L13 Open Economies In The SR

Question 1

We wanna explain output volatility so return to Keynesian setting. What are the THREE assumptions and how does it relate to the goods market equation?

Answer 1

Y = C + I + G + NX(ę)

1 assumption: sticky prices

SO ę= eP/P*

So changes to ę map one-to-one into changes to e

2 assumption: perfect capital mobility, r=r*

3 assumption: exogenous sticky inflation expectations, which implies a fixed i

Question 2

Implications for the money market with M/P curve and L(i, Y) curve? (1)

Ie monetary policy + BOP = ….

Answer 2

We can’t have a range of choice for i, there’s only ONE solution, the only variable that can change is Y. For the closed econ we have multiple solutions of i for any Y, and that’s the LM curve!

…. eq’m Y

Question 3

Is monetary policy ineffective in affecting Y? (2)

Answer 3

Actually it’s EVEN MORE EFFECTIVE as don’t have downward-sloping IS curve

A monetary expansion shifts down the LM curve, Y rises.

CB M^s rises pushes output up DIRECTLY, against Classical dichotomy

Question 4

What’s the quantity theory interpretation of money market eq’m?

Answer 4

M/P = L( i, Y )

Supposing L(i,Y) unit elastic in Y ie 
= Y • l(i)

Then the money market requires

M • 1/ l(i) = PY

But i = i*, V is fixed so long as i is fixed

Question 5

Role of IS? Against what space can you draw the curve?

Where is the equilibrium? (3) what must adjust to restore it at r*

Answer 5

As Y against r or ę (in former M-L condition must hold)

Well we know what LM can’t move so long as M^s unchanged SO gotta change e!
Through app/depreciations, IS will adjust due to NX changes!

Question 6

SO the analysis works in two steps:

How can we graph up the second stage in the (e,Y) space ie how does it look like (4)

Answer 6

1. Given M/P we pin down Y

2. Given Y, e adjusts to ensure goods market eq’m

Question 7

Changes in world real interest rate and effects on Y and e, give both interpretations (second being QTM) - MONEY MARKET

Answer 7

1. Money market (LM curve and r*)

Lower r* -> lower i * -> more demand for real money balances -> for balancing purposes money demand must acc fall so -> Y must fall

QTM style:
Lower i, demand linear homogeneous degree 1 so demand for money falls, velocity of it circulating slows as the opportunity cost of holding is lower, given M and P are fixed this must reduce Y.

Question 8

Changes in world real interest rate and effects on Y and e, give both interpretations (second being QTM) - GOODS MARKET when plotted (e,Y space)

Answer 8

Given that income falls for any e, there’s an inward shift of the LM* curve

BUT also there’s some goods market stuff as investment rises as r* lower

Overall effect: an appreciation in e

Question 9

So what’s the intuition behind the change in r*? Graph to see this in (r, Y) space? (5)

Answer 9

Falls,
makes home more attractive for foreigners,
capital inflows e appreciates,
this causes NX to fall so Y falls,
this continues until Y is low enough for money market eq’m at i*

Question 10

What are the compositional effects of change in r* in M-F model?

Answer 10

If it falls

Y = 1/(1-c) { Č + I(r) + G + NX(e) }

We know overall Y falls

We have a rise in I(r)
BUT also fall in NX(e)

And the latter should overpower the former