The Open Economy Pt. 2

Question 1

Characteristics of the medium-run equilibrium for the open economy:

Answer 1

• supply side is in equilibrium (WS = PS), no inflationary pressure
• unemployment at equilibrium values
• demand side in equilibrium
• domestic interest rate does not deviate from world interest rate

Question 2

What is the supply curve called in the open economy?

Answer 2

ERU curve - equilibrium rate of unemployment curve; because unemployment is in equilibrium and inflation is constant (no inflationary pressure)

Question 3

Is there an inflationary pressure in the MRE?

Answer 3

No. ERU implies that in the medium run equilibrium, inflation is constant, since W (ps) = W (ws)

Question 4

Graphical representation of the MRE supply curve (ERU):

Answer 4

• the point of intersection between WS and PS dictates the equilibrium rate of unemployment (ERU) at constant inflation
• the ERU curve is vertical in this case
• while y is on the horizontal axis, the ERU is plotted against the log real exchange rate - q - vertically

Question 5

What does the ERU curve plot?

Answer 5

• The ERU curve shows: combinations of (log) real exchange rate (q) and real output y at which wPS = wWS
• at any point on the ERU curve, inflation is constant

Question 6

What is the algebraic expression of the ERU curve?

Answer 6

• ERU curve : y = ye

- y = ye (zW, zP)

Question 7

Why does the ERU curve shift?

Answer 7

• ye will shift with wage push and price push factors (zW and zP)
• ye shifts when either the WS or the PS curve shifts

Question 8

How is the demand curve deducted in the open economy?

Answer 8

By combing the open economy IS curve and the UIP curve.

Question 9

What is the open economy IS curve?

Answer 9

yt = At - a r(t-1) + b q(t-1)

The IS curve incorporates net exports. The impact of net exports is experienced with a one-period lag.

Question 10

How does the IS curve look like after incorporating the UIP condition (that q and expected q are equal, and home interest rates do not deviate from world interest rates?

Answer 10

Y = A - ar* + bq

Question 11

What does the open economy aggregate curve depict?

Answer 11

The medium-run AD curve shows combinations of (log) real exchange rate (q) and real output y at which the goods market is in equilibrium.
The AD curve is upward sloping (showing a positive relationship between depreciation and aggregate output).

Question 12

How does the adjustment (as a result of either a supply shock or a demand shock) work in the medium-run open economy?

Answer 12

• r is tied to r*
• therefore, as a shift in one of the curves, there is either a depreciation or an appreciation, as well as a change in equilibrium unemployment and equilibrium output.

Question 13

How do q and r respond to a shock in a small open economy?

Answer 13

• the medium run interest rate r is pinned down by r*

- q moves in response to a shock

Question 14

What is the RX curve?

Answer 14

It is the interest-exchange rate curve.

Question 15

How is the RX curve useful for the Central Bank?

Answer 15

The RX curve shows CB’s best real interest rate response, taking into account the forex market’s reaction.

Question 16

What do CB decisions reflect in the open economy?

Answer 16

• forward-looking forex market behaviour

- the effect of q on y

Question 17

How does the CB use the RX curve for stabilisation policy?

Answer 17

Instead of adjusting back to equilibrium on the IS curve, the CB adjusts on the flatter RX curve.

Question 18

What is the RX curve equation?

Answer 18

yt - ye = (a + b/1-λ) (r(t-1) - r*)

where λ = 1 / 1+ (α^2 x β)

Question 19

What does the RX curve go through? What shifts the RX curve?

Answer 19

The intersection between r* and ye.

Thus, the RX curve shifts if and only if r* or ye changes.

Question 20

What does the slope of the RX depend on?

Answer 20

(i) the interest rate sensitivity -a- and exchange rate sensitivity -b- of AD;
(ii) the CB’s preference β
(iii) the slope of the Philips curve α

Question 21

What is the policy implication of a flatter RX curve? What makes the RX curve flatter?

Answer 21

A flatter RX curve means CB raises interest by less.

1. RX is flatter if IS curve is flatter: if a (interest sensitivity of demand) is higher or b (exchange rate sensitivity of demand) is higher.
2. RX is flatter if MR is steeper. MR is steeper if: (1) PC is flatter (lower α) or (2) CB is less inflation averse (lower β)

Question 22

What are the steps of the dynamic adjustment to a temporary inflation shock in the open economy?

Answer 22

1. MRE with inflation at target
2. News of inflationary shock
3. CB and forex market foresee a lengthy period with higher interest rates to bring inflation to target
4. CB raises interest rates and exchange rate appreciates
5. Output and inflation fall
6. CB gradually reduces interest rates and exchange rate gradually depreciates
7. Output rises back to equilibrium and inflation falls to target.

Question 23

Where is the demand side of the economy during an adjustment?

Answer 23

Economy is not on AD during the adjustment !(because AD entails r=r)!, and during the adjustment period r=/=r. Thus, the economy is above the AD curve (for a positive inflation shock) and gets clooser and closer to the AD curve as adjustment is made.

Question 24

Differences in the closed vs open economy: an inflation shock?

Answer 24

1. Initial rate hike after inflation shock is higher in closed economy. In open ecomomy, q appreciation shoulders some of the burden.
2. In open economy, IS shifts in every period, as the change in q also changes y due to net exports.
3. In closed economy, moves along the IS towards equilibrium. In open economy, moves along the flatter RX curve towards equilibrium.