Short run open economy (UIP, floating/fixed exchange rate regimes, the Eurozone)

Question 1

Define UIP

Answer 1

The arbitrage condition in FOREX markets, where the return on investing at home must be equal to the return from investing in any other country

Question 2

What is the mathematical equation for UIP?

Answer 2

E_t = (RW_t - RD_t ) + E_(t+1)^e

E is the nominal exchange rate: increase in this term is a depreciation of the domestic currency / rise in competitiveness

RW_t is the world nominate interest rate in period t

RD_t is the domestic nominal interest rate in that period

E_(t+1) is the expected nominal exchange rate in the next period

Can also be written in real terms (lowercase)

Question 3

How, mathematically, do we get to the medium run equilibrium real exchange rate?

Answer 3

E_t = (RW_t - RD_t) + E_t+1^e

e_t = (rw_t - rd_t) + e_t+1^e

Replace the last term with the UIP condition for the next period. Keep doing this for n periods…

e_t = (rw_t - rd_t) + (rw_t+1^e - rd_t+1^e) + … + (rw_t+n^e - rd_t+n^e) + e_t+n+1^e

The last term is the medium run equilibrium real exchange rate, as shown on the Swan diagram.

Question 4

What happens (according to UIP) if there is an unexpected 4-year rise in interest rates of 1% a year?

Answer 4

The real exchange rate will immediately appreciate by 4%, and then depreciate by 1% a year, so that the medium run rate doesn’t change.

If the change is anticipated, the initial jump up happens when the announcement is made.

Question 5

What does UIP show?

Answer 5

If interest rates (real/nominal) are held at world levels, and are expected to remain that way, then any changes in the expectd medium run equilibrium exchange rate will immediately lead to an identical change in the short run exchange rate in the current period

Question 6

What happens if there is a permanent negative demand shock (AD shifts left) when there are FLEXIBLE exchange rates? [3]

Answer 6

1) In the medium run (stable inflation), the economy will be on the ERU curve - so the medium run equilibrium exchange rate (on Swan diagram) moves upwards
2) According to UIP, this means that the short run exchange rate will also depreciate by the same amount, instantaneously
3) Since the transition is instant, there is no need for policy intervention (at new medium run equilibrium)

C&S addition: In the short run, output is fixed, so adjustment is not instant. When AD moves, the economy comes off the ERU curve. Worker demand higher wages, firms put prices up, and domestic prices higher than word prices cause a real exchange rate appreciation, moving the economy down the new AD curve to the medium run equilibrium.

Question 7

How can policy makers make the transition to lower output (following a negative demand shock in a floating exchange rate system) more gradual?

Answer 7

By lowering interest rates:

Cause a depreciation past the medium run equilibrium, allow inflation (this might be costly), and then slowly bring rates back up to world levels, softening the shift to medium run equilibrium.

Question 8

What is Dornbusch overshooting? [6]

Answer 8

1) Change in monetary policy (e.g. unanticipated permanent decrease in the money supply by 10%, to get inflation down)
2) Interest rates rise to reduce money demand
3) Gradually, goods prices fall, and interest rates go back down
4) The medium term nominal exchange rate must appreciate by 10% (since goods prices will have fallen by 10%)
5) But, in the meantime, interest rates will have been higher
6) So in the short run, the exchange rate will appreciate by more than 10% - an overreaction

Question 9

What is the solution to Dornbusch overshooting?

Answer 9

Fiscal policy - don’t change interest rates when you change the money supply; instead deflate the economy through a temporary move in the AD/IS curve

Question 10

What happens if there is a permanent negative demand shock (AD shifts left) when there are FIXED exchange rates? [5]

Answer 10

1) Since prices are sticky, a fixed nominal exchange rate means a fixed real exchange rate in the short run - and the economy suffers a large fall in output as AD shifts
2) Since demand and output have decreased, the economy is no longer on the ERU, indicating deflationary pressure
3) The Impossible Trinity means that with a fixed exchange rate, and free capital flows, you cannot change interest rates - so painful deflation occurs
4) With prices in your country rising slower than elsewhere, the real exchange rate starts depreciating - the economy slowly moves up the AD curve, back onto the ERU
5) The medium run equilibrium is eventually reached, but output has been below the natural level even for new lower levels of AD

Question 11

What happens if you are below (above) the ERU curve?

Answer 11

Inflation falls (rises)

Question 12

What is the alternative to painful devaluation in a fixed exchange rate regime (after a permanent negative demand shock)?

Answer 12

Devaluation of the nominal exchange rate

Question 13

What are the problems with a one-off devaluation?

Answer 13

1) The economy is not only hit with the original low output, but then very quickly by soaring prices and inflation, which erodes real wages
2) People with overseas borrowings suddenly face larger interest payments
3) Loss of credibility of the exchange rate peg

Question 14

Why would a country peg its exchange rate? [3]

Answer 14

1) Should give credible inflation control (if you peg to somewhere like Germany)
2) Encourages trade between countries
3) Shields the domestic economy from volatile exchange rate swings

Question 15

What are the problems with a pegged currency? [3]

Answer 15

1) Loss of monetary policy (can’t change interest rates)
2) Build up of reserves in order to maintain the peg - which can be costly
3) No automatic rebalancing of trade deficits

Question 16

What are the three main problems in the Eurozone that make it likely to experience a decade of low growth?

Answer 16

1) Fiscal excess - peripheral countries’ interest rates fell dramatically when they joined, leading to booms, inflation, a loss of competitiveness, and a reliance on fiscal spending
2) Competitiveness - the periphery must go through painful periods of deflation to regain competitiveness (can’t use monetary policy as they’re at the ZLB and Germany will not compensate, also can’t use fiscal policy)
3) Banking contagion - exacerbated the problem