Open Economy Stabilisation Channels

Question 1

Open-Economy Assumptions

Answer 1

1. Perfect international capital mobility.
2. The home country is ‘small’, meaning it cannot affect world interest rates.
3. Households can hold 2 types of assets: foreign and home bonds and money.
4. Perfect substitutability between home and foreign bonds. (Same default risk).

Question 2

Lags in the open economy?

Answer 2

We assume a one-period lag between exchange rate changes and the impact on output through the IS curve.

Question 3

What happens during an inflation shock in the open economy?

Answer 3

Inflation is above target. Central banks and forex traders will react.

The central bank raises the nominal interest rate, leading to a negative output gap. This puts downwards pressure on inflation.

The forex market expects the rate to rise, leading to higher yields for home bonds. Demand for £ increases leading to a currency appreciation. This leads to a fall in e and price competitiveness.

Question 4

How does the open economy affect monetary policy?

Answer 4

There are now two channels in which monetary policy has an impact: interest rate changes from the central bank and exchange rate changes.

The exchange rate channel reinforces monetary policy, meaning the CB has to raise interest rates by less than in the closed economy.