Open Economy Flashcards
What is the formula for the nominal exchange rate
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
What is the formula for the real exchange rate?
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
What happens when a shock pushed inflation above target?
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)
How is the multiplier different in an open economy
Lower multiplier due to leakage to imports
steeper curve
Does a change in the exchange rate affect the IS curve
Depreciation shifts right
Appreciation shifts left
Does trade and investment in financial markets drive the forex market?
trade in international financial markets that dominates the foreign exchange
market
What are 4 assumptions made about the international financial markets?
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)
What are the 2 factors affecting the expected return on bonds
1) expected interest rate differential
2) expected development of exchange rate
What type of expectations does the forex market have
rational
What does the UIP condition imply in the case of the home interest rate rising 2% above the world?
Upon the rise the the policy rate, the pound immediately appreciates by 2% it then depreciates over the course of a year by 2%
What is the UIP condition (words)?
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
What is the effect of forex markets basing their actions on expectations of the future
jumps in the exchange rate and increased macroeconomic volatility.
What is the UIP formula?
it - i* = expected et+1 - et / et
with logs: it - i* = log expected e1 - log e0
interest gain (loss) = expected depreciation (appreciation)
What are 4 key features of the UIP curve?
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
When is the closed economic in equilibrium
When inflation is constant. Inflation is constant along the ERU curve
What does the open economy AD curve represent?
good market equilibrium and home real interest rate is equal to the world interest rate
What does the ERU represent?
combinations of the real exchange rate and output at which the wage-setting real wage is equal to the price-setting real wage.
What is the formula for the open AD curve?
y = A - art-1 + bqt-1
A includes multiplier and demand shif variables
r= r*
When r is not = r*, is the economy on the AD curve?
no
In MRE what variable adjusts in response to demand and supply shocks?
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.
Why does openess affect CB’s policy?
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
In an open economy, what curve does the economy adjust along?
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
Explain open economy response to inflation shock
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
When does the economy economy IS curve shift
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)
Where does the RX curve cross
IS curve at C (exchange rate one) and through point A,Z
Through intersection of r* and ye and shifts with these
What does the RX curve show?
shows the interest rate required to achieve
a given output gap, taking into account the reaction of the forex market
What is exchange rate overshooting>
phenomenon of the nominal and real exchange rate jumping by more than the equilibrium adjustment in response to shocks
Why does exchange rate overshooting exist (3)?
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.
What is the trade balance
exports - imports
What is the current account?
trade balance + net interest and profit receipts
Reflects fact that residents can receive income from assets owned in other countries
What are the capital and financial accounts?
records changes in the stock of various types of foreign owned assets, and official foreign reserves of the CB
What is the balance of payments
trade balance + net interest receipts + net capital inflows - change in CB reserves
= (BT +INT) + (F - change R) = 0
When is the ERU downwards sloping?
when wage e setting behaviour is based on real consumption wages which include import prices.
How are AD shocks different with a downwards sloping ERU curve?
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.
What is the Marshel Learner condition?
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.
What is the CPI formula
( 1 - phi which is import share)P + phi P*e
How does a real depreciation affect the WS=PS curves?
Shifts PS down
What kind of shocks shift the BT curve
external trade shocks (AD also shifts such that if vertical ERU BT is unchanged)
What are the trade effects of positive supply and demand shocks
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.
