Open Economy - policy reactions

Question 1

How does a real exchange rate depreciation affect output in an open economy?

Answer 1

Net exports increase (as domestic goods become cheaper to foreigners) and output increases

Question 2

Why is the required interest rate hike smaller in an open economy?

Answer 2

Because exchange rate appreciation helps dampen demand, reducing the need for large rate hikes

Question 3

What is the UIP’s role during inflation shock stabilisation?

Answer 3

It shifts based on expected appreciation, influencing the IS curve and exchange rate movements

Question 4

How does the Central Bank stabilize inflation in an open economy?

Answer 4

It raises the interest rate, causing real appreciation and shifting IS left
Then gradually lowers rates and allows q to depreciate

Question 5

How does the open economy IS curve differ from the closed economy?

Answer 5

It includes q, so exchange rate changes affect output, making it flatter and more reactive

Question 6

What is the RX curve in open economy models?

Answer 6

It shows the interest rate needed to achieve a given output gap, factoring in forex movements via UIP

Question 7

How does the Central Bank respond to a negative AD shock in an open economy?

Answer 7

It lowers interest rates, q depreciates, and output is raised via demand stimulus

Question 8

What is exchange rate overshooting?

Answer 8

When the exchange rate moves more than necessary before settling at the new MR equilibrium

Question 9

Why do exchange rates overshoot?

Answer 9

Due to short-run price rigidity and fast-adjusting expectations about inflation and exchange rates

Question 10

What happens to the exchange rate after an inflation shock?

Answer 10

Initial appreciation is fully reversed over time

Question 11

What happens to the exchange rate after an AD shock?

Answer 11

Only part of the initial depreciation is reversed over time