The Open Economy: Demand and Supply combined Flashcards
For diagrams about +ve supply, demand and external shocks:
Check notes -> supply shock sees ERU shift out, demand shock sees AD shift out and external shock sees BT and AD shift out
What is the value of Q when the economy is in MRE?
Q = 0
If Q = 0 during MRE, what does that home inflation must equal?
Home inflation = world inflation + home nominal depreciation
Is it possible to have a constantly higher or lower exchange rate than the rest of the world?
Yes, you would just have to constantly appreciate or depreciate it to make sure that that gap remains
What must the ratio of home prices be to world prices to maintain competitiveness?
Home inflation must equal world inflation
In a flexible exchange rate, how will MRE inflation be determined?
The CB will set a target inflation that they will work to achieve
How will an exchange rate fluctuate in a fully floating exchange rate regime?
It will fluctuate in accordance to nominal exchange rate fluctuations -> target inflation - world inflation
In a fixed exchange rate regime, how will MRE inflation be determined?
Inflation will be fixed against world inflation
What is the consequence of the CB operating in a fixed exchange rate regime?
They will lose control over their monetary policy
What was the impact of the fixed exchange rate being introduced in the Eurozone?
It helped establish low and credible inflation -> anchored low inflation expectations
How will the economy operating in long run equilibrium?
Inflation will be constant and the trade will be balance -> BT = 0
In the UK during 1990-2007 they saw low unemployment and steady inflation, what 2 shocks brought this about?
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
How would the CB react to the 2 shocks that occurred in the UK in 1990-2007?
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.
Evidence of supply side shock: what supply side reform did the UK government introduce over the 80’s?
During the 80’s the Thatcher government worked to weaken trade unions, reducing their bargaining power
What impact did the UK reforms in the 80’s have on WS-PS and ERU?
The weakening of the unions will have shifted WS out, shifting ERU to the right
What effect did the supply side reforms in the 80’s have on inflation and output?
Output increased, but inflation remained constant
Did the effect of the supply side reforms kick in straight away?
No, it is likely that the reforms had lagged effects
What occurred in the product market in the 80’s and 90’s that will have impacted the supply side of the UK economy?
The level of competition increased -> this shifted PS out and ERU further to the right
What was the overall impact of the total supply side reforms on the UK economy?
They would tend to reduce equilibrium unemployment, lead to a depreciated exchange rate and an improved trade balance
What however did the occur in the UK from 1997 onwards that did not match the assumed effects of the supply side reforms?
There was a large appreciation of the UK currency -> this contradicted the supply side hypothesis which predicted a depreciation in the currency
What happened in the demand side of the UK economy during 1990-2007?
There was an AD boom
How might this have explained the failing of the supply side hypothesis about the exchange rate?
It saw the currency appreciate significantly -> trade deficit created as a result
What 3 factors provided evidence of the demand boom during 1990’s?
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.
What was happening to real wages during the demand boom in the UK?
Real wage growth outstripped productivity growth
How did the real wage impact the UK economy at this time?
Q decreased -> price of imports decreased -> real consumption wage increased -> consumption increased
What happened when household consumption slackened during the demand boom?
Government spending increased to maintain the AD boom
What other hypotheses existed for the appreciation of the UK currency?
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
For diagram of all hypotheses combined:
Check notes -> ERU shifts right, large AD shift out and a BT shift out as well
