestic currency –>leads to depreciation

Question 3

How to calculate PPP exchange rate

Answer 3

-EPPP= P € / P $

Question 4

What are short-run limitations of PPP

Answer 4

-transportation costs, information costs, tariffs
-imperfect competition (low price elasticity demand)
-consumption baskets differ across countries
-many goods prices contain non-traded components

Question 5

Why does PPP fail in short-run

Answer 5

-Floating nominal exchange rates is greater than the variance in price indices
-Partly attributed to the stickiness of nominal prices

Question 6

What is the real exchange rate

Answer 6

-q = E x P $ / P €
-The relative price index of goods and services between two countries (denoted as q)
-According to PPP should be constant

Question 7

What is relative PPP

Answer 7

-The exchange rate over time should correspond to inflation differential of two currencies
-The change in exchange rates should cancel out any change in prices over time

Question 8

What two factors influence Exports and Imports’ reaction to a depreciation of currency

Answer 8

-Substitutability of domestic and foreign goods (Value)
-In what currency do exporters fix their prices: pass-through of exchange rates to consumer (Volume)

Question 9

What dominates between Value and Volume effect

Answer 9

-In the short-term, the value effect
can dominate.

Question 10

What is the J-curve of CA

Answer 10

-Initially worsening of the trade balance before
improvement after q ↑.

Question 11

What is the Marshall-Lerner condition

Answer 11

A large enough response of volumes will lead to dominant volume effect in long run

Question 12

Why do we assume NEX increases

Answer 12

A depreciation in the real exchange rate increases competitivness

Question 13

What are features of the AA curve

Answer 13

-Higher GDP raises money demand and appreciates the exchange rate
-A negative relation between Y€ and E
-Combinations between Y€ and E
such that asset markets are in equilibrium

Question 14

What are features of the DD curve

Answer 14

-At equilibrium Aggregate Demand = Output (Y)
-Output and Income determined by demand
-A nominal depreciation improves competitiveness
-positive relation between E and Y€
-Curve steeper in a closed economy

Question 15

Why are AA and DD curves inverted

Answer 15

because of the way that E is represented, a increase in E is a depreciation of currency.

Question 16

What is the difference between Monetary Policy and Fiscal Policy

Answer 16

-Monetary policy is very efficient in an open economy because of the exchange rate channel of monetary policy
-Fiscal Policy is less efficient in an open economy because appreciation of currency and deterioration of CA (as net exports crowded out)

Question 17

How has globalization changed macro-policy

Answer 17

-Financial and trade openness make fiscal policy less effective:
-Fiscal expansion more beneficial for the foreign economy than the domestic economy
-Trade and financial openness make monetary policy more effective:
-Monetary expansion is effective at home but negatively impacts the foreign economy

Question 18

What do policies need to do in times of crisis

Answer 18

-Need to replace falling private demand with increasing public demand
-Need for global cooperation to limit impacts of crisis

Question 19

What are the two responses to crisis that the central bank uses

Answer 19

-Conventional response: cut policy interest rates
-Unconventional response: buy government bonds to increase inter-bank transactions and liquidity provisions (also reduces cost of borrowing)