The open economy

Question 1

Capital mobility

Answer 1

Firm’s choice of production locations

Question 2

Labour mobility

Answer 2

Example: free movement of workers in the EU

Question 3

domestic demand for goods

Answer 3

Demand within the country for both domestic and imported goods.

Question 4

The demand for domestic goods

Answer 4

demand for domestically produced goods by both domestic consumers and foreign buyers (exports)

Question 5

The demand for domestic goods: calculation

Answer 5

Z = C + I + G - IM/e (exchange rate) + X

–> subtracting the value of imports from domestic demand and then adding exports.

Question 6

Domestic demand for goods : calculation

Answer 6

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.

Question 7

higher domestic income leads to ..

Answer 7

higher import

Question 8

The more expensive domestic goods are rela- tive to foreign goods—or, equivalently, the cheaper…

Answer 8

foreign goods are relative to domestic goods

–> et inversement

Question 9

imports: calculation

Answer 9

IM = IM(Y, e)

Question 10

Tradable good

Answer 10

goods that compete with foreign goods in either domestic markets or foreign markets.

Question 11

The real exchange rate

Answer 11

the price of domestic goods relative to foreign goods

Question 12

nominal exchange rate

Answer 12

as the price of the domestic currency in terms of foreign currency (E)

Question 13

appreciation of the domestic currency is..

Answer 13

an increase in the price of the domes- tic currency in terms of a foreign currency.

Question 14

A depreciation of the domestic currency is..

Answer 14

a decrease in the price of the domestic currency in terms of a foreign currency

Question 15

fixed exchange rates

Answer 15

a system in which two or more countries maintain a constant exchange rate.

Question 16

revaluations

Answer 16

increases in the exchange rate

Question 17

devaluations

Answer 17

Decreases in the exchange rate

Question 18

real appreciation

Answer 18

An increase in the real exchange rate—that is, an increase in the relative price of domestic goods in terms of foreign goods

Question 19

real depreciation

Answer 19

A decrease in the real exchange rate—that is, a decrease in the relative price of domestic goods in terms of foreign goods

Question 20

real exchange rate : equation

Answer 20

e = E x P/P*

P: domestic price level
P* : foreign price level

Question 21

bilateral exchange rates

Answer 21

exchange betweem two country

Question 22

multilateral exchange rates

Answer 22

many exchange in the world

Question 23

foreign exchange

Answer 23

The volume of transactions in foreign exchange markets gives a sense of the importance of interna- tional financial transactions

Question 24

A country’s openness in financial markets has an important implication

Answer 24

allows the country to run trade surpluses and trade deficit

Question 25

Trade deficit

Answer 25

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

Question 26

balance of payments

Answer 26

Trade flows and financial flows

Question 27

current account transactions

Answer 27

The transactions above the line record payments to and from the rest of the world.

Question 28

current account balance

Answer 28

all financial transactions between residents of a country and the rest of the world --> flow of goods, services, income, and transfers,

Question 29

current account surplus

Answer 29

If net payments from the rest of the world are positive

Question 30

current account deficit

Answer 30

If net payments from the rest of the world are negative

Question 31

financial account

Answer 31

flow of financial capital and reflects how a country finances its current account balance

Question 32

uncovered interest parity relation: calculation

Answer 32

it ≈ i*t - E^et+1 - Et / Et it : domestic interest rate it* : foreign interest rate

Question 33

uncovered interest parity relation: definition

Answer 33

domestic interest rate must equal the foreign interest rate minus the expected appreciation (or depreciation) of the domestic currency.

Question 34

Application to Exchange Rate Movements (uncovered interest parity relation)

Answer 34

interest rates in different countries tend to move together

Question 35

The UIP condition assumes that.. (abritage and expected return)

Answer 35

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

Question 36

What affect demand for good ?

Answer 36

the interest rate, taxes, government spending, foreign output, and the real exchange rate

Question 37

The demand for domestic goods (graphically )

Answer 37

The line ZZ (figure 18.1)

Question 38

Equilibrium condition

Answer 38

determines output as a function of all the variables we take as given, from taxes to the real exchange rate to foreign outpu

Question 39

The Effects of an Increase in Government Spending

Answer 39

An increase in government spending leads to an increase in output and a trade deficit.

Question 40

The equilibrium level of output is given by..

Answer 40

Y = Z --> The goods market is in equi- librium when domestic output is equal to the demand for domestic goods.

Question 41

The increase in output is larger than the increase in government spending : so what ?

Answer 41

There is a multiplier effect

Question 42

The Effects of an Increase in Foreign Demand

Answer 42

An increase in foreign demand leads to an increase in output and a trade surplus.

Question 43

An increase in domestic demand leads to

Answer 43

an increase in domestic output but also to a deterioration of the trade balance

Question 44

An increase in foreign demand lead to

Answer 44

an increase in domestic output and an improvement in the trade balance.

Question 45

Marshall-Lerner condition

Answer 45

real depreciation leads to an increase in net exports

Question 46

The depreciation leads to a shift in...

Answer 46

foreign and domestic, toward domestic goods

Question 47

Reducing the Trade Deficit without Changing Output, what does the government do?

Answer 47

the government must both achieve a depreciation and decrease government spending

Question 48

current account : equation

Answer 48

Y = C + I + G + EX − IM

Question 49

Mundell-Fleming model

Answer 49

A model of simultaneous equilibrium in both goods and financial markets for an open economy

Question 50

The IS-LM Model in an Open Economy

Answer 50

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

Question 51

The effect of Monetary policy in open economy : increase the interest rate (flexible interest rate)

Answer 51

An increase in the interest rate leads to a decrease in output and an appreciation LM curve change positon figure 19.3

Question 52

Fiscal policy: The effects of an increase in governing spending with an unchanged interest rate (flexible interest rate)

Answer 52

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

Question 53

Flexible Exchange Rates: Equilibrium is determined (Mundell-Fleming model)

Answer 53

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

Question 54

The Effects of an Increase in Government Spending When the Central Bank Responds by Raising the Interest Rate

Answer 54

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

Question 55

both consumption and government spending increase, what happened ?

Answer 55

consumption goes up because of the increase in income, and government spending goes up by assumption

Question 56

Fixed Exchange Rates: Equilibrium (Mundell-Fleming model)

Answer 56

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

Question 57

devaluation

Answer 57

decrease in the exchange rate under a regime of fixed exchange rates --> rather than depreciation

Question 58

crawling peg

Answer 58

is a type of exchange rate regime in which a country’s currency is fixed to another currency

Question 59

Monetary policy with fixed exchange rate

Answer 59

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

Question 60

Fiscal policy Fiscal Policy When the Exchange Rate Is Fixed

Answer 60

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

Question 61

float

Answer 61

allow a move from a fixed to a flexible exchange rate regime. --> in the medium run

Question 62

floating exchange rate regime

Answer 62

is the same as a flexible exchange rate regime

Question 63

Expectations that a devaluation may be coming can trigger an..

Answer 63

exchange rate crisis

Question 64

To faced to the expectation that a devaluation may be coming can trigger an exchange rate crisis, the government can ?

Answer 64

- 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.

Question 65

Exchange rates often move even in the absence of...

Answer 65

movements in interest rates

Question 66

a relation among current and expected future domestic and foreign real interest ratese

Answer 66

equation (20,5)

Question 67

The exchange rate today depends on both:

Answer 67

1. the difference between current and expected future domestic interest rates, and current and expected future foreign interest rates 2.the expected future exchange rate

Question 68

The interest parity condition implies that..

Answer 68

- 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.