The open economy Flashcards
Openness in goods market
the ability of consumers to choose between domestic goods and foreign goods
Openness in the financial markets
The ability for investors to choose between domestic assets and foreign assets
Openness in factor markets
The ability for firms to choose where to locate production, and for workers to choose where to work
tariffs
taxes on imported goods
quotas
restrictions on the quantity of goods that can be imported
Proportion of imports and exports in the UK
30% of GDP today compared to 205 in 1960
In an open economy consumers have two options
save or buy
buy domestic or foreign goods
real exchange rate
the price of the domestic goods relative to the foreign goods
it is not directly observable
Nominal exchange rates can be quoted in two ways
price of domestic in terms of foreign
price of foreign in terms of domestic
Nominal exchange rate
the price of the domestic currency in terms of the foreign currency. denoted by E
nominal appreciation
an increase in the price of the domestic currency in terms of foreign currency. An increase in the exchange rate
nominal depreciation
a decrease in the domestic currency in terms of foreign currency. A decrease in the exchange rate
fixed exchange rates
where two or more countries maintain a constant exchange rate between their currencies
revaluations
increases in the exchange rate under a fixed exchange rate scheme
devaluations
decreases in the exchange rate under a fixed exchange rate scheme
GDP deflator
index of prices for all good produced
real exchange rate relation
ε= EP/P*
ε= real exchange rate E= nominal exchange rate P = price of UK goods in pounds P* = Price of european goods in euros
Constructed by multiplying the domestic price level by the nominal exchange rate and then dividing by the foreign price level
real appreciation
an increase in the real exchange rate. an increase in the relative price of domestic goods in terms of foreign goods
real depreciation
a decreases in the real exchange rate. a decrease in the relative price of domestic goods in terms of foreign gades with the UK and how much it competes with the UK in other countries
multilateral exchange rate
comparing the exchange rates across more than one country by weighing how much each country
foreign exchange
buying or selling foreign currency
Another implication of an open financial market
allows a country to run trade surpluses and deficits
Balance of payments
transactions such as trade flows and financial flows with the rest of the world
Current account transaction
Exports
Imports
UK residents receive investment income
net transfers received - aid
current account surplus/deficit
if the current account balance is positive/negative
net capital flows
the increase in foreign holdings of UK assets minus the decrease in UK holdings of foreign assets
Uncovered Interest parity
riskless arbitrage opportunity stating if financial assets both foreign and domestic are to be held they must have the same expected return
(1+it)=(1+it*)(Et/Et+1)
interest parity condition (to be remembered)
it ≈ it* - (Eet+1 - Et)/Et
arbitrage by investors implies that the domestic interest rate must me equal to the foreign interest rate minus the expected appreciation rate of the domestic currency
Demand for domestic goods in an open economy
Z=C+I+G+IM/ε +X
Determinants of imports
domestic income and the real exchange rate
If domestic income goes up leads to higher demand for all good and thus imports goes up. If the real interest rate goes up the value of imports will go down and so increase the amount bought.
Determinants of exports
Foreign income and the real exchange rate
An increase in the foreign income will increase the demand for all goods including foreign goods and thus exports. An increase in the real exchange rate will decrease the amount of exports as it is more expensive for the foreign country to buy the foreign goods.
Net exports
the difference between the number of imports and number of exports Is positive if exports is greater than imports. and vice versa
trade surplus
exports>imports
trade deficit
exports<imports
According to the interest parity condition an increase in the domestic interest rate leads to….
an increase in the exchange rat
According to the interest parity condition an increase in the foreign interest rate leads to….
a decrease in the exchange rate
According to the interest parity condition an increase in the expected future exchange rate leads to….
an increase in the current exchange rate
IS relation in the open economy
Y=C+I+G+NX(Y,Y, 1+i/1+i E)
LM relation in the open economy
M/P = YL(i)
What effect does and increase in the interest rate have on the IS relation?
First, as in the open economy, it has a decrease in investment, a decrease in the demand for domestic goods and a decrease in output.
Secondly, only present in the open economy, is it appreciates the exchange rate making it cheaper to buy foreign goods rather than domestic and thus net exports decreases. This in turn decreases output.
What effect does an increase in output have on the LM relation?
Increased output has an increase in the demand for money and thus to an increase in the equilibrium interest rate.
What effect does an open economy have on the multliplier
The multiplier is smaller as the the demand line is flatter
When effect does an increase in government spending have?
It shifts the demand (ZZ) curve upwards. This creates a trade deficit. The effect on an increase in spending is smaller in an open economy as an increase in demand doesnt just fall on domestic goods
What effect does an increase in the foreign output have on domestic output?
An increase in foreign output causes there to be an increase in demand for goods and therefore an increase in the demand for exports. This causes net exports to increase and the net exports line to shift upwards. Causes the ZZ line to shift upwards. There is now a trade surplus
Coordination
whereby the countries coordinate their macro policies as as to increase domestic demand simultaneously in doing so without increasing the trade deficit
Reason, in reality, there is limited coordination among countries
Some countries might have to do more than other countries and may not want to do so.
Countries have a strong incentive to promise to coordinate and then not deliver on that promise
Marshall-Lerner condition
The condition under which a real depreciation( decrease in ε) leads to an increase in net exports (increase in NX)
Effect of real depreciation on exports
Exports increases as the real depreciation make the domestic goods relatively less expensive abroad
Effect of a real depreciation on imports
Imports decrease. The depreciation makes foreign goods more relatively expensive in the domestic economy. SHift in the domestic economy to domestic goods from foreign goods
Effect of rela depreciation on “the relative price of foreign goods in terms of domestic goods”
1/ε increases. This therefore the import bill as you get less goods for the same price.
Further effects of depreciation on the trade balance
Similar to an increase in the foreign output. Depreciation leads to a shift in demand, both foreign and domestic, towards domestic goods. This shift in demand leads to both and increase in domestic output and an improvement in the trade balance.
The difference between increase in foreign output and real depreciation
Whilst they will have the same effect on output and the trade balance, depreciation works by making foreign goods relatively more expensive which can make people worse off and lead to strikes
If the economy is a the natural level and is running a trade deficit what combination of policy and exchange rate alterations will rid the deficit whilst maintaining output?
It must depreciate the exchange rate to encourage the consumption of domestic goods. This will however shift the demand function also increasing output. In order to avoid the increase in output it must therefore cut government spending.
Policy combination for low output but a trade surplus in order to maintain a natural level
Increase government spending and depending on the magnitude at which the increased spending affects the trade balance appreciate (still surplus) or depreciate (if becomes a deficit)
Policy combination for high output but a trade surplus in order to maintain a natural level
Depreciate the real exchange rate which will make foreign goods more expensive and so increase the consumption of domestic goods increase. Depending on how much the depreciation increases the demand by the government may need to increase spending further in order to boost output or decrease spending to reduce the output
J- curve
graphically displays the idea that initially when depreciation occurs the effects on imports and exports does not take effect immediately due to a lag effect due to consumers taking time to realise relative prices have changed and also for firms to change their suppliers. In this case a depreciation leads to a deterioration of the trade balance leading to decline in NX. And then after some time the trade balance restores to its initial level and then surpasses
Private Saving
S=Y-C-T
Condition of Net exports in relation to saving
NX= S+(T-G)-I
A trade surplus must correspond to an excess saving over investment; a trade deficit must correspond to an excess of investment over saving
An increase in investment must be reflected in what in the net exports relation?
an increase in private saving or public saving, or a deterioration in the trade balance
An increase in the budget deficit must be reflected in what in the net exports relation?
an increase in private saving, a decrease in investment or a deterioration in the trade balance
A country with a high savings rate must have either….
a high investment rate or a large trade surplus
What effect does an increase in government spending have in the the open economy (in relation to the IS-LM relation)
An increase in spending shifts the IS relation to the right due to an increase in the output. This increase in output causes the interest rate to rise. This interest rate increase affects the interest parity relation and causes and appreciation of the exchange rate.
Effect of monetary contraction on the
a monetary contraction leads to a decrease in output, an increase in the interest rate and an appreciation
LM Curve shifts upwards. Interest rate rises. On the interest rate parity it causes an increase in the exchange rate
Crawling peg
countries that typically have higher inflation rates that exceed the US choosing a predetermined rate of depreciation against the dollar
EMS
groups of countries agreed to maintain their exchange rates with each other in a system with narrow limit
If the country decides to peg What happens to the interest parity relation?
Et becomes Ebar and then as the foreign markets believe the exchange rate will remain pegged their expected future exchange rate is also Ebar. With this the party relation becomes
1+i = 1+i*
Therefore under a fixed exchange rate and perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate
In a fixed exchange rate what role does the central bank play?
It has to alter the money stock in order to maintain the interest and exchange rate and still meet the demand for money. With this it gives up monetary policy as a policy instrument
What is the effect of fiscal policy under a fixed exchange rate?
A fiscal expansion will cause the IS curve to shift rightwards. This not only increases output but also the interest rate which is “fixed”. In order to return to the agreed interest rate the central bank undergoes monetary accommodation to shift the LM curve down. This further increases output.
Disadvantage of fixed exchange rates
country gives up powerful tool for correcting trade balances or changing economic activity
gives up control of interest rate. country must match movements in the foreign interest rates at the risk of unwanted effects in its own activity
Only one policy instrument
Open economy aggregate demand relation
Y=Y(EbarP/P*, G, T)
Aggregate supply relation in the open economy
P=Pe(1+μ)F(1-Y/L , z)
What happens to the price level if output is below the natural level?
The lower equilibrium point will cause the AS curve to shift downwards, moving along the AD curve until AS=AD=Yn
This causes a reduction in the price level over time and therefore a decrease in the real exchange rate. The steady decrease in price level has the effect of increasing output until it is at the natural level
What effect can a one-time devaluation have in the medium run in a fixed exchange rate?
A shift in the AD curve rightwards and therefore making the relation AD=AS=Yn. This will however increase the price level which in turn can increase the price of imports and the price of a consumption basket. With this workers will push for higher wages
What happens if the domestic currency is overvalued i.e the exchange rate is too high?
real depreciation is called for. This can be achieved in the medium run but governments may opt to just devalue
When is an overvaluation likely to happen?
When a country pegs its nominal exchange rate to the currency of a country with lower inflation. Higher relative inflation implies a steadily increasing price of domestic goods relative to foreign goods, a steady real appreciation and a steady worsening trade position
What if a country wants to decrease its interest rates?
It can float its exchange rate in order to break from fixed to flexible scheme and trigger a decrease in the nominal exchange rate
What options does a government have when faced with an exchange rate crisis?
- Give in and devalue
2. fight and maintain the parity at the cost of high interest rates and potential recession.
The relation of Et being determined by an expected exchange in the future means that the current exchange rate depends on two things:
- current and expected domestic and foreign interest rates for each year over the next 10 years
- The expected exchange rate 10 years from now
(taking 10 to be a large number for n)
Exchange rates and the current account
Countries do not wish to borrow - run a current account deficit - forever and will not want to lend - run a current account surplus forever. News that affects the forecasts of the current account in the future is likely to affect the exchange rate today.
Exchange rates and current and future expected interest rates
Any factor that moves the interest rates between years t and t+n moves the current exchange rate to. i.e increase in current or expected future domestic interest rates causes an appreciation
Exchange rate volatility
In reality it is hard to work out whether the mechanism of lowering the interest rate by the central back in temporary or for longer. All this makes it difficult to predict the effect of a change in the interest rate on the exchange rate
argument against flexible exchange rates
the exchange rate is likely to fluctuate a lot and so will be difficult to control through monetary policy
Way to reduce money growth and inflation
fixed exchange rate approved by the monetary authority
Hard peg
making it symbolically or technically harder to change the parity
Extreme form of hard peg
changing the entire currency to that of a foreign one
Dollarisation
when an extreme form of hrd peg is taken up and the chosen currency is the dollar
currency board
when the central bank stands ready to exchange foreign currency for domestic.
Common currency
where large areas or group or groups of countries share a currency
Two conditions for optimal currency (one of two needs to be satisfied)
- the countries have to experience similar shocks
2. If the countries experience different shocks they must have high factor mobility - i.e. movement of workers
