Shocks and Equilibrium in the open economy Flashcards
Equilibrium in the open economy.
AD curve: y=y(ad)
ERU curve: y= ye (constant inflation).
Real exchange rate: q = q bar
Difference between shocks in an open and closed economy.
In the open economy: the medium run real rate is pinned down by r* (world rate), so q moves in response to shocks.
In the closed economy: the is a new stabilising real rate in response to shock. We arrive at this new rate after the shock’s impact and policy maker’s response.
Draw a positive supply shock diagram in the open economy and describe what happens.
(Vertical ERU)
A positive supply shock would be caused by an upwards shift of the PS curve along the WS curve, as a result of an increase in productivity. This raises real wages.
At the new WS=PS equilibrium, the ERU curve has shifted rightward along the AD curve, leading to a rise in employment and output.
The outward shift of the ERU curve will lead to a rise in q (real depreciation), as the interest rate is fixed. The depreciation was necessary bc at the new higher output, there would have been insufficient demand without it.
Draw a positive demand shock diagram in the open economy and describe what happens.
(Vertical ERU)
A positive demand shock would be caused by an increase in “demand shift” factors, represented by A in the AD curve. Let’s say government spending increases.
This would cause an outward (downward) shift of the demand curve along the ERU causing a real appreciation. This is because, at the old real interest rate, demand was too high, so a new appreciated rate was needed to dampen exports.
Draw a negative demand shock diagram in the open economy and describe what happens.
(Vertical ERU)
A negative demand shock would be caused by a fall in “demand shift” factors, such as a fall in autonomous consumption or government spending.
This would cause an inwards (upwards) shift of the AD curve, leading to a deprecation (fall in q). This is because, at the old exchange rate, demand was too low, so a new depreciated rate is needed to boost exports.
Draw a negative supply shock in the open economy and describe what happens.
(Vertical ERU)
A negative supply shock would be caused by either a rise in WS factors or a fall in PS factors, such as a rise in unionisation.
This would cause a leftward shift of the WS factors, leading to a leftward shift of the ERU curve along the AD curve. As a result, there would be a real appreciation, as at the old equilibrium, the real exchange rate would have been too low.
