The open economy

Question 1

Openness in markets

Answer 1

• openness in goods markets: there can be no tariffs or quotas. Any good can be bought
• openness in financial markets: there is no capital. Any foreign or domestic investment can be made
• openness in factor markets: freedom of movement (people)

Question 2

What is the current account, interest parity, and real exchange rate?

Answer 2

The capital account is the flipside of the current account. If you exclude currency reserves, the accounts will no longer mirror each other and can both be positive.

Interest parity: appreciation - the exchange rate goes up and vice versa with depreciation. If the exchange rate is expected to appreciate E will be smaller in approximation.

Real exchange rate: the price of Swiss goods in €/ price of goods from EU in €

Question 3

Nominal and real exchange rates

Answer 3

in an open exchange rates regime, the government (i.e.) the national bank) lets the exchange rate float around freely however it likes

the nominal exchange rate is defined as the price of the domestic currency in terms of the foreign currency

whereas the real exchange rate is defined as the nominal exchange rate times the ratio of the price levels in each respective country

the real exchange rate and the nominal exchange rate always move closely together, and the nominal exchange rates tend to be quite stable.

Question 4

flexible vs fixed exchange rate regimes

Answer 4

flexible:
- depreciation: domestic currency becomes worth less
- appreciation: domestic currency rises in value

fixed:
- devaluation: domestic currency becomes worth less
- revaluation: domestic currency rises in value

Question 5

the Mundell-Fleming model

Answer 5

simultaneous equilibrium in the goods market (IS curve), foreign exchange market (interest parity), and the money market (interest rate of LM curve)

it’s an important framework for small open economies to understand the effect of economic policies

Question 6

Analysis of Monetary and fiscal policy

Answer 6

• Restrictive monetary policy that restricts and controls pressure
• With a fixed exchange rate regime, the monetary policy can’t do this – you can only expand fiscal policy with a flexible exchange rate
• Interest rate affects output also through exchange rate channel – if lower interest rates boost depreciation, which then affects the output
• Monetary policy isn’t effective with fixed exchange rates because it’s endogenous. If output increases this boosts imports

Question 7

How to obtain equilibrium in the Mundell-Fleming model?

Answer 7

determining endogenous variables:
- flexible rates mean that the central bank is free to do what they want
fixed rates mean that exchange rates need to be set to interest rate

Question 8

Case of fixed exchange rates

Answer 8

It can happen, that it won’t correspond to market fundamentals
- during the EMS crisis the UK used the country’s reserves to defend the exchange rate (risky)
- with the expected appreciation crisis, a lot of funds were moved to CH, funding additional appreciation pressure

Question 9

Expectations and exchange rate crisis

Answer 9

Devaluations can trigger exchange rate crisis
- either devalue or
- keep parity: cost in terms of high interest rates and potential recession

volatility through self-fulfilling expectations
- criteria for optimal currency areas: symmetric shocks and factor mobility within the currency area