Medium run open economy (Swan diagram: ERU/AD/BT, Twin deficits)

Question 1

Why is there a wedge between consumer and producer wages?

Answer 1

Import prices, income/sales/employment taxes

Question 2

What is the main difference between an open and closed economy?

Answer 2

The exchange rate, θ, equates supply and demand, rather than the real interest rate

Question 3

The more the exchange rate depreciates…? [2]

Answer 3

1) The more competitive we are in selling goods abroad

2) The more the price of imports rises

Question 4

Which curve shifts when the exchange rate changes?

Answer 4

The PS curve: if the price of imports rises, then consumers can buy fewer goods, so real wages (w/p) fall. The PS shifts downward and a new NAIRU is reached.

Question 5

What does the ERU curve show?

Answer 5

The Equilibrium Rate of Unemployment for a given level of output and real exchange rate.

Question 6

How is the ERU drawn?

Answer 6

Downward-sloping: exchange rate depreciates (up the y-axis!), real wage falls so PS shifts downwards, employment falls so output falls.

Question 7

What happens if the economy is above the ERU curve?

Answer 7

1) Real wages are too low (you’re below the WS curve)
2) Wage demands create domestic inflation, moving it above world inflation
3) Real wages rise as prices rise
4) Interest rates rise to combat the domestic inflation
5) The exchange rate appreciates and the economy moves back down onto the ERU curve

Question 8

What are the characteristics of the AD curve? [3]

Answer 8

1) Comprised of domestic demand + balance of trade
2) Graph in θ-output space
3) Positively sloped - depreciation (up y-axis) means more exports so higher output

Question 9

What does the BT curve show?

Answer 9

Where imports equal exports at the given exchange rate

Question 10

What happens when the economy is above the BT curve?

Answer 10

It is running a trade surplus

Question 11

Which curve does the economy not have to be on for equilibrium in the medium term?

Answer 11

The BT curve: countries have intertemporal action on their current accounts, like individuals, so in the medium term there is no reason to be on the BT curve. However ERU must still equal AD for equilibrium.

Question 12

What shifts the ERU curve outwards?

Answer 12

Supply side changes - e.g. technical innovation or an increase in the working population - increase the equilibrium rate of unemployment. Ceteris paribus, the economy gets more competitive and the exchange rate depreciates.

Question 13

What shifts the AD curve outwards?

Answer 13

Demand side changes - e.g. domestic fiscal expansion or an increase in world demand. Ceteris paribus, we become less competitive and our currency appreciates.

Question 14

In the Swan diagram, what are on the axes?

Answer 14

x-axis: output

y-axis: real exchange rate (getting more competitive = depreciation)

Question 15

What happens in the Twin Deficit problem?

Answer 15

Shocks that cause a worsening of the government’s budget deficit also lead to a worsening of the economy’s current account and thus a trade deficit.

Question 16

How does the Twin Deficit problem work graphically?

Answer 16

Fiscal expansion shifts AD outwards, increasing domestic output but causing a fall in competitiveness. If the economy keeps importing at the same rate, the new equilibrium will be to the right (below) the BT curve, and thus the trade deficit worsens.

Question 17

How does the Twin Deficit problem work mathematically?

Answer 17

Current account = private disposable income - private consumption - investment + (taxes - public spending)

CA = (Y+rB-T) - C - I + (T-G)

Private disposable income - private consumption = private saving; Taxes - public spending = government saving

CA = private saving - investment + government saving

CA deficit = investment - private saving + budget deficit

Holding investment and saving constant, if the budget deficit increases, so does the current account deficit!

Question 18

Why might we be unable to hold investment and saving constant as assumed in the Twin Deficit problem? [2]

Answer 18

1) Ricardian equivalence: if taxes are lowered now to fund spending, people will save against them rising in the future - so private saving rises to offset the budget deficit and there is no change to the CA deficit
2) Crowding out: if the government borrows to fund spending, interest rates will rise, which crowds out investment - investment falls to offset the budget deficit (Note that the more open the economy, the less interest rates will rise)

Question 19

When is the Twin Deficit problem most likely to hold?

Answer 19

Where the fiscal shock is less persistent, or where the economy is more open (because of crowding out - bigger effect for a close economy where the borrowing persists)

Question 20

Did global imbalances cause the recession?

Answer 20

China had high savings levels, plus supply side changes shifting the ERU curve out (so a high CA surplus).

The US had a strong dollar and cheap imports. Interest rates were low so borrowing (from the Chinese) was cheap. Bubbles were created, AD shifted out, and they had a big CA deficit.

The imbalances weren’t the root - it was the savings ‘glut’ which caused low interest rates that was the problem.