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
For UIP diagram for a change in i:
check notes
What will cause a movement along the UIP curve?
A change in i
What will cause a shift of the UIP curve?
1) given i*, a change in log(e^E)
2) given log(e^E), a change in i*
How can the UK CB keep exchange rate expectations the same after a change in i*?
If they match the change in i* by an equal change in i -> so that i = i* still
The intersection of which curves pins down ERU at constant inflation?
PS and WS
In MRE what condition do we expect the labour market to be in?
We expect the labour market to be in equilbrium -> WS = PS
What does the ERU show combinations of at WS=PS?
It shows the combinations of q and y at which WS=PS
What is the nature of inflation to the left of the ERU and why?
There is downward pressure on inflation and a -ve output gap as WS
What is the nature of inflation to the right of the ERU and why?
There is upward pressure on inflation and a +ve output gap as WS>PS
What will cause the ERU to shift?
Shifts in WS or PS
What does the AD curve show in the open economy?
The combinations of q and y at which point the goods market is in equilibrium
How long does it take for a change in q to impact y?
1 period
What is the equation for the IS curve in the open economy?
yt = At - (ar)t-1 + (bq)t-1, where a = responsiveness of investment to changes in the interest rate and b = responsiveness of demand (net exports) to a change in q
What will happen to demand if the real interest rate decreases?
It will increase (a>0)
What will happen to demand if the home currency depreciates?
It will increase (b>0)
Why are the real interest and exchange rates equal to their expected values in MRE?
It comes from the UIP condition ( (r)t-r* = (q^E)t+1 - (q)t )
It is the fact that the UIP condition must hold that implies that r=r* and the exchange rate is constant (and not expected to change)
In a closed economy, what is changed in MRE after a shock to stabilise the economy?
There will be a new stabilising interest rate
In an open economy, what is changed in MRE after a shock to stabilise the economy? Why is this different to a closed economy?
q will change to stabilise the economy -> q must change because r is pinned at r* so cannot be changed to stabilise the economy
For diagrams about supply and demand shocks in an open economy:
Check notes
What does the RX curve show in an open economy?
The CB’s best response, having taken the forex market into account
How does the adjustment in an open economy differ from the adjustment in a closed economy in r-y space?
In an closed economy it adjusts along the IS curve, whereas in an open economy it adjusts along the flatter RX curve
Why is the RX curve flatter than the IS curve in a closed economy?
Because it takes the forex market into account, meaning that the CB has to make smaller changes to r to stabilise the economy
What other factors does the CB need to take into account in an open economy when making policy decisions?
1) the effect of q on y
2) the forward-looking forex market and how it will behave
Does wage setter behaviour differ in an open economy compared to a closed economy?
No, wages are set on domestic prices which will not change if the economy is open or closed
For a diagram about an inflation shock in an open economy:
Check notes
Does the CB face any different PC’s in an open economy compared to a closed economy?
No, the CB faces the same PC in an open economy as the PC is anchored in the labour market which is domestically impacted
What are the key features of the RX curve?
1) it goes through the intersection of r* and ye
2) the slope reflects: interest and exchange rate sensitivity of AD, the CB’s preferences and the slope of the PC
3) It is flatter than the IS -> if IS gets flatter then so will RX
4) RX will be flatter if MR is steeper -> if the PC is flatter or the CB is less inflation averse
How is the RX impacted if r* or ye change?
It will shift
How will an open economy respond to a -ve demand shock?
Given that r is fixed at r*, a depreciated q is needed to boost exports and offset the demand reduction to bring the economy back to ye
How will a closed economy respond to a -ve demand shock?
A lower r will be set to stabilise demand by increasing investment and hence AD until the economy is back at ye
For an advanced permanent -ve demand shock in an open economy:
Check notes
What is exchange rate overshooting?
When the exchange rate is appreciated/depreciated past equilibrium to create an output gap that reverses the initial output gap created by the demand shock e.g. q is depreciated more than needed to create a positive y-gap to offset an initial -ve y-gap from an AD reduction
