Open Economy

Question 1

What is the formula for the nominal exchange rate

Answer 1

e = no. units of home currency / 1 unit of foreign

rate at which the currencies of two economies
can be exchanged for one another.

Higher e is deprecation

Question 2

What is the formula for the real exchange rate?

Answer 2

q = price of foreign expressed in home / price of home goods = P*e / P

Higher Q = depreciation

rate at which domestic and foreign
goods and services can be exchanged for each other accounting for relative price levels

Question 3

What happens when a shock pushed inflation above target?

Answer 3

CB and forex market know a - output gap will be required to reign in inflation and the interest rate will be raised, creating an arbitrage opportunity due to higher return on home bonds

Currency appreciated, depressed net exports and investment (make the economy less competitive and depresses aggregate
demand for home products)

Question 4

How is the multiplier different in an open economy

Answer 4

Lower multiplier due to leakage to imports

steeper curve

Question 5

Does a change in the exchange rate affect the IS curve

Answer 5

Depreciation shifts right

Appreciation shifts left

Question 6

Does trade and investment in financial markets drive the forex market?

Answer 6

trade in international financial markets that dominates the foreign exchange
market

Question 7

What are 4 assumptions made about the international financial markets?

Answer 7

1) perfect international capital mobility
2) small home country
3) can hold home money, home bonds and foreign bonds
4) perfect substitutability between foreign and home bonds (risk identical only difference is return)

Question 8

What are the 2 factors affecting the expected return on bonds

Answer 8

1) expected interest rate differential

2) expected development of exchange rate

Question 9

What type of expectations does the forex market have

Answer 9

rational

Question 10

What does the UIP condition imply in the case of the home interest rate rising 2% above the world?

Answer 10

Upon the rise the the policy rate, the pound immediately appreciates by 2% it then depreciates over the course of a year by 2%

Question 11

What is the UIP condition (words)?

Answer 11

Interest gain from holding home currency over foreign bonds = loss from expected depreciation of home currency

Means the exchange rate will jump so as to eliminate differences in expected
returns on bonds

Question 12

What is the effect of forex markets basing their actions on expectations of the future

Answer 12

jumps in the exchange rate and increased macroeconomic volatility.

Question 13

What is the UIP formula?

Answer 13

it - i* = expected et+1 - et / et
with logs: it - i* = log expected e1 - log e0

interest gain (loss) = expected depreciation (appreciation)

Question 14

What are 4 key features of the UIP curve?

Answer 14

1) plots i against log e
2) slope of -45 going through logeE, i*
3) change in home interest rate moves along curve
4) curve shifted up by change in world interest rate or expected exchange rate

Question 15

When is the closed economic in equilibrium

Answer 15

When inflation is constant. Inflation is constant along the ERU curve

Question 16

What does the open economy AD curve represent?

Answer 16

good market equilibrium and home real interest rate is equal to the world interest rate

Question 17

What does the ERU represent?

Answer 17

combinations of the real exchange rate and output at which the wage-setting real wage is equal to the price-setting real wage.

Question 18

What is the formula for the open AD curve?

Answer 18

y = A - art-1 + bqt-1
A includes multiplier and demand shif variables
r= r*

Question 19

When r is not = r*, is the economy on the AD curve?

Answer 19

no

Question 20

In MRE what variable adjusts in response to demand and supply shocks?

Answer 20

The real interest rate is pinned down by the world real interest rate in MRU
so the real exchange rate varies in response to demand and
supply shocks.

Question 21

Why does openess affect CB’s policy?

Answer 21

need to take account of the forward looking
behaviour in the foreign exchange market and the effect of changes in the exchange
rate on aggregate demand

Question 22

In an open economy, what curve does the economy adjust along?

Answer 22

Instead of adjusting back to equilibrium along the IS curve as in the closed economy, CB adjusts along a flatter ‘interest rate — exchange rate’ (RX) curve

Question 23

Explain open economy response to inflation shock

Answer 23

1) inflation shock
2) Central bank and forex market foresee a lengthy period with higher interest rates to reduce inflation to target
3) CB raises rates and currency appreciates
4) output and inflation fall
5) CB gradually reduces rates and exchange rate gradually depreciates
6) economy moves back towards equilibrium

Question 24

When does the economy economy IS curve shift

Answer 24

Normal but also in response to currency jump

At point C there is a new IS curve (to the left of the original in the case of a + shock)

Question 25

Where does the RX curve cross

Answer 25

IS curve at C (exchange rate one) and through point A,Z

Through intersection of r* and ye and shifts with these

Question 26

What does the RX curve show?

Answer 26

shows the interest rate required to achieve

a given output gap, taking into account the reaction of the forex market

Question 27

What is exchange rate overshooting>

Answer 27

phenomenon of the nominal and real exchange rate jumping by more than the equilibrium adjustment in response to shocks

Question 28

Why does exchange rate overshooting exist (3)?

Answer 28

Basically, only some prices (such as currency and commodities) respond immediately

1) internationally integrated financial markets
2) ration expectations in forex market which results in jumps in the exchange rate
3) lags in adjustment of wages and prices in the economy, which requires the central bank to keep the interest rate above (or below) the world interest rate until inflation returns to target.

Question 29

What is the trade balance

Answer 29

exports - imports

Question 30

What is the current account?

Answer 30

trade balance + net interest and profit receipts

Reflects fact that residents can receive income from assets owned in other countries

Question 31

What are the capital and financial accounts?

Answer 31

records changes in the stock of various types of foreign owned assets, and official foreign reserves of the CB

Question 32

What is the balance of payments

Answer 32

trade balance + net interest receipts + net capital inflows - change in CB reserves

= (BT +INT) + (F - change R) = 0

Question 33

When is the ERU downwards sloping?

Answer 33

when wage e setting behaviour is based on real consumption wages which include import prices.

Question 34

How are AD shocks different with a downwards sloping ERU curve?

Answer 34

Shift in aggregate demand will result in new equilibrium on a downwards sloping ERU

+ demand shock associated with new constant inflation equilibrium at lower unemployment and appreciated exchange rate.

Question 35

What is the Marshel Learner condition?

Answer 35

if the sum of the price elasticity of demand for exports and the price elasticity of demand for imports exceeds one, a depreciation will improve the balance of trade.

Question 36

What is the CPI formula

Answer 36

( 1 - phi which is import share)P + phi P*e

Question 37

How does a real depreciation affect the WS=PS curves?

Answer 37

Shifts PS down

Question 38

What kind of shocks shift the BT curve

Answer 38

external trade shocks (AD also shifts such that if vertical ERU BT is unchanged)

Question 39

What are the trade effects of positive supply and demand shocks

Answer 39

positive supply shocks are associated with a real exchange rate depreciation and hence an improvement in the trade balance,

positive demand shocks are associated with an appreciation in the real exchange rate and a deterioration in the trade balance.