The Open Economy Pt. 4

Question 1

What does the Marshall Lerner condition set to elucidate?

Answer 1

What the impact of a real depreciation (increase in q) do to the Trade Balance. It looks at which one of the volume effect and the Terms of Trade effect is bigger in magnitude.

Question 2

What is the Marshall-Lerner condition?

Answer 2

As long as the sum of the price elasticity of demand for exports and the price elasticity of demand for imports exceeds 1, a real depreciation will improve the balance of trade.

Question 3

What is the export function?

Answer 3

X= σ(Q)y*
where y* is world income and σ(Q) is the country’s share of world trade, determined by the exchange rate.

X(Q, y*)

Question 4

What is the value of imports in home currency?

Answer 4

=(P*e)m(Q)y
Where:
-P*e are foreign prices in home currency
-m is the marginal propensity to import determined by q (the bigger the q, the smaller the m) 
- y is home output

Question 5

What is the import function?

Answer 5

=Qm(Q)y

M(Q, y)

Question 6

What are the balance of trades components?

Answer 6

X-M = σ(Q) y* - y Q m(Q)

Question 7

For the following BT equation: X-M = σ(Q) y* - Qm(Q)y, what is the effect of a real depreciation?

Answer 7

As Q increases:

1. σ(Q)y* increases - VOLUME effect (BT improves)
2. m(q)y decreases - VOLUME effect (BT improves)
3. q increases - ToT effect (BT worsens)

Question 8

What happens to ye and the IS curve after a real depreciation?

Answer 8

A depreciation increases net exports. An increase in net exports raises aggregate demand. Output and income rise and equilibrium is established at a higher y=ye. The IS curve shifts rights.

Question 9

By how much does output increase after a real depreciation?

Answer 9

Δy = 1/ (1-c1(t-1)+m) Δ(X-M)

The change in income is equal to the net export change times the open economy multiplier.

Question 10

Will the trade balance be in equilibrium in the medium run after a real depreciation?

Answer 10

Since:

the income generated from a real depreciation (Δy) is smaller than the income increase needed to fuel imports to the level they counter balance the increase in exports (ΔyBT), the economy will experience a trade surplus in the medium run.

Why trade surplus?
Δy< ΔyBT

Question 11

Will there be BT imbalances in the long run equilibrium?

Answer 11

No. In the LR, the economy is in equilibrium with constant inflation and balanced trade. In the LR, there is pressure to ensure a sustainable current account position.

Question 12

What is the point of LR equilibrium?

Answer 12

Where the AD, the ERU and the BT curves intersect.

Question 13

What is the assumption behind the downward sloping ERU curve?

Answer 13

How consumers/ employers are allowed to base their wage decisions on all goods (including imports).

w= W/Pc

Question 14

What is P?

Answer 14

P is the domestic price index. It is not affected by the exchange rate in the price setting curve, so the PS curve stays the same. P= (1+μ) W/λ (price is here expressed as a mark up)

Question 15

What is Pc? What is Pc’s formula?

Answer 15

Pc is the consumer price index (CPI), which includes both domestic and foreign goods.

Pc = P (1-φ) + P*e φ

Where φ is the share of imports in total consumption.

Question 16

What do wage setters care about? What do price setters care about?

Answer 16

Wage setters are assumed to care about the Pc, while price setters about P.

Question 17

How does the WS-PS diagram alter?

Answer 17

The WS-PS curves are depicted in the W/Pc - N space. Changes in q mean the Pc will change, but P will not. W/P will deviate from W/Pc. If q depreciates (higher q), PS shifts down, as it deviates from Pc. If q appreciates (lower q), PS shifts upwards. The PS curve moves along the WS curve.

Question 18

Why des the MRE allow for different output levels consistent with constant inflation?

Answer 18

Because lower (or higher) import prices raise the real consumption wage (W/Pc) and labour supply, raising employment and output without causing domestic producers to increase their prices.

Question 19

How do the closed economy WS-PS diagram and the open economy WS-PS diagram differ?

Answer 19

In the closed economy, there is a unique equilibrium employment level Ne; on its right there is inflationary pressure, on its left downward pressure.

In the open economy, there are multiple equilibrium levels of employment and output for which there is no inflationary pressure (either positive or negative). That is because low import prices (appreciation) allow for higher employment and output, without putting pressure on domestic prices (and the other way around).

Question 20

What happens to the real consumption wage with an appreciation or depreciation?

Answer 20

1. Appreciation
   The real consumption wage increases, as imports become cheaper. Workers are willing to work more at the unchanged real wage offered by firms (W/P) (since they can buy more imports with that income). Thus, equilibrium employment increases, as well as equilibrium output.
2. Depreciation
   The real consumption wage decreases, as imports become more expensive. Less workers are willing to work at the unchanged rate offered by firms (W/P) (since they can buy less imports with that income). Thus, equilibrium employment decreases, as well as equilibrium output.

Question 21

What determines a (positive) trade balance shock?

Answer 21

A BT shock can come from either:

1) a change (increase) in σ (world trade share)
2) a change (increase) in y* (world income)

Question 22

What happens to the BT and AD curves after a (positive) external trade shock?

Answer 22

The BT curve and AD curve shift (to the right) together by the same amount (the new equilibrium entails a trade surplus).