The open economy Flashcards
Capital mobility
Firm’s choice of production locations
Labour mobility
Example: free movement of workers in the EU
domestic demand for goods
Demand within the country for both domestic and imported goods.
The demand for domestic goods
demand for domestically produced goods by both domestic consumers and foreign buyers (exports)
The demand for domestic goods: calculation
Z = C + I + G - IM/e (exchange rate) + X
–> subtracting the value of imports from domestic demand and then adding exports.
Domestic demand for goods : calculation
C + I + G = C(Y-T) +I( Y,r)+G
–> Consumption depends positively on disposable income
–> investment depends positively on production, Y, and negatively on the real policy rate, r.
higher domestic income leads to ..
higher import
The more expensive domestic goods are rela- tive to foreign goods—or, equivalently, the cheaper…
foreign goods are relative to domestic goods
–> et inversement
imports: calculation
IM = IM(Y, e)
Tradable good
goods that compete with foreign goods in either domestic markets or foreign markets.
The real exchange rate
the price of domestic goods relative to foreign goods
nominal exchange rate
as the price of the domestic currency in terms of foreign currency (E)
appreciation of the domestic currency is..
an increase in the price of the domes- tic currency in terms of a foreign currency.
A depreciation of the domestic currency is..
a decrease in the price of the domestic currency in terms of a foreign currency
fixed exchange rates
a system in which two or more countries maintain a constant exchange rate.
revaluations
increases in the exchange rate
devaluations
Decreases in the exchange rate
real appreciation
An increase in the real exchange rate—that is, an increase in the relative price of domestic goods in terms of foreign goods
real depreciation
A decrease in the real exchange rate—that is, a decrease in the relative price of domestic goods in terms of foreign goods
real exchange rate : equation
e = E x P/P*
P: domestic price level
P* : foreign price level
bilateral exchange rates
exchange betweem two country
multilateral exchange rates
many exchange in the world
foreign exchange
The volume of transactions in foreign exchange markets gives a sense of the importance of interna- tional financial transactions
A country’s openness in financial markets has an important implication
allows the country to run trade surpluses and trade deficit
Trade deficit
buying more from the rest of the world than it is selling to the rest of the world
–> To pay for the difference between what it buys and what it sells, the country must borrow from the rest of the world. It borrows by making it attractive for foreign financial investors to increase their holdings of domestic assets
balance of payments
Trade flows and financial flows
current account transactions
The transactions above the line record payments to and from the rest of the world.
current account balance
all financial transactions between residents of a country and the rest of the world
–> flow of goods, services, income, and transfers,
current account surplus
If net payments from the rest of the world are positive
current account deficit
If net payments from the rest of the world are negative
financial account
flow of financial capital and reflects how a country finances its current account balance
uncovered interest parity relation: calculation
it ≈ i*t - E^et+1 - Et / Et
it : domestic interest rate
it* : foreign interest rate
uncovered interest parity relation: definition
domestic interest rate must equal the foreign interest rate minus the expected appreciation (or depreciation) of the domestic currency.
Application to Exchange Rate Movements (uncovered interest parity relation)
interest rates in different countries tend to move together
The UIP condition assumes that.. (abritage and expected return)
financial investors care only about the expected rate of return and will invest in the bonds with the highest expected return, ignoring differences in risk or transaction costs
What affect demand for good ?
the interest rate, taxes, government spending, foreign output, and the real exchange rate
The demand for domestic goods (graphically )
The line ZZ (figure 18.1)
Equilibrium condition
determines output as a function of all the variables we take as given, from taxes to the real exchange rate to foreign outpu
The Effects of an Increase in Government Spending
An increase in government spending leads to an increase in output and a trade deficit.
The equilibrium level of output is given by..
Y = Z
–> The goods market is in equi- librium when domestic output is equal to the demand for domestic goods.
The increase in output is larger than the increase in government spending : so what ?
There is a multiplier effect
The Effects of an Increase in Foreign Demand
An increase in foreign demand leads to an increase in output and a trade surplus.
An increase in domestic demand leads to
an increase in domestic output but also to a deterioration of the trade balance
An increase in foreign demand lead to
an increase in domestic output and an improvement in the trade balance.
Marshall-Lerner condition
real depreciation leads to an increase in net exports
The depreciation leads to a shift in…
foreign and domestic, toward domestic goods
Reducing the Trade Deficit without Changing Output, what does the government do?
the government must both achieve a depreciation and decrease government spending
current account : equation
Y = C + I + G + EX − IM
Mundell-Fleming model
A model of simultaneous equilibrium in both goods and financial markets for an open economy
The IS-LM Model in an Open Economy
An increase in the interest rate reduces output both directly and indirectly (through the exchange rate). The IS curve is downward sloping, for both reasons. The LM curve is horizontal at the interest rate set by the central bank
–> Figure 19,2
The effect of Monetary policy in open economy : increase the interest rate (flexible interest rate)
An increase in the interest rate leads to a decrease in output and an appreciation
LM curve change positon
figure 19.3
Fiscal policy: The effects of an increase in governing spending with an unchanged interest rate (flexible interest rate)
An increase in government spending leads to an increase in output. If the central bank keeps the interest rate unchanged, the exchange rate also remains unchanged
IS curve shift to the right
Flexible Exchange Rates: Equilibrium is determined (Mundell-Fleming model)
Equilibrium is determined by the IS curve and the interest parity condition, yielding values for 𝑌 and 𝐸
–> the domestic interest rate is set by the central bank and is a key factor in determining the level of domestic output 𝑌
The Effects of an Increase in Government Spending
When the Central Bank Responds by Raising the
Interest Rate
An increase in government spending leads to an increase in output. If the central bank responds by raising the inter- est rate, the exchange rate will appreciate
IS shift by the right
LM upwards
–> see figure 19.5
both consumption and government spending increase, what happened ?
consumption goes up because of the increase in income, and government spending goes up by assumption
Fixed Exchange Rates: Equilibrium (Mundell-Fleming model)
Equilibrium is determined by the IS curve and the LM curve, yielding values for 𝑌 and domestic interest rate
–>The domestic interest rate must equal the foreign interest rate to maintain the fixed exchange rate, which means the intersection of the IS curve and the LM curve will determine both the domestic output Y and the interest rate 𝑖
devaluation
decrease in the exchange rate under a regime of fixed exchange rates
–> rather than depreciation
crawling peg
is a type of exchange rate regime in which a country’s currency is fixed to another currency
Monetary policy with fixed exchange rate
the domestic interest rate must be equal to the interest rate of the foreign country the country is pegging to
–> refer to the interest parity condition
Fiscal policy Fiscal Policy When the Exchange Rate Is Fixed
By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbalances or changing the level of economic activity.
By committing to a given exchange rate, a country also gives up control of its interest rate
Although the country retains control of fiscal policy, one policy instrument may not be enough
–> a fiscal expansion can help the economy get out of a recession
float
allow a move from a fixed to a flexible exchange rate regime.
–> in the medium run
floating exchange rate regime
is the same as a flexible exchange rate regime
Expectations that a devaluation may be coming can trigger an..
exchange rate crisis
To faced to the expectation that a devaluation may be coming can trigger an exchange rate crisis, the government can ?
- give in and devalue, or
- fight and maintain the parity, at the cost of very high interest rates and a potential
recession. Fighting may not work anyway; the recession may force the government to change policy later on—or force the government out of office.
Exchange rates often move even in the absence of…
movements in interest rates
a relation among current and expected future domestic and foreign real interest ratese
equation (20,5)
The exchange rate today depends on both:
- the difference between current and expected future domestic interest rates, and current and expected future foreign interest rates
2.the expected future exchange rate
The interest parity condition implies that..
- differences between domestic and foreign interest rates can be explained by expected changes in the nominal exchange rate.
-if the domestic interest rate is above the foreign interest rate (it > i∗t ), investors expect that the nominal exchange rate will decrease.
-if the foreign interest rate is above the domestic interest rate (i∗t > it), investors expect the domestic currency to appreciate.
