The Open Economy: The Demand side Flashcards
What is the relation of the slope of the IS in an open economy relative to a closed economy?
The IS will be steeper in an open economy
Why is the IS steeper in an open economy?
Because the multiplier is smaller because some of an increase in income is spent on imports
How does a smaller multiplier affect the IS curve?
The smaller the multiplier is the smaller the change in y comes from a change in r -> the steeper the curve
For algebra about why the open economy multiplier is smaller:
Check notes -> but it is because the marginal propensity to import is included in the open economy multiplier, making it smaller
In this model, how do firms determine export prices?
They use home-cost pricing -> they charge the same for exports as they do for the goods domestically
What market structure do we assume exists in this model?
We assume the firms operate in an imperfectly competitive market
How does being in an imperfectly competitive market affect firms price control?
It means that firms have some price-setting power
What does having price-setting power allow firms to do?
Set prices at a mark-up over cost
What would happen to export prices if the costs for UK firms increase?
As costs increase, export prices will also increase as domestic prices will have increased -> P increases in the P*e/P equation
What has evidence shown is the main reason for changes in Q in the UK?
Nominal and real exchange rate changes have moved very closely together, meaning that changes in Q have mainly come from changes in e not P
For algebra and equations for volume of exports and imports and BT:
Check notes
What does the Marshall Lerner condition state happens when there is a real depreciation in currency?
There will be a trade surplus and IS shifts right as export increase exceeds increase in price of imports
What needs to be the case for the Marshall Lerner condition to hold?
The PED of exports and imports must add up to more than 1
Why does the sum of the PED’s have to be larger than 1 for the Marshall Lerner condition to hold?
Given that an increase in Q impacts exports positively and imports negatively, we need to increase in exports to exceed the negative aspect coming from the increased price of imports -> we need the sum of the responses to the relative change in prices to exceed 1
Does the negative ToT effect impact exports? Why?
No it does not. We assumed that export prices are in line with costs and given that costs have not increased export prices will remain constant
