The Open Economy: Demand and Supply combined

Question 1

For diagrams about +ve supply, demand and external shocks:

Answer 1

Check notes -> supply shock sees ERU shift out, demand shock sees AD shift out and external shock sees BT and AD shift out

Question 2

What is the value of Q when the economy is in MRE?

Answer 2

Q = 0

Question 3

If Q = 0 during MRE, what does that home inflation must equal?

Answer 3

Home inflation = world inflation + home nominal depreciation

Question 4

Is it possible to have a constantly higher or lower exchange rate than the rest of the world?

Answer 4

Yes, you would just have to constantly appreciate or depreciate it to make sure that that gap remains

Question 5

What must the ratio of home prices be to world prices to maintain competitiveness?

Answer 5

Home inflation must equal world inflation

Question 6

In a flexible exchange rate, how will MRE inflation be determined?

Answer 6

The CB will set a target inflation that they will work to achieve

Question 7

How will an exchange rate fluctuate in a fully floating exchange rate regime?

Answer 7

It will fluctuate in accordance to nominal exchange rate fluctuations -> target inflation - world inflation

Question 8

In a fixed exchange rate regime, how will MRE inflation be determined?

Answer 8

Inflation will be fixed against world inflation

Question 9

What is the consequence of the CB operating in a fixed exchange rate regime?

Answer 9

They will lose control over their monetary policy

Question 10

What was the impact of the fixed exchange rate being introduced in the Eurozone?

Answer 10

It helped establish low and credible inflation -> anchored low inflation expectations

Question 11

How will the economy operating in long run equilibrium?

Answer 11

Inflation will be constant and the trade will be balance -> BT = 0

Question 12

In the UK during 1990-2007 they saw low unemployment and steady inflation, what 2 shocks brought this about?

Answer 12

1) +ve supply shock -> ERU shifts out and a trade surplus is created
2) +ve demand shock -> AD shifts out and a trade deficit is created

Question 13

How would the CB react to the 2 shocks that occurred in the UK in 1990-2007?

Answer 13

They would not have reacted to the supply shock -> the CB does not react to supply shocks
They may have increased r to create a -ve output gap to correct the AD shift and bring the economy back to equil.

Question 14

Evidence of supply side shock: what supply side reform did the UK government introduce over the 80’s?

Answer 14

During the 80’s the Thatcher government worked to weaken trade unions, reducing their bargaining power

Question 15

What impact did the UK reforms in the 80’s have on WS-PS and ERU?

Answer 15

The weakening of the unions will have shifted WS out, shifting ERU to the right

Question 16

What effect did the supply side reforms in the 80’s have on inflation and output?

Answer 16

Output increased, but inflation remained constant

Question 17

Did the effect of the supply side reforms kick in straight away?

Answer 17

No, it is likely that the reforms had lagged effects

Question 18

What occurred in the product market in the 80’s and 90’s that will have impacted the supply side of the UK economy?

Answer 18

The level of competition increased -> this shifted PS out and ERU further to the right

Question 19

What was the overall impact of the total supply side reforms on the UK economy?

Answer 19

They would tend to reduce equilibrium unemployment, lead to a depreciated exchange rate and an improved trade balance

Question 20

What however did the occur in the UK from 1997 onwards that did not match the assumed effects of the supply side reforms?

Answer 20

There was a large appreciation of the UK currency -> this contradicted the supply side hypothesis which predicted a depreciation in the currency

Question 21

What happened in the demand side of the UK economy during 1990-2007?

Answer 21

There was an AD boom

Question 22

How might this have explained the failing of the supply side hypothesis about the exchange rate?

Answer 22

It saw the currency appreciate significantly -> trade deficit created as a result

Question 23

What 3 factors provided evidence of the demand boom during 1990’s?

Answer 23

1) retail sales grew
2) there was a reduced saving ratio -> credit restraints were reduced
3) household wealth increased from factors such as rising house prices etc.

Question 24

What was happening to real wages during the demand boom in the UK?

Answer 24

Real wage growth outstripped productivity growth

Question 25

How did the real wage impact the UK economy at this time?

Answer 25

Q decreased -> price of imports decreased -> real consumption wage increased -> consumption increased

Question 26

What happened when household consumption slackened during the demand boom?

Answer 26

Government spending increased to maintain the AD boom

Question 27

What other hypotheses existed for the appreciation of the UK currency?

Answer 27

1) Monetary policy impact -> in 1997 the Bank of England became independent, seeing them increase nominal interest rates
2) The emergence of UK export strength in knowledge-based service saw exports increase -> this helps explain the limited deterioration of BT despite the large appreciation -> UK share of world output increased

Question 28

For diagram of all hypotheses combined:

Answer 28

Check notes -> ERU shifts right, large AD shift out and a BT shift out as well