Three Equation Model in the Open Economy Flashcards
What is the home nominal interest rate equation and what is it denoted by?
e = no.of units of home currency / 1 unit of foreign currency
What does the nominal interest rate show?
How many £’s are required to buy 1 unit of foreign currency
What is the home real interest rate equation and what is it denoted by?
Q = price of foreign goods in home currency / price of home goods -> P*e/P
What does the real interest rate show?
How many £’s you need to buy goods abroad compared to how much that good costs at home
How does the interest rate stabilisation channel work in the open economy?
Say there is a demand shock -> CB increases i -> this creates a -ve output gap -> reduced inflation back to target
How does the exchange rate stabilisation channel work in the open economy?
Say there is a demand shock -> forex market expects i to increase -> increased returns to home bonds (arbitrage opportunity) -> currency appreciates -> decreases exports -> reduces AD -> reduces inflation
How does the exchange rate impact how much the CB needs to change r by?
Given the presence of the forex market, the CB needs to increase r by less because the currency appreciation will also work to reduce y, meaning that less of an increase in r is required
How does the AD (IS relation) change in an open economy and how is the multiplier affected?
It will now include exports and imports -> means the multiplier is reduced as some of the increased income will be spent on imports
How does the Phillips curve change in an open economy?
Domestic inflation is still used to set wages -> PC is no different than in a closed economy
How does the MR curve change in an open economy?
CB may target domestic inflation or CPI (which includes the prices of imports) so there may be a changed MR
What does UIP stand for?
Uncovered Interest Parity
What does the UIP condition explain?
How forex traders respond to interest rate changes
What assumption do we make between home and foreign bonds in the UIP condition?
That they are perfectly substitutable
Given that bonds are perfectly substitutable in the UIP condition, what are the factors that differentiate expected returns on bonds in the forex market?
1) expected differences in the r on those bonds -> higher the r the higher the returns on those bonds
2) expected development of the exchange rate over a time period -> you need to buy the home currency to buy their bonds, so if the exchange rate is not favourable, then UIP will not be profitable
For diagrams on a UK increase of i:
Check notes
How will forex traders react to increase of i on UK bonds and how will that affect the UK exchange rate?
The exchange rate will immediately appreciate as traders will buy GBP to buy the bonds
What do we assume will happen to the exchange rate after it immediately appreciates after an i increase?
We will assume that it will return back to its original level
How does the UK e returning back to its original level affect the price of UK bonds?
As e depreciates, it makes the returns possible from selling UK bonds reduce
What does the UIP condition state about gains from investing in UK bonds?
Interest rate gains coming from owning UK bonds = loss from expected depreciation of the UK exchange rate
What would happen to the UK e if no investment in UK bonds occurred?
It would remain constant
Why does the UK e only gradually return to its original level and not suddenly?
Because traders will be willing to see the e depreciate a little before selling their bonds as the interest rate gains still exceed the exchange rate related losses
What happens to the incentives to buy UK bonds as time passes since the UK i increase?
The incentive to buy UK bonds falls as the losses coming from the UK currency depreciation grows
When do the largest gains in owning UK bonds after an i increase occur?
Right as the increase in i is made
What is the UIP condition formula?
(i) t - i* = log(e^E)t+1 - log(e)t
(i) t - i* = (e^E)t+1 - (e)t / (e)t
