openness in the markets Flashcards
what is openness in the goods market ?
refers to the degree to which country’s engage in trade.
- in foreign goods bought from foreign countries
and domestic goods bought by a foreign country
this is expressed as a % of GDP
the larger the % the more open the economy
the uk is a very open economy, why are there arguments that we should be less open ?
it makes us very susceptible to shocks in other countrys
what is the relationship between trade and domestic output ?
AD rises , Y rises
FOREIGN rises , Y falls
when deciding whether or not to buy domestic or foreign goods/services consumers must consider the nominal ER. what is the nominal exchange rate ?
the price of domestic currency in terms of foreign currency.
uk residents must be concerned about the cost of uk goods relative to their cost in euro currency.
this means that they must look at the real exchange rate, what is the real exchange rate ?
price of domestic goods in terms of foreign
3 = EP / P*
EP = price of domestic good in domestic currency x nominal ER
P* = price of euro area goods
how do we use the real exchange rate ?
we consider the rate of change of 3 not actual 3 changes called depreciation or appreciation.
what is an increase / decrease in the RER called ?
increase - appreciation
decrease - depreciation
whats the problem with RER ?
its only Bi lateral and the uk has many main trading partners which we must consider to determine strength of currency.
what is the REER ?
real effective exchange rate.
this is the value of domestic currency relative to value of ER of trading partners.
what is the structure of the BoP ?
record of transfers with the rest of the world
comprised of 2 main accounts
current :
- X + M ( goods and services )
- recipes and payments of investment income
- unilateral transfers (gifts between economies )
capital :
- flows of investment across borders
- direct vs portfolio investment
what issues are there with the bop accounts being in balance ?
there are measurement issues.
if a country is running a current account deficit, how is it financed ?
. sell assets
. borrow money to finance
. use cb currency reserves - limited to keeping value of 3 months of imports
selling assets is most desirable
when considering whether or not to hold foreign or domestic assets what do we consider ?
- we must confine to one asset class SR , IR bearing assets
- we must factor in the idea that foreign assets are affected by the nominal exchange rate
- domestic bond rates
- foreign bond rates
- current nominal exchange rate
- expected exchange rate in a year
why do we use the UNCOVERED INTEREST PARITY CONDITION ?
if we use this it takes into account all the factors necessary into account and therefore helps us chose between foreign and domestic assets
what reduces the expected rate of return on foreign financial assets ?
- expected appreciation of domestic currency
- or depreciation of foreign currency
what is the UNCOVERED INTEREST PARITY CONDITION ?
no transaction costs
ignores risk and uncertainty
only usable when i and Xa are less than 20 %
it ss i*t - [ Eet+1 - Et / Et ]
domestic return - it
i*t - foreign return
[ Eet+1 - Et / Et ] - expected app of domestic or depp of foreign (Xa
what happens in scenario 1 of the parity condition
where it > i*t - Xa ?
then the investors will invest into domestic bonds because the return is larger. thus funds will be flowing into the domestic bond market, until the parity is ss
what happens in scenario 2 of the parity condition
where it < i*t - Xa ?
investors will chose foreign bonds
what happens in scenario 3 of the parity condition
where it ss i*t - Xa ?
then investors are indifferent
what is the full interest parity condition and when do we use it ?
used if i or Xa exceed 20%
1 + it = ( 1 + i*t ) / ( 1 + Xa )
how is the IS relation different in an open market ?
zz = C + I + G + X - IM / 3
I’m - imports in terms of pounds
3 = exchange rate
what are the equations for
a. imports
b. exports
a. IM = IM ( Y , 3 )
( +, + )
b. X = X ( Y* , 3 )
( + , - )
exports are autonomous determined outsidewhen imports are added to DD what happens to the curve ?
it becomes flatter because at higher levels of income you have to remove more imports
what happens to the curve, after imports have been added, when exports are added ?
the curve is shifted up to become the ZZ curve .
where on a graph with the zz and dd curves is trade balance ?
where they cross
where is there a trade surplus or trade deficit on the dd and zz curve ?
at income below Ytb - surplus
at income beyond Ytb - deficit
consider an increase in domestic demand, how does this effect the ZZ curve ?
consider gov increases G - income increases - output increases - and trade balance falls
- G increases - ZZ shifts up
- Y increases
and as Y2 is beyond where the original trade balance equilibrium is below it ( because the balance hasn’t adjusted yet )
it means there is a trade deficit
what is different about the multiplier in an open economy ?
zz is flatter than dd which implies multiplier is smaller in open economy
in an open economy, an increase in Y not only satisfied by domestic goods but also an increase in imports
consider an increase in domestic demand, how does this effect the ZZ curve ?
consider an increase in Y*
increase in total D*
increase in demand for X
shift of ZZ curve upwards
also shifts the whole NX as every level of domestic income exports are increased.
there is a trade surplus.
what is coordination between countries of fiscal policy desirable ?
because when only one country implements fiscal policy it can lead to a larger Bop deficit, but is both countries coordinate it can mean that AD for both countries rises but the Bop stays the same
why is there limited actual evidence of governments coordinating their fiscal policy ?
- some countries would have to do more than` others
- there is a high motivation to cheat/pull out of the deal
- may not have desired effect ( difficult to know marginal propensity to import/export)
what are the home multiplier and foreign multiplier for the effect that fiscal policy has when countries trade a lot with each other ?
home = 1 / (1 - c1 + m/3)
foreign = 1 / (1 - c1 + m/3)
how does the fiscal multiplier different in an open economy to a closed one ?
in an open econ the multiplier is lower than an closed economy
what is the marshall lerner condition ?
the condition that when holds means that for a real depreciation net exports increases because exports have risen more than the value of imports ( IM/3)
what is the J curve ?
it is a concept based on consumers imperfect knowledge and immobility.
when the exchange rate appreciates, the trade balance actually gets a lot worse because the value of imports increases and it takes consumers time to realise that their imported goods are more expensive and find alternatives.
