The Open Economy Pt.1

Question 1

What is the FOREX market?

Answer 1

• The marketplace where various national currencies are traded
• Market where forward-looking traders with rational expectations attempt to profit from arbitrage opportunities.
• The FOREX is assumed to have the correct model of the economy, but the motive is profit.

Question 2

What does the FOREX market impact?

Answer 2

• connects interest and exchange rates
• affects the economy’s reaction to shocks

Forex used to be driven by trade, now is dominated by international financial markets.

Question 3

The link between forex, exchange rates and interest rates - EXAMPLE

Answer 3

Home country (UK) increases interest rates, thus, returns on UK gilts are more attractive. The financial market will sell $ to buy £. The forex market reacts quickly: the exchange rate will appreciate almost instantaneously.

• Exchange rates jump in response to news affecting relative bond yields among countries.

Question 4

What are the two types of exchange rates

Answer 4

The nominal exchange rate is the rate at which a currency is converted into another.

The real exchange rate takes account of price differences between the country, thus relates to the exchange of the volume of goods / services.

Question 5

Home nominal exchange rate

Answer 5

e = number of units of home currency / 1 unit of foreign currency

RISE IN e - a depreciation of the home currency
DECREASE IN e - appreciation of the home currency

Question 6

Real exchange rate

Answer 6

Q = price of foreign good in terms of home currency / price of home goods =
= (p*/ p) x e

Rise in Q is a real depreciation of home currency.
Fall in Q is a real appreciation of home currency.

Question 7

Properties of real exchange rate (Q)

Answer 7

• measures price competitiveness
• home country goods become cheaper, and more competitive if:
  i) e increases
  ii) p decreases
  iii) p* increases
• a rise in competitiveness Q will boost net exports (X-M)

Question 8

Open economy stabilisation channels assumptions

Answer 8

1. The exchange rate is freely floating
2. There is a one-period lag between exchange rate changes and the impact on output through the IS curve.
3. The CB takes forex reaction and exchange rates into account when setting monetary policy.
4. The country is small - it cannot influence world interest rates
5. Perfect substitution between foreign and home bonds.

Question 9

Implications of the open economy

Answer 9

• The exchange rate channel reinforces the interest channel when it comes to monetary policy. Therefore, initial interest rate changes should be smaller than in the closed economy case.
• Differences in the 3 equation model in an open economy

Question 10

There are 2 open-economy stabilisation channels:

Answer 10

1. The interest rate channel
2. The exchange rate channel

They act in the same direction and counter to the shock.

Question 11

The IS curve in the Open Economy

Answer 11

• includes net exports (X-M)
• has a lower multiplier, because some of the increase in income leaks to imports
• the higher the marginal propensity to import, the lower the multiplier

Question 12

The Philips curve in the Open Economy

Answer 12

Same as before. Domestic expected inflation is used to set W.

Question 13

The monetary response (MR) curve in the Open Economy:

Answer 13

Assumed initially same as before BECAUSE assumed CB cares exclusively about domestic inflation, and does not care about imported inflation ΔP*.

Question 14

What does the Uncovered Interest Parity state?

Answer 14

The difference in interest rates between home and world will be equal to the relative change in exchange rates over the same period.

Question 15

The expected return on a bond held for an expected duration of time depends on:

Answer 15

1. expected differences in interest rates across time horizon
2. expected development of the exchange rate over the same time horizon

Question 16

Uncovered Interest Parity example:

Answer 16

Example: interest rates UK increase for one year (2.5%). The pound instantly appreciates by 2.5% and depreciates slowly over the year. At the end of the year, e and i are back to their initial levels.

Question 17

How much does e appreciate after an increase in i?

Answer 17

Until there is no remaining profit opportunity; at the point where future expected depreciation of the pound will reduce the $ value of £ bond holdings to the point that there is 0 profit to be made by switching from US to UK bonds.

Question 18

The Uncovered Interest Parity (UIP) condition:

Answer 18

Interest gains from holding home rather than foreign bonds

Loss from expected home currency depreciation against foreign currency

Question 19

What is the UIP condition mathematically?

Answer 19

it - i* = e(t+1) EXPECTED - e(t) / e(t)

Question 20

What shifts the UIP curve?

Answer 20

• log(e) Expected fixed, Δi* changes
  OR
• i* fixed, Δlog(e) Expected changes