IS-LM in open economy (topic 6)

Question 1

What is the the goods market in open economy?

Answer 1

The goods market = the proportion of domestic and foreign products within total consumption.

Question 2

What is the financial market in open economy?

Answer 2

The financial market = the proportion of domestic and foreign bonds within total bond holding.

Question 3

Explain trade openness.

Answer 3

Trade openness = the ability for consumers and firms to choose between domestic and foreign goods (there are restrictions to trade such as tariffs and quotas).

Smaller countries will tend to be more open, as they depend more on their trade with other nations.

Question 4

What is the balance of payments?

Answer 4

Balance of payments/balance of international payments = a record of all payments or monetary transactions between a country and the rest of the world in a specific period.

Encompasses all transactions between residents and non-residents of the country (involving goods, services and income, financial claims on and liabilities to the rest of the world (i.e., transfers and gifts)).

Question 5

What does the balance of payments consist of?

Answer 5

Current account: 
Trade balance (export – import) 

Net income (income received – income paid) Salaries, income from asset holdings, etc.

Net transfers received (Aids, donations, workers remittance, etc.)

Capital account:
Capital account balance (purchases of domestic holdings by foreigners – purchases of foreign assets by the domestic country)

Statistical discrepancy (lack of balance)

Question 6

Why is it hard to balance the current and capital accounts?

Answer 6

The current account and capital account should balance (but as there often is statistical discrepancies, it rarely happens).

Question 7

Explain trade deficit.

Answer 7

If a country’s imports are larger than its exports, there is a current account deficit (trade deficit), and the country is a net debtor to the rest of the world as it is investing (borrows) more than it saves.

Question 8

Explain a trade surplus.

Answer 8

If imports are smaller than exports, there’s a current account surplus (trade surplus), and the country is a net creditor to the rest of the world as it is providing an abundance of resources to other economies.

Question 9

What determines the nominal exchange rate, E?

Answer 9

Is determined on the foreign exchange market by supply and demand.

When the demand for domestic currency is high, the nominal exchange rate tends to increase and vice versa.

Question 10

Explain the flexible exchange rate regime.

Answer 10

Flexible exchange rates = the central bank lets the exchange rate adjust freely on the foreign exchange market.

in the flexible exchange rate regime can the domestic currency,

• Appreciate (i.e., the nominal exchange rate increases)
• Depreciate (i.e., the nominal exchange rate decreases)

Question 11

Explain a fixed exchange rate regime.

Answer 11

Fixed exchange rates = the central bank has an explicit exchange rate target and uses monetary policy to achieve this (e.g., Denmark and the ERM2)

In the fixed exchange rate regime can the domestic currency,

• Revaluate (i.e., the nominal exchange rate increases)
• Devaluate (i.e., the nominal exchange rate decreases)

Question 12

What is the function of the real exchange rate, epsilon, as the price of domestic goods in terms of foreign goods? And the price of foreign goods in terms of domestic goods?

Answer 12

The real exchange rate = the price of domestic goods in terms of foreign goods (denoted by epsilon)

∈=EP/(P*)

Epsilon = the price of domestic goods in terms of foreign goods.

1/∈= the price of foreign goods in terms of domestic goods.

Real exchange rate determines the choice between consuming domestic or foreign goods (as it takes the price difference across countries into account).

Changes in epsilon = real appreciations/depreciations.
- It is not observable (the one you get in the newspaper is the nominal exchange rate).

Question 13

What is the function for demand for domestic goods and what values can import consist of?

Answer 13

Z = C (Y-T) + I (Y,i) + G + X (Y*,ϵ) - IM(Y,ϵ)
IM = the value of imports in terms of foreign goods. 

Z = C (Y-T) + I (Y,i) + G + X (Y*,ϵ) - IM(Y,ϵ) / ϵ
IM/ϵ = the value of imports in terms of domestic goods

Question 14

What does imports, IM, depend on?

Answer 14

IM = IM (Y,ϵ)
(+,+)

Y = domestic income (positive relation i.e., the higher the domestic income, the higher the demand for (foreign and domestic) goods).

ϵ = real exchange rate (positive relation i.e., the higher the price of domestic goods in terms of foreign goods, the higher level of imports).

Question 15

Explain the determinants for exports, X.

Answer 15

X = X (Y*,ϵ)
(+,-)

Y* = foreign income (positive relation i.e., the higher the foreign income, the higher the demand for (foreign and domestic) goods.

ϵ = real exchange rate (negative relation i.e., the higher the price of domestic goods in terms of foreign goods, the lower the level of exports).

Question 16

Explain the effects of an expansionary fiscal policy.

Answer 16

G increases or T decreases

demand increases

increase in output (more than the increase in G through the multiplier effect

the increase in output will lead to an increase of imports (X is unaffected)

increase in trade deficit or decrease in trade surplus (deterioration of the trade balance)

Question 17

Explain the multiplier in open economy.

Answer 17

The larger the sensitivity of imports to changes in income, the smaller is the multiplier.

Countries that are more open (not self-sufficient) are more sensitive and have a smaller multiplier.
• Example: increase in G,
• Increase in demand -> increase in supply -> consumption increases, but as we are in open economy, this does not only concern domestic goods, but foreign as well, i.e., that in closed economy the effect on demand for domestic goods would have been larger (the multiplier is smaller in open economy).

This means that the slope of the demand relation (graphically) is smaller in open economy as well.

Question 18

Explain what happens when there is changes in foreign demand, Y*.

Answer 18

Increase in Y* =
Increase in exports and through the multiplier effect, output will increase by more.

Graphically the ZZ line shifts upwards and the same will happen to the NX curve.

Decrease in Y* =
Decrease in exports and output.

ZZ line and NX curve shifts downwards.

Question 19

Why should trade openness be taking into account?

Answer 19

As the multiplier is smaller in open economy, fiscal policies are also less effective.

Expansionary fiscal policies deteriorate the trade surplus and thereby accumulates debt (in the rest of the world).

There is no control of foreign demand i.e., a shock to demand in one country will affect other countries (if your trade partner has a decrease in Y*, this will affect the GDP in this country and in the domestic country as well, which is how economic crisis spread).

Question 20

Explain the Marshall-Lerner condition.

Answer 20

Marshall-Lerner condition: exports increase, and imports decrease enough to compensate for the increase in the price of imports (and therefore a real depreciation leads to an increase in net exports)

Question 21

What are the effects of changes in the nominal exchange rate in a flexible exchange rate regime?

Answer 21

Depreciation – nominal exchange rate decreases:
Direct effects:
- Exports increases.
- Import decreases.
The relative price of foreign goods in terms of domestic goods (1/epsilon) increases.

Indirect effects:

• NX increases (Marshall-Lerner) – NX and ZZ line shifts upwards.
• Domestic output goes up (through the multiplier effect) and the ZZ curve shifts upwards.
• Improvement of the trade balance (despite imports increasing)

Appreciation – nominal exchange rate increases:

• Import increases.
• Export decreases.
• 1/epsilon decreases.
• Output will decrease.
• NX and ZZ will shift downwards.
• Trade balance deteriorates.

Question 22

How do you choose between domestic and foreign bonds?

Answer 22

Example – the domestic currency is euros, and you want to invest in the US:

You have €1 and can invest it in your domestic country where the interest rate from period t to period t+1 is it, or you can exchange your euros to dollars and invest in the US where the interest rate from period t to period t+1 is i*t.

If you invest in your domestic country, your expected return at the end of the period will be: 1+i_t euros.

If you invest in the U.S.:
You convert your euros to dollars at the rate: Et and thereby get Et dollars.

You invest for the period and your return will be: (1+i_t^*)E_t dollars.

You then convert the dollars back to euros, where you expect to get: (1+i_t^* ) E_t/(E_(t+1)^e ) euros.

Question 23

What is arbitrage?

Answer 23

Arbitrage = when investors take advantage of a price difference and buy the bonds with the highest expected rate of return.

I.e., if he US investment brings a higher expected return, then investors will only invest in the US  the demand for dollars will be high/the demand for euros will be low -> Value of dollars increase/value of euros decrease -> exchange rate depreciates (Et decreases) -> expected return of investments in the US will decrease until the expected returns in the US and domestic country are equal.

Question 24

Explain the interest parity condition.

Answer 24

1+i_t=(1+i_t^* ) E_t/(E_(t+1)^e ) or
i_t ≈ i_t^*-〖E_(t+1)^e-E〗_t/E_t

Return on domestic bonds = return on foreign bonds.

Domestic interest rate must be equal to the foreign interest rate minus the expected appreciation rate of the domestic currency. (Because of arbitrage)

Question 25

Explain the equation:

E=(1+i)/(1+i*) E ̅^e

Answer 25

Rewrite of the IPC.

E being: E=E(i,i^*,E ̅^e)

Depends positively on i because an increase in the domestic interest rate makes as it makes it more attractive to invest -> demand will increase -> domestic currency will appreciate.

Depends negatively on i* as an increase in foreign interest rate makes domestic investments less attractive -> decrease in demand for domestic currency -> depreciation of domestic currency.

Depends positively on Ee as an increase in E_(t+1)^e means that the price of the domestic currency is expected to increase in a period -> expect less domestic currency when converting returns from foreign investments to domestic currency (as domestic currency will have become more expensive) -> increase in demand for domestic currency (if domestic and foreign interest rates remain constant) -> appreciation of the domestic currency.

Question 26

How can the equilibrium in the goods market, money market and bonds market be written in 2 equations?

Answer 26

IS: Y = C (Y-T) + I (Y,i) + G + NX (Y,Y^,(1+i)/(1+i) E ̅^e)

LM: i=i-bar

Question 27

Why is the IS curve downward sloping?

Answer 27

Increase in interest rate -> investment decreases -> demand decreases -> output decreases.

In open economy: increase in interest rate -> appreciation of the domestic currency -> decrease in net exports -> decrease in demand -> decrease in output.

Question 28

What are the effects of fiscal policies in a flexible exchange rate regime?

Answer 28

Expansionary:
Increase in G or decrease in T -> increase in demand -> increase in output (through the multiplier) -> increase in consumption -> increase in investment

No changes in the interest rate means that the exchange rate is unaffected.
Domestic income increases -> imports increase, while exports are stable (determinants are unaffected) -> the trade balance deteriorates.

Contractionary:
Decrease in G of increase in T -> decrease in demand -> decrease in output -> decrease in consumption and investment.

Exchange rate is unaffected.

Domestic income decreases -> imports decrease -> deterioration of the trade balance.

Question 29

What are the effects of monetary policies in a flexible exchange rate regime?

Answer 29

Expansionary:
Interest rate decreases -> depreciation of the domestic currency (foreign investments are more attractive) -> increase in demand and output (through an increase in investment and net exports)

Contractionary:
Increase in interest rate -> appreciation (domestic investments are more attractive) -> decrease in demand and output (through the decrease in investments and net exports. The appreciation tends to decrease NX, which causes the decrease in output, where I tend to increase NX)

Question 30

In a flexible exchange rate regime, what should the central bank do if there’s a risk for appreciation?

Answer 30

When the demand for domestic currency is too high (risk for appreciation), the central bank should either

• decrease the interest rate and thereby make it less attractive to make financial investments in the domestic country
• sell the domestic currency by buying foreign assets (which then goes into the central bank’s foreign exchange reserve).-> the demand for domestic currency decreases and thereby prevents appreciation.

Question 31

What can the central bank do to avoid depreciation? and why should it be avoided?

Answer 31

In a flexible exchange rate regime, it is important to limit large fluctuations in the exchange rate/avoid depreciation because, if people observe depreciation of their currency and expect it to depreciate further, they might want to convert their money into a foreign currency/invest in foreign currency (so that in the future if their currency depreciates further, they will get more domestic currency when converting back).

If the country relies on imports, a depreciation will increase the price of imported goods -> leads to inflation.

To prevent depreciation:

• Increase the interest rate.
• Prevent a drop in demand for foreign currency (sell foreign exchange reserves or impose capital control measures to prevent the sale of domestic assets and/or
• boost the purchase of domestic currency and assets