Lent - Lecture 13 - Open Economies in the Short Run

Question 1

When we work with open economies in the short-run, what do we assume about prices?

Answer 1

assume exogenous (fixed) prices

Question 1

Explain why changes to the real exchange rate map one-to-one into changes to the nominal exchange rate

Answer 1

• P and P* are exogenously fixed
• ε = eP / P* (∝ e)

Question 2

What does the assumption of perfect capital mobility mean for r?

Answer 2

• r = r*
• if r > r* ⇒ NCF → +∞
• if r < r* ⇒ NCF → −∞
• (BoP can only balance when r = r*)

Question 3

What do exogenous inflation expectations (π(e) = π̅) mean for i?

Answer 3

i = i* (= r* + π̅)

Question 4

Explain why given M/P, there is a unique possible Y

Answer 4

• a fixed M/P is money supply
• money demand = L(i, Y)
• as i = i*, there is a unique value Y which equilibrates supply and demand

Question 5

Explain why e changes to allow goods market equilibrium

Answer 5

• C, I and G are fixed/exogenous
• hence, e is the only endogenous variable
• hence, e changes, changing NX in order to allow for LM = IS at r*

Question 6

Assuming the Marshall-Lerner condition is met, explain why e appreciates if the point where IS = LM is at a r > r*

Answer 6

• r > r* would mean that NCF → +∞
• but this is inconsistent with CA + NCF = 0
• hence, foreign capital is attracted to home, driving up the value of home currency: e appreciates
• this causes NX(e) to fall, so IS shifts in, allowing equilibrium at r = r*