Term 2: Week 5 - Open Economy Macro

Question 1

Foreign Exchange (forex) market.

Answer 1

• Connect interest and exchange rates
• affects economy’s reaction to shocks.
• e.g. a rise in home country interest rates (UK) makes UK gilts more attractive, as return on gilts are now higher.
• Therefore, the financial market sells dollars for pounds in order to buy gilts.
• Forex market reacts super quickly, and the UK exchange rate appreciates.
• Exchange rates “jump” in response to news affecting relative bond yields across countries.

Question 2

Nominal exchange rate

Answer 2

• The rate at which one country’s currency is converted into the other’s
  e = number of units of home country/ number of units of foreign currency.
• a rise in e represents a depreciation in home currency. That is more units of home currency are required to buy a single unit of foreign currency.

Question 3

Real exhange rate

Answer 3

• takes account of price differences between the country, and so relates to the exchange of the volume of goods/services.
• Home’s real exchange rate (RER):
  Q= P*e/P
• Where P* is the price in foreign country.
• P is price in home country
• e is nominal exchange rate.
• A rise in Q represents a depreciation in home currency.
• Where Q measure competitiveness. If currency depreciates, then home country become more competitive, as exports become cheaper, boosting net exports.

Question 4

Open economy stabilistion

Answer 4

• The central bank stabilises economy after exchange rate shocks
• We assume that there is a one period time lag between exchange rate, and impact on output through the IS curve.
  -The CB takes forex reaction and exchange rate impacts into account when setting monetary policy.
  The open economy has 2 stabilisation channels: the interest rate and the
  exchange rate channels

Question 5

Open economy stabilisation example

Answer 5

• A shock in the economy, raises inflation beyond time period t.
• This causes the central bank to increase nominal interest rates.
• thereby decreasing the output gap, and decreasing inflation.
• Forex predicts this and increases returns to home bonds.
• Therefore home currency appreciates, causign net exports to fall, therefore AD falls, and inflation falls.
• therefore CB raises by less than the closed economy case as the existence of the exchange rate channel produce the same direction impact on inflation and output gap.

Question 5

Open economy stabilisation example

Answer 5

• A shock in the economy, raises inflation beyond time period t.
• This causes the central bank to increase nominal interest rates.
• thereby decreasing the output gap, and decreasing inflation.
• Forex predicts this and increases returns to home bonds.
• Therefore home currency appreciates, causign net exports to fall, therefore AD falls, and inflation falls.

Question 6

UIP (Uncovered interest rate parity)

Answer 6

• the difference in interest rates between two countries will equal the relative change in exchange rates over the same period.
• Assumes that future exchange rates do not change.

Question 7

Supply in the medium run

Answer 7

• medium run equilibrium, in any economy, inflation is constant.
• constant-inflation equilibrium, WS and PS curves must intersect. There must be no deviation of the real wage demanded by workers from the real wage firms are prepared to pay; it must be the case that.
• That is W(ws)=W(ps)
  WS-PS intersection pins down the equilibrium rate of unemployment at constant inflation.

Question 8

ERU (equilibrium rate of unemployment)

Answer 8

• medium run aggregate supply curve is called ERU because the medium run supply curve corresponds to the equilibrium rate of unemployment.
• the equilibrium rate of unemployment is where the ws and the ps curve intersect.
• no upward or downward pressure on prices.

Question 9

WS and PS

Answer 9

when WS curve is below PS, causes downward pressure on inflation.
when ws curve is above PS , upward pressure on inflation.