Open Economy - FOREX market & AD shocks Flashcards
(19 cards)
What clears the foreign exchange market?
The exchange rate (e) clears the FX market
What is the role of the real exchange rate (q) in an open economy?
It varies in response to permanent AD and supply shocks, acting like the real interest rate in a closed economy
What are the two stabilization channels in the open economy?
Interest rate channel and exchange rate channel
How does an interest rate rise affect the exchange rate?
Higher interest rates attract capital, leading to currency appreciation and reduced aggregate demand
What are the assumptions of the open economy model?
Perfect international capital mobility
small country assumption
perfect bond substitutability
What is Home-cost pricing?
Exporters set prices based on domestic costs in home currency
What is World-pricing?
Exporters match foreign competitors’ prices in foreign currency, squeezing margins if domestic costs rise
What is Purchasing Power Parity (PPP)?
The idea that traded goods should have the same price across countries after accounting for exchange rates
What is Covered Interest Parity (CIP)?
Interest rate differentials are offset by forward exchange rate differentials
What is Uncovered Interest Parity (UIP)?
Interest rate differentials are offset by expected future exchange rate changes
How does a rise in foreign interest rates affect the UIP curve?
The intercept moves up, and the home currency depreciates
What happens if the central bank raises rates less than expected?
The home currency depreciates
How does UIP affect exchange rates?
Exchange rates adjust immediately to changes in expected interest differentials and long-run expectations
What happens in the short-run under a floating exchange rate?
Prices are fixed, and the central bank uses r to stabilize output
What happens in the medium-run?
Prices and wages adjust, and output depends on productive capacity, not monetary policy
What happens to monetary policy autonomy under a fixed exchange rate?
There is no autonomy—exchange rate is pegged to a foreign currency
What does the IS curve look like in an open economy?
It includes exports and imports, making it less responsive due to leakages abroad
What shifts the AD curve in an open economy?
Fiscal policy and other demand shocks shift the AD curve; MP moves along it
How does a central bank interest rate cut affect the AD curve?
It shifts output up, causes real depreciation, and increases foreign demand for goods
