Open economy Flashcards
What is GNP?
GDP plus factor income from abroad (labour and capital)
What is the BOP and what are the 3 accounts it is made up of?
Measures transactions of one country with the rest of the world. Made up of the current account (net income from abroad from the trade balance, sale of goods and services), financial account (transaction of financial assets), capital account (acquisitions of licenses and patents).
What is the current account made up of?
Trade balance, net income from abroad and net unilateral transfers e.g aid and remittances.
Define nominal exchange rate?
Value of one currency in terms of another countries currency.
What is the difference between a free floating and fixed exchange rate system?
Free floating is where the CB lets the domestic currency fluctuate and a fixed is where the CB intervenes to maintain the exchange rate at a constant value.
What is the real exchange rate and the formula?
Real exchange rate is the price of domestic goods relative to foreign goods. Real exchange rate = domestic goods in foreign currency price / the price of the same good in the foreign price.
What is the trade balance dependant on?
Domestic income ( higher it is then more imports so trade balance worsens). Foreign income (higher foreign income then higher exports so trade balance rises). Demand shocks that effect trading partners. Exchange rate - if pound depreciates then imports become more expensive for domestic customers and exports become cheaper so the trade balance improves.
What is the formula showing the rate of return for holding the domestic currency?
1+ domestic interest rate
What is the formula showing the rate of return for holding the foreign currency?
Exchange rate/ expected exchange rate for next period ( 1 + foreign countries interest rate)
When are investors indifferent to whether they hold domestic or foreign currency?
When the rate of returns are equal to eachother so when 1+E = (1+i)E/E
What does the domestic interest rate vs exchange rate diagram portray? What shifts the curve?
An upward sloping curve shows that a rise in interest rate leads to a rise in the domestic exchange rate. Factors that shift the curve inc change in foreign country interest rate and change in the expected exchange rate for the next period.
What is different about the IS-LM diagram in the open economy?
Changes in interest rate has 2 effects: increase in interest rate decreases investment so output falls and it also increases the exchange rate so output falls - IS-LM model shown alongside the UIP model (interest rate vs exchange rate)
Why does fiscal expansion become even less effective in an open economy under a floating regime?
The crowding out effect is larger as investment and the exchange rate is effected.
What is the marshal lerner condition?
A depreciation in the pound will increase exports and decrease imports as imports have become relatively more expensive. Although the quantity of imports will fall, the value may not necessarily fall as the price rise may compensate it. So for the trade balance to improve, imports need to fall by enough to compensate for the rise in the price of imports.
Why does contractionary monetary policy become more effective under a floating regime?
MS falls so LM falls and shifts upwards. IS remains the same so interest rate rises. This causes a fall in investment and a rise in the exchange rate which worsens the trade balance and causes AD to fall.
