L27 - Economic Policy in an Open Economy Flashcards
Why do we need to look at the interactions between our macro models and the rest of the world?
- Firstly, while we have always had net exports in our models, we have not paid attention to all the possible implications of trade balance
- Secondly, the financial markets have become more integrated around the word –> the globalisation of the financial markets –>due to high international mobility of financial capital - the money markets in own country are influenced by what happens in the world’s financial market
- thirdly the exchange-rate regime matters fro the conduct of monetary policy because it affects the possibilities for arbitrage between domestic and overseas financial markets –> therefore a link between the two countries interest rates
What is Arbitrage?
- involes buying where a price is low and selling where it is high in order to make profit
- the process of arbitrage tends to drive prices of the same commodity or asset towards equality in different locations
What does capital flow mean in the context of the balance of payments?
- its not the imports and exports of capital goods, but rather about the trade in assets and liabilities such as money balances shares and bonds, or lending by banks in one country to customers in another
What are the two reasons why is capital flow important?
- changes affecting capital flows have implications for net exports (possibly via exchange rate changes)
- capital flow also influence the domestic interest rate
Why does the openness of a economy matter?
Openness of the economy matters, as international factors directly affect:
- real demand,
- world financial forces influence domestic financial markets,
- and the exchange rate regime affects the policy choices that are available.
Why is the exchange rate regime important?
- it determines which variables are free to adjust
What can occur under a fixed exchange rate?
- it ties together the value of domestic and foreign money which implies the domestic price level cannot deviate from the foreign price level in the long run
- Fixed exchange rates with mobile capital also tie domestic and foreign interest rates together because there is no exchange rate uncertainty –> in these circumstances the domestic monetary authorities have no discretion in setting the domestic interest rate
- the money supply is endogenously determined by demand at whatever the interest rate is dictated by world money markets
- in general monetary authorities of nations with independent currencies can fix any one (but only one), of the interest rate, exchange rate and the money supply, –> also applies to groups of a single currency e.g. eurozone
- Once choosing one the others become endogenous
- Fixing interest rates in one monetary policy but having done this authorities cannot also control either the interest rate or the money supply –> most major countries set short-term interest rates and let the money supply and the exchange rate adjust
Where does most of the adjustment to shocks come from under the two exchange rate policies?
- under floating exchange rates much of the adjustment to shocks comes through exchange -rate changes and the resulting effect on the relative price of domestic and foreign goods (and assets)
- under fixed exchange rates much more of the adjustment to shocks is worked out via aggregate demand, money stock, and output changes at give relative prices
In the long run what does fiscal policy affect?
- the long-run impact of fiscal policy is mainly on the trade balance
What can financial and spending linkages between economies cause?
- Financial and spending linkages between economies cause business cycles to have similar patterns in many major economies.
What does the IS-LM model look when incorporating Perfect Capital Mobility?
- With interest rates (r) on the y-axis and Real GDP (Y) on the x-axis
- inclined line of LM
- declined line of IS
- a horizontal line of BB –> represents combinations of the interest rate and GDP which there is equality between the current account balance of payments and capital flow
- there is an equilibrium point of i=i* when these lines cross
What are the implications of Perfect Capital Mobility?
- With perfect capital mobility the domestic interest rate must be equal to foreign interest rate in equilibrium.
- The BB line shows the combinations of interest rates and GDP for which a current account surplus (deficit) equals the associated capital outflow (inflow).
- The BB line is drawn horizontally at the point where the domestic interest rate is equal to the foreign rate i*.
- The shape of BB means that any size of current account deficit can b financed by borrowing at the going interest rate on
world capital markets.
What is Perfect Capital Mobility?
- for this model we make the assumption that that foreign demand for domestic bonds is perfectly elastic with respect to the interest differential –> they are perfect substitutes
- this assumption is close to the realities of the modern world of globalised finance and highly mobile international capital than the assumption of perfect immobility
What are two relationships we need to keep in mind when incorporating capital flow into the IS-LM model?
- since net capital flows must be of equal size and opposite sign to the current account balance of payment surplus or deficit, an actual capital inflow implies a current account deficit of equal size
- the foreign demand for domestic bonds depends in part upon the differential in interest rates between domestic and foreign bonds
What does Perfect capital Mobility imply about the exchange rates?
- Perfect capital mobility implies that with fixed exchange rates the domestic interest rate must always equal the foreign interest rate
- with floating exchanges rates any interest differential must be dictated by the expect exchange-rate change
- this will be zero in full equilibrium