IMF Chapter 7

Question 1

What does the flexible price model assume?

Answer 1

PPP holds continuously

Question 2

What is the big difference between sticky price and flexible price?

Answer 2

Sticky price only assumes that PPP holds in the long run

Question 3

What does the UIP requires?

Answer 3

It requires that capital is perfectly mobile and equal currency risk

Question 4

What does the UIP state?

Answer 4

The interest rate difference is the expected depreciation of those two currencies

Question 5

What is the formula for Exact UIP?

Answer 5

1 + r = Es/S * (1+r*)

Question 6

What is the formula for Approximate UIP?

Answer 6

r - r* = Es

Question 7

What are the differences between CIP and UIP?

Answer 7

1. CIP: r-r* = f-s and UIP: r-r* = Es
2. Equality via: CIP arbitrage, UIP speculation
3. Coverted back at CIP Forward market at t, and UIP at spot market a t+1
4. CIP no risk (Covered) and UIP risk (uncovered)

Question 8

What happens if both CIP and UIP holds?

Answer 8

Then the forward rate is equal to the Expected exchange rate: f=Es

Question 9

What should we keep in mind about UIP and deriving Es?

Answer 9

We can only use UIP formula to derive Es in Equilibrium

Question 10

How are the markets in the flexible price model cleared?

Answer 10

International bond market: cleared by r -> UIP: Es = r-r*
Money market: cleared by p -> m = p + ρy - σr
International goods market: cleared by s -> PPP (Absolute) s = p - p*

Question 11

How does the flexible price model determine equilibrium?

Answer 11

1. A change in a exogenous variable (M, Y)
2. Money market equilibrium is disturbed
3. Prices clear money market, such that p adjust to bring market in equilibrium
4. change goods price affect competitiveness, exchange rate restures i.e PPP

Question 12

What is the real interest parity (RIP)?

Answer 12

r - Ep = r* - Ep, where (r- Ep*) is foreign real rate and Ep is expected inflation

Question 13

What is the implication of RIP?

Answer 13

In the long run, a higher r can only result from a higher Ep and this from a higher currency depreciation i.e Es

Question 14

What does the formula in the flexible price model look like?

Answer 14

s = (m-m) - rel(y-y)+rel(r-r)

Question 15

How do the economic causalities rotate?

Answer 15

Money market (p) -> goods market PPP (s) -> bond market UIP (r) -> …

Question 16

What is the short run effect of the interest rate on the exchange rate?

Answer 16

If r increases, return H (deviation from UIP) increases, capital inflow and decrease of s

Question 17

What is the long run effect of the interest rate on the exchange rate?

Answer 17

an increase in r, can only come from expected inflation (Ep+) which means expected depreciation (Es+), so
Es+ -> r+ -> md <ms -> p+ -> s+

Question 18

How are the markets in the Dornbusch model cleared?

Answer 18

Money market: cleared by r -> m = p + ρy - σr
International bond market: cleared by s -> UIP Es = θ(s’ - s) Where s’ is the long run exchange rate
Domestic goods market: cleared by p

Question 19

Why is the GG upward sloping in the Dornbusch schedule?

Answer 19

+s -> net exports + -> d+ -> d>y -> net exports - -> p +

Question 20

Why is the MB-curve downward sloping?

Answer 20

p- -> L < M -> r- -> excess demand foreign bonds -> Es - -> s+