The Open Economy: Trade Balance and Terms of Trade notes

Question 1

What is the definition of trade openness?

Answer 1

Exports and imports as a % of GDP

Question 2

What is the definition of financial openness?

Answer 2

Gross external assets and liabilities as a % of GDP

Question 3

What does the Balance of Payments account record?

Answer 3

Transactions of goods and financial flows between the home and foreign countries

Question 4

What is the BP split into?

Answer 4

The Current and Capital account

Question 5

What does the current account represent?

Answer 5

The goods economy

Question 6

What does the capital account represent?

Answer 6

The financial economy

Question 7

What is the definition of the trade balance?

Answer 7

Net exports -> exports - imports (X - M)

Question 8

What is contained within the current account?

Answer 8

The trade balance + net interest and profit receipts from assets

Question 9

What is contained within the capital account?

Answer 9

Changes in stocks of foreign assets owned by home residents, home assets owned by foreign residents (private net capital flows) - changes in the forex reserves

Question 10

What is the BP equation?

Answer 10

(Trade balance + net interest receipts) + (private net capital flows + changes in forex reserves)

Question 11

What will the BP always equal and why?

Answer 11

It will always be equal to 0 because any increase in wealth from the current account is invested into the capital account

Question 12

How do exchange rate regimes affect forex reserves?

Answer 12

Fully floating regime - no intervention to buy or sell currency, so has no control over the exchange rate
Fixed regime - a commitment to buy and sell currencies to maintain the chosen exchange rate -> this will require forex reserves to change

Question 13

When will forex reserves increase in a fixed exchange rate regime?

Answer 13

When the government is trying to depreciate the UK currency by buying the currencies of foreign countries to increase the supply of UK currency

Question 14

When will forex reserves decrease in a fixed exchange rate regime?

Answer 14

When the government is trying to appreciate the UK currency by using foreign currency to buy home currency and reduce the supply of UK currency

Question 15

What is the definition of revaluation?

Answer 15

Authorities changing the fixed exchange rate so that e decreases

Question 16

What is the definition of devaluation?

Answer 16

A new fixed exchange rate set by authorities that involved increasing e

Question 17

What is the real exchange rate (Q) also seen to represent?

Answer 17

The competitiveness of a country. As Q decreases it means that P>P* for a given e meaning an increase in competitiveness -> as Q decreases, competitiveness increases

Question 18

What is the definition of the Terms of Trade?

Answer 18

The ratio of the prices of exports to the prices of imports

Question 19

What is the ToT formula?

Answer 19

Price of exports / Price of imports

Question 20

What happens when the ToT formula is seen to increase?

Answer 20

This means the ToT have improved as a greater volume of imports can be bought for a given volume of exports

Question 21

What kind of shock is a ToT shock? Example?

Answer 21

A ToT shock is an exogenous one e.g. a rise in oil prices will increase the price of UK imports -> -ve ToT shock

Question 22

How does an increase in Q affect the ToT?

Answer 22

A rise in Q (real depreciation) will worsen the ToT as the real prices of imports increases

Question 23

What is the volume effect when referring to a real depreciation?

Answer 23

An increase in Q -> increases competitiveness -> increases net exports -> BT improves

Question 24

What is the relative price or ToT effect when referring to a real depreciation?

Answer 24

An increase in Q -> increases the price of given volume of imports -> BT worsens

Question 25

For the Marshall Lerner condition to hold, what must be the case in the relation of the volume effect to the ToT effect?

Answer 25

The volume effect > ToT effect -> causing IS to shift right

Question 26

What does the BT curve look like?

Answer 26

It will intersect where AD and ERU intersect in equilibrium and will be flatter than AD

Question 27

What is the nature of the BT above/below the curve?

Answer 27

Above -> trade surplus

Below -> trade deficit

Question 28

When will the ERU curve be vertical?

Answer 28

When wage setters define real wage using domestic prices

Question 29

What causes the vertical ERU to shift?

Answer 29

Shifts in the WS and PS curves

Question 30

When will the ERU be downward sloping?

Answer 30

When wage setters define real wage using consumer prices (includes imports)

Question 31

What causes the downward sloping ERU to shift?

Answer 31

Shifts in WS, PS and AD

Question 32

Why is the BT flatter than AD?

Answer 32

Assuming there is a real depreciation that will increase net exports and AD. This creates a trade surplus because only a proportion of that increase in income will be spent on imports -> not a 1 for 1 balance out of exports and imports.
Assuming there is a real appreciation, that will decrease net exports and AD, so imports will exceed exports -> AD is below the trade balance as there is not a 1 for 1 balance again

Question 33

In the AD-BT-ERU model, what will always happen as q increases?

Answer 33

BT will always improve

Question 34

Why does BT always improve in the AD-BT-ERU model when q increases?

Answer 34

Because of the Marshall-Lerner condition and when the multiplier is < 1/m -> where m = marginal propensity to import

Question 35

For AD-BT-ERU model equations:

Answer 35

Check notes

Question 36

How will a +ve supply shock in the AD-BT-ERU model impact the BT?

Answer 36

There will be a trade surplus as ERU shifts out due to the increased output. At the increased output Q increases to bring AD into equilibrium with the new ERU and larger output

Question 37

How will a +ve demand shock in the AD-BT-ERU model impact the BT?

Answer 37

There will be a trade deficit because ERU remains constant and a real appreciation is needed to bring the new higher AD into equilibrium with ERU -> appreciation makes imports cheaper so they increase to match the new higher demand

Question 38

What will cause a +ve ToT shock in the AD-BT-ERU model?

Answer 38

Would be a +ve exogenous shock in UK share of world trade or world trade as a whole

Question 39

How will a +ve ToT shock in the AD-BT-ERU model impact the BT?

Answer 39

The BT will be in balance because although initially the BT shifts out due to the improved ToT causing a trade surplus, that trade surplus will increase AD due to increased net exports which will shift out AD into equilibrium with the new BT curve. At new equilibrium there is a real appreciation as competitiveness needs to be reduced to match the new AD with ERU at ye