open economy 1 Flashcards
three distinct dimensions in an open economy
-openness in goods markets: ability to choose between domestic and foreign goods and services
-openness in financial markets: ability to choose between domestic and foreign assets
-openness in factor markets: ability of firms to choose where to locate production and ability of workers to choose where to work
exchange rate (different, appreciation vs depreciation, examples, nominal vs real and equation)
-price of foreign currency in terms of domestic currency
-different: amount of domestic currency that can be exchanged for one foreign vs amount of foreign that can be exchanged for one domestic
-appreciation: value of domestic currency rises, depreciation: value of domestic currency weaker v foreign
-example: currency appreciated, mini budget crisis, removed limit on bonuses, cut basic income to 19%, market did not believe UK could do this so did not trust UK investment so left
-nominal e.r.: amount of foreign currency units that can be exchanged for one domestic
-real e.r.: unit of US$ per unit of sterling in real terms
-equation: E=(E dollars/pounds)x(price UK/ price US)
openness in financial markets
-country’s transactions with the rest of the world can be summarised by a set of accounts called the balance of payments
-current account: payments made to and from the world- exports (payments from rest of the world) imports (Payments to the rest of the world). difference between exports and imports is trade balance.
-capital account: financial transactions made to and from the rest of the world. balance of payments should balance exactly- when it doesn’t it is accounted fro as a statistical discrepancy
interest parity equation (and explanation)
(1+it)=(1+it)(Et/E^e t+1)
approximated as: it=it-(E^e t+1 -Et)/Et
if foreign is greater than domestic, sell domestic, prices fall and foreign bonds rise. as foreign bonds rise, yield falls and buy domestic, continue until it=i*t
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interest parity condition (history and effects of the euro)
-provides an intuitive way of thinking about interest and exchange rate movements
-additional factors to consider: effect of risk premium, rate of inflation
-pre joining Eurozone, Greece interest rate on bonds was very high. by 2002 they converged to similar levels of other European countries
-why?- all governments with bad credit histories inherited credit rating from Germany. but greece elected government lied about deficit spending spooking financial markets
demand for goods, determinants of imports, determinants of exports, domestic demand and domestic demand for domestic goods
demand for goods: Z=C+I+G+X-IM/e
-IM/e is imports in terms of domestic goods
-determinants of imports (IM=f(Y,e). rise in domestic income leads to rise in imports, rise in real exchange rate leads to rise in imports
-determinants of exports (x=f(Y*, e): increase in foreign income leads to rise in exports, increase in real exchange rate leads to fall in exports
-domestic demand (DD)= C+I+G
-domestic demand for domestic goods (AA)= C+I+G-IM/e
-c is total consumption, c1 is slope, part of consumption on imports, c1=mpcd+mpcim
effect of rise in government in spending on demand and net exports graph
-set up graphs (top demand and output, bottom, net exports and output, and then exports and imports and output)
-DD above AA, graph below crosses at equilibrium (difference in DD and AA is x)
-rise in g, rise in output, rise in c, i, im, rise in c and i lead to multiplied rise in output
-trade deficit above equilibrium, trade surplus below equilibrium
-bottom: IM shifting up, x horizontal
equilibrium output and trade balance (explanation and graph)
-goods market in equilibrium when do for domestic output is d for domestic goos
-no need for trade balance in equilibrium
-set up keynesian cross and net exports as normal
-fall in g, fall in y, fall in c i and im, fall in y
-ZZ shifts down
-overshoot now trade surplus in bottom graph
changes in demand and exchange rates
-increases in demand: suppose econ in recession, gov increase to increase z (assume trade balance)
-now in open economy need to consider effect of rise in G on trade balance (rise in d, part spent on imports), no effect on exports
-now assume econ in equilibrium, also trade balance (rise in world output, rise in exports)
-demand for domestic goods increases by rise in exports, new exports increase by rise in x
-rise in incomes thus will increase d and output. rise in output will see some increase in imports but less than initial rise in exports
-zz shifts up, NX shifts right meeting equilibrium and trade balance (x shifts up)
fiscal and exchange rate policy (explanation and graph)
-consider equilibrium with trade deficit. government want to eliminate this but keep output constant
-can depreciate real exchange rate (increase NX)
-now output moved beyond target gov can combine e.r. policy with fiscal
set up keynesian cross and net exports as above
-fall in e.r. affects NX
-rise in x affects x
-leads to smaller trade deficit
-gov can increase taxes or reduce spending to meet Yn
