Open Economy Medium Run

Question 1

Medium run characteristics

Answer 1

• Short-run adjustments have taken place, so we don’t include them.
• The supply side is in equilibrium, with WS=PS.
• Inflation is constant.
• Domestic real interest rate doesn’t deviate much from the world interest rate.
• Goods market is in equilibrium, so output = demand.

Question 2

Supply in the open economy

Answer 2

For inflation to be constant, supply must be in equilibrium. No deviation of the wage demanded by workers from the real wage firms is willing to pay. W^ws = P^ps.

The Supply-side is ERU, as it a reminder that the supply side comes from the labour market.

Inflation is constant along all points on the ERU curve.

Question 3

How would a leftward (inward) shift of the WS curve affect the ERU?

Answer 3

Caused by a rise in WS factors, e.g. increased unionisation. Real wage demands rise, but real wage is fixed by the PS curve. Fewer ppl are willing to work at the original wage.

It would also lead to a leftward shift of the ERU curve, leading to lower output and employment.

Question 4

Demand in the Open Economy

Answer 4

The demand curve is derived from the open economy IS curve and UIP. We now incorporate exports and imports, which respond to q movements.

Real UIP condition means home and world interest rates must be identical. rt = r*
Therefore no time subscripts on open economy demand curve, bc at all times, home and world rates are identical.

y= A - ar* + bq

Question 5

IS curve open economy

Answer 5

yt= At - art-1 + bqt-1

q= real exchange rate.
b= positive parameter.
A rise in qt-1 means a depreciation in currency last period, and will therefore boost demand this period.

a= constant parameter
rt-1= increase in the real interest rate last period will depress demand this period.

At= exogenous or “demand shift” factors: E.g. world trade and government spending.

Question 6

What does the open economy AD curve show?

Answer 6

It shows all the combinations of log real exchange rate (q) and real output y at which the goods market is in equilibrium. Real interest rate equals world real interest rate, and it is plotted in q-y space.

Depreciation (rise in q) will boost AD.