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Princples Of Economics-Macro > The Open Economy > Flashcards

The Open Economy Flashcards

1
Q

Nominal exchange rate definition

A

The price of one currency in terms of another

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2
Q

Real exchange rate definition

A

The relative price of domestic goods in terms of foreign goods

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3
Q

Real exchange rate formula and how to know which is cheaper

A

Exchange rate x Domestic price (P) / Foreign Price (P*)

If answer is less than one, domestic is cheaper than foreign

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4
Q

What is a net exporter/importer

A

Net exporter-when exports>imports

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5
Q

Balance of payments

A

Records financial transactions flowing in and out an economy

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6
Q

Forms of transactions in BOP (3) and which account are they recorded in

A

Trade in goods/services-current account
Capital movements-capital account
Financial flows-financial account

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7
Q

Capital account

A

Records capital transfers of non-produced, non-financial assets. E.g copyright, patents, trademarks

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8
Q

Financial account components (5)

A

FDI
Portfolio investment
Transactions in financial derivatives
Reserve assets
Other

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9
Q

Difference between FDI and portfolio investment

A

Control- FDI allows investor to have direct influence over firm

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10
Q

Derivatives and examples

A

Financial instruments e.g options, futures and swaps.

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11
Q

Reserve assets

A

Foreign exchange reserves that the central bank holds e.g bonds, other currencies etc.

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12
Q

Is an increase in FCR a negative or positive entry on BOP

A

Negative as money going out in exchange for FCR

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13
Q

What does other component include

A

Borrowing and lending

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14
Q

Is borrowing and lending in other component positive or negative in BOP

A

Borrowing-positive-money inflow
Lending-negative-outflow

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15
Q

Autonomous transactions and name them from each account

A

Autonomous transactions are for own benefit.

Current account items are autonomous as we import items for personal benefit
Capital account items are autonomous
Financial account (only FDI and portfolio are autonomous)

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16
Q

Accomodating transactions and example

A

Undertaken for BOP purposes.

All other items on financial account are accomodating-essential to balance out the BOP

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17
Q

Two ways an open economy interacts with other countries. and equation that links them

A

Buying/selling goods and services (net exports NX)-current account
Buying/selling assets (net capital outflow NCO)-capital/financial account

CA+KFA=0 (BALANCE EACH OTHER!)

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18
Q

Closed economy identity vs Open economy national income identity

A

Total expenditure=total output
Vs
C+I+G+NX

Domestic spending can exceed output (import>exports)-trade deficit
Output can also exceed domestic spending (exports>imports)-trade surplus

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19
Q

Net capital outflow formula (NCO)

A

Capital outflow (CO) -Capital inflow (CI)

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20
Q

Capital outflow vs inflow

A

Outflow is purchase of foreign financial assets by domestics
Inflow is purchase of domestic financial assets by foreigners

21
Q

Capital and financial account (KFA) and net capital outflow (NCO) relationship and why

A

KFA=-NCO

Thus means NCO<0 so CI>CO, Payments from foreigners (CI) are positive in BOP, but enters NCO negatively. This is because it is money we owe to others as they purchased an asset from us therefore NCO negative

Foreigners BUYING OURASSETS=negative NCO

22
Q

Net buyer or seller of financial assets???

A

CO>CI. NCO Surplus-we buy more foreign assets
CI>CO. NCO Deficit-we sell more domestic assets (so saving>investment, so we lend out)

Basically opposite of how trade balances work.
Trade surplus-sell more than buy
NCO surplus-buy more than sell

23
Q

What domestic citizens need foreign currency for (2), and so what do they do

A

Imports
Capital outflows

So supply domestic currency
IM+CO

24
Q

What foreign citizens need domestic currency for (2)

A

Exports
Capital inflows (from domestic POV-BUYING ASSETS FROM DOMESTICS)

So demand domestic currency
EX+CI

25
Q

Supply and demand is IM+CO=EX+CI and can be rearranged as..

And how can it be seen in BOP formula

A

Ex-IM=CO-CI which is just NX=NCO

BOP=CA+KFA=0
Where CA=NX KFA=-NCO

26
Q

NCO balance in a trade deficit

A

Trade deficit means import>exports so NX<0

As NX=NCO NCO is also <

As a result of increased income from selling their exports, foreigners can spend more on domestic assets (CI). So NCO will mean CI>CO (we sell more domestic financial assets to foreigners) which is also a NCO deficit

AND BECAUSE KFA=-NCO, it is a KFA surplus

27
Q

Loanable funds market for an open economy IN TERMS OF BORROWING AND LENDING (where NCO>0 or NCO<0)

A

NCO<0-more domestic assets are sold. So this is net borrowing-we are borrowing savings (in exchange for our assets) from foreigners (can then be invested)

NCO>0-saving>investment we buy more foreign assets than we sell. So we are lending (in exchange for foreign assets) to foreign economy (which they can invest)

28
Q

Supply of funds in open economy formula

A

Supply= Savings (S)- NCO

SUPPLY=INVESTMENT IN CLOSED ECONOMY, BUT IN AN OPEN ECONOMY THERE IS INFLOWS AND OUTFLOWS OF MONEY SO NCO INCLUDED.

SO
Savings-NCO=Investment
Savings=Investment+NCO
Savings-Investment=NCO

29
Q

S-i=NCO Significance

A

If NCO positive
It means S>I, which means savings is left, which is lent abroad

If NCO negative
I>S, which means THEY WANT TO INVEST MORE THAN THEY SAVE, AND the difference in money wanted to invest is borrowed from abroad

30
Q

Relationship between NCO and interest rate r

A

As domestic interest rate goes up. Investment more attractive, creating CI>CO , so NCO falls.

Inverse relationship-HIGHER INTEREST=LOWER NCO

31
Q

LFM diagram axes

A

R-interest rate y axis
NCO-x axis

32
Q

Diagram to represent NCO and interest rate relationship

A

Downward sloping NCO
Dotted vertical line through NCO

Left of the line=NCO<0 as interest rate gets higher, more foreigners purchase domestic assets (CI>CO) so explains why NCO<0

Right of the line NCO>0 as lower interest means we buy more foreign assets so CO>CI, so explains why NCO>0

33
Q

LFM model diagram for open economy

A

Supply (saving) still vertical

Demand=Investment+NCO

As remember Saving=Investment+NCO

34
Q

Axis of foreign exchange market (FEM) model

A

Y axis- real exchange rate
X axis- NCO/NX

35
Q

Where does the supply of domestic currency come from in the FEM model? And why?

A

NCO, as S-I=NCO.

If NCO is positive, S>I, so economy saves more than invests, and so domestic currency is supplied.

NCO is the supply of domestic currency, as S-I

36
Q

What is NCO determined by?

A

Real interest rate

Higher r=lower NCO as more capital inflows (CI>CO)

37
Q

What does supply for FEM look like on diagram

A

Vertical line.

38
Q

What does demand for domestic currency depend on and why?

A

Because we assume homogeneity with goods and services, we say it depends on the real exchange rate.

(Due to homogeneity we ignore possible things such as quality, trade restrictions etc).

39
Q

Relationship between exchange rate and demand for currency

A

Inverse.

Strong rate=exports expensive, so export demand falls, demand for domestic currency falls.

40
Q

What does demand for domestic currency look like on diagram

A

Downward sloping, denoted NX

41
Q

FEM demand curve diagram

A

Dotted vertical line through the middle
Left of the line=NX<O, as we buy more imports and sell less exports as the exchange rate increases

Right of the line=NX>O, as a fall in exchange rate means we buy less imports and sell more exports.

42
Q

LFM and FEM axis’s and supply and demand denotations.

A

LFM-real interest rate and NCO
Supply-Savings (vertical-fixed)
Demand-Investment+NCO (depends on interest rate)

FEM-real exchange rate and NX
Supply-supply for domestic currency (vertical-fixed)
Demand-demand for domestic currency. (Depends on exchange rate)

43
Q

Expansionary fiscal policy on FEM (hint:links to LFM too)

A

1.An increase in G will decrease saving in the LFM, pushing interest rate up.

2.Increased interest causes increases in capital inflows, so NCO falls

3.Fall in NCO reduces available pounds for NX (fall in supply), causing an appreciation, so exports get more expensive, so demand for NX falls.

44
Q

Effects of import quota on FEM model

A

Imports restricted, so we have a shift in NX curve to the right for any given exchange rate. (we demand domestic currency (NX) as we no longer can buy imports)

The trade balance remains the same, as NCO is unchanged and so is NX, only change is an appreciation in exchange rate. Quota does not impact saving, investment or NCO.

(Think about in real life, no additional goods are actually being sold to foreigners, the domestic consumers are just switching to domestic goods, so it is not an export, and so trade balance remains the same, despite us demanding domestic currency again)

Remember demand for domestic currency is from G&S exports and capital inflows, but QUOTA doesn’t impact CI, hence why unchanged LFM model.

45
Q

FEM for a small open economy assumptions (3)

A

Too small to influence real interest rate, so have to accept a world interest rate. (R*)

Perfect capital mobility

Domestic and foreign bonds are perfect substitutes (financial assets yield same return)

46
Q

Domestic expansionary fiscal policy for small economy

A

As, small, real interest rate is unchanged. (r=r*)

Fiscal reduces saving (S-I=NCO), so NCO falls. (CI>CO)

Increased capital inflows appreciate currency, thus reducing export demand worsening NX.

47
Q

Expansionary fiscal policy by large economies on FEM for a small country

A

As large contribute to overall world saving, world real interest rate r* increases (unlike small)

As small countries have to accept r*, Investment decreases in small economy, as more expensive to invest.

NCO=S-I so NCO increases, CO>CI so we supply our currency.

Therefore exchange rate depreciates and NX improves

48
Q

How do we find NX=NCO

A

Work out what domestic currency is demanded for, equated to what foreign currency is demanded for

EX+CI=IM+CO

Princples Of Economics-Macro (8 decks)

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