L7: Economic Politics in Open Economies Flashcards
law of one price (LOP)
on competitive markets, in absence of transport costs and tariffs, two identical goods must be sold at the same price (expressed in the same currency)
long-term arbitrage mechanism
purchasing power parity (PPP)
idea that consumption baskets in different markets should be the same once expressed in the same currency
derived from LOP
also a theory of exchange rates: exchange rate such that it is equal to the ratio of the price indices in both countries
why does LOP fail in the short run?
not puzzling for non-traded goods like services but it is for traded goods
large fraction of goods consumed are not traded across borders
- most services are local services and not traded across borders (e.g. just because a service is cheaper somewhere else does not mean you travel to gain that service)
- local services much cheaper in underdeveloped countries
transport costs and trade barriers (tariffs/regulations) make arbitrage more difficult
imperfect competition
- firms segment markets to have high prices where PED is low
- price differences cannot be so large because people start to arbitrage across markets
many goods considered to be highly traded contain non-traded components
- retail and wholesale costs (distribution costs) account for around 50% of final consumer price
real exchange rate
relative price index of goods and services between two countries
changes in the nominal exchange rate should reflect?
inflation differential
e.g. high inflation countries should see their currency depreciate while their PPP holds
J-curve
initial worsening of the trade balance before improvement after the real exchange rate increases
improvement under the Marshall-Lerner condition stating a large enough response of volumes
AA curve
negative relationship between output and exchange rate - interpret as the supply of money on the goods market
when you increase the supply of currency the AA curve moves upwards - more supply of currency means that the currency depreciates more for a given level of output
DD curve
positive relationship between output and exchange rate - interpret as the demand for currency on the goods market
upwards sloping because of the convention that higher values mean lower prices
slope of the curve depends on how open the economy is to the rest of the world (completely vertical when the economy is closed)
demand for goods telling us that if the currency depreciates, we can export more and output will be higher as a result of that
what happens when there is a temporary monetary policy shock in terms of an increase in money supply?
AA curve shifts upward as the exchange rate depreciates
move along the DD curve
easier to export but imports are more expensive so you substitute
output rises as external demand rises so aggregate demand and output rise
depreciation in the currency boosting net exports, aggregate demand and output
when is monetary policy the most efficient?
in open/smaller economies when used to stabilise the economy (stimulating demand after a demand slump)
larger increase in the output following monetary policy because the depreciating currency helps them export more and import less
effects are mitigated in larger and closed economies that rely less on imports/exports from the rest of the world
what happens when there is a temporary fiscal policy shock?
fiscal policy shifts aggregate demand so DD curve moves to the right
change in the value of goods so the currency has to appreciate and you move along the AA curve
end up with more output but not as much as you would have had if there was no exchange rate adjustment
- shift in aggregate demand is so large that the increase in output is smaller
currency appreciation along the process
- while increasing aggregate demand, you increase spending in the economy so the currency appreciates and it is harder to export even if imports are relatively cheaper
increase in aggregate demand partially offset by a drop in net exports due to currency appreciation
when is fiscal policy the most efficient?
in closed economies due to the fiscal multiplier
aggregate demand curve is completely vertical and the shift in aggregate demand is more than proportional to the shift in government spending because of the multiplier effect but there is no crowding out
lower in an open economy means that there is crowding out of net exports on top of crowding out of investment (limits the extent to which output can rise following a rise in government spending and a positive fiscal shock)
how has globalisation changed the effectiveness of macro policies?
trade openness makes domestic fiscal policy less efficient to stimulate aggregate demand
- demand generated by fiscal expansion leaks more (shift in DD curve is smaller)
- increased demand benefits both domestic and foreign firms
- appreciation of the currency affects net exports negatively and hurts the economy’s competitiveness (benefits trade partners since their currencies are depreciating)
trade openness makes monetary policy more efficient
- benefit from the extra exchange rate channel (the more the exchange rate drops, the more people sell the currency)
- this generates depreciation and increases net exports - a more open economy with a flatter DD curve has a larger effect on output
why might fiscal policy be inefficient?
lags involved
- takes time to be implemented and to feed into the economy
crowding out of consumption, investments and net exports
debt sustainability and sovereign risk
- harder to pay back debt
- prevents further spending since overall cost of borrowing increases
fiscal adjustments
necessary after large fiscal stimulus (need for fiscal austerity)
more painful in large, closed economies and countries with fixed exchange rates
- less costly in open economies since you export austerity to other countries and it is less costly to you
also more painful in highly indebted economies
