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EC204 Macro Notes > Three Equation Model in the Open Economy > Flashcards

Three Equation Model in the Open Economy Flashcards

1
Q

What is the home nominal interest rate equation and what is it denoted by?

A

e = no.of units of home currency / 1 unit of foreign currency

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2
Q

What does the nominal interest rate show?

A

How many £’s are required to buy 1 unit of foreign currency

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3
Q

What is the home real interest rate equation and what is it denoted by?

A

Q = price of foreign goods in home currency / price of home goods -> P*e/P

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4
Q

What does the real interest rate show?

A

How many £’s you need to buy goods abroad compared to how much that good costs at home

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5
Q

How does the interest rate stabilisation channel work in the open economy?

A

Say there is a demand shock -> CB increases i -> this creates a -ve output gap -> reduced inflation back to target

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6
Q

How does the exchange rate stabilisation channel work in the open economy?

A

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

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7
Q

How does the exchange rate impact how much the CB needs to change r by?

A

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

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8
Q

How does the AD (IS relation) change in an open economy and how is the multiplier affected?

A

It will now include exports and imports -> means the multiplier is reduced as some of the increased income will be spent on imports

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9
Q

How does the Phillips curve change in an open economy?

A

Domestic inflation is still used to set wages -> PC is no different than in a closed economy

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10
Q

How does the MR curve change in an open economy?

A

CB may target domestic inflation or CPI (which includes the prices of imports) so there may be a changed MR

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11
Q

What does UIP stand for?

A

Uncovered Interest Parity

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12
Q

What does the UIP condition explain?

A

How forex traders respond to interest rate changes

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13
Q

What assumption do we make between home and foreign bonds in the UIP condition?

A

That they are perfectly substitutable

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14
Q

Given that bonds are perfectly substitutable in the UIP condition, what are the factors that differentiate expected returns on bonds in the forex market?

A

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

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15
Q

For diagrams on a UK increase of i:

A

Check notes

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16
Q

How will forex traders react to increase of i on UK bonds and how will that affect the UK exchange rate?

A

The exchange rate will immediately appreciate as traders will buy GBP to buy the bonds

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17
Q

What do we assume will happen to the exchange rate after it immediately appreciates after an i increase?

A

We will assume that it will return back to its original level

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18
Q

How does the UK e returning back to its original level affect the price of UK bonds?

A

As e depreciates, it makes the returns possible from selling UK bonds reduce

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19
Q

What does the UIP condition state about gains from investing in UK bonds?

A

Interest rate gains coming from owning UK bonds = loss from expected depreciation of the UK exchange rate

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20
Q

What would happen to the UK e if no investment in UK bonds occurred?

A

It would remain constant

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21
Q

Why does the UK e only gradually return to its original level and not suddenly?

A

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

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22
Q

What happens to the incentives to buy UK bonds as time passes since the UK i increase?

A

The incentive to buy UK bonds falls as the losses coming from the UK currency depreciation grows

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23
Q

When do the largest gains in owning UK bonds after an i increase occur?

A

Right as the increase in i is made

24
Q

What is the UIP condition formula?

A

(i) t - i* = log(e^E)t+1 - log(e)t

(i) t - i* = (e^E)t+1 - (e)t / (e)t

25
Q

For UIP diagram for a change in i:

A

check notes

26
Q

What will cause a movement along the UIP curve?

A

A change in i

27
Q

What will cause a shift of the UIP curve?

A

1) given i*, a change in log(e^E)

2) given log(e^E), a change in i*

28
Q

How can the UK CB keep exchange rate expectations the same after a change in i*?

A

If they match the change in i* by an equal change in i -> so that i = i* still

29
Q

The intersection of which curves pins down ERU at constant inflation?

A

PS and WS

30
Q

In MRE what condition do we expect the labour market to be in?

A

We expect the labour market to be in equilbrium -> WS = PS

31
Q

What does the ERU show combinations of at WS=PS?

A

It shows the combinations of q and y at which WS=PS

32
Q

What is the nature of inflation to the left of the ERU and why?

A

There is downward pressure on inflation and a -ve output gap as WS

33
Q

What is the nature of inflation to the right of the ERU and why?

A

There is upward pressure on inflation and a +ve output gap as WS>PS

34
Q

What will cause the ERU to shift?

A

Shifts in WS or PS

35
Q

What does the AD curve show in the open economy?

A

The combinations of q and y at which point the goods market is in equilibrium

36
Q

How long does it take for a change in q to impact y?

A

1 period

37
Q

What is the equation for the IS curve in the open economy?

A

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

38
Q

What will happen to demand if the real interest rate decreases?

A

It will increase (a>0)

39
Q

What will happen to demand if the home currency depreciates?

A

It will increase (b>0)

40
Q

Why are the real interest and exchange rates equal to their expected values in MRE?

A

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)

41
Q

In a closed economy, what is changed in MRE after a shock to stabilise the economy?

A

There will be a new stabilising interest rate

42
Q

In an open economy, what is changed in MRE after a shock to stabilise the economy? Why is this different to a closed economy?

A

q will change to stabilise the economy -> q must change because r is pinned at r* so cannot be changed to stabilise the economy

43
Q

For diagrams about supply and demand shocks in an open economy:

A

Check notes

44
Q

What does the RX curve show in an open economy?

A

The CB’s best response, having taken the forex market into account

45
Q

How does the adjustment in an open economy differ from the adjustment in a closed economy in r-y space?

A

In an closed economy it adjusts along the IS curve, whereas in an open economy it adjusts along the flatter RX curve

46
Q

Why is the RX curve flatter than the IS curve in a closed economy?

A

Because it takes the forex market into account, meaning that the CB has to make smaller changes to r to stabilise the economy

47
Q

What other factors does the CB need to take into account in an open economy when making policy decisions?

A

1) the effect of q on y

2) the forward-looking forex market and how it will behave

48
Q

Does wage setter behaviour differ in an open economy compared to a closed economy?

A

No, wages are set on domestic prices which will not change if the economy is open or closed

49
Q

For a diagram about an inflation shock in an open economy:

A

Check notes

50
Q

Does the CB face any different PC’s in an open economy compared to a closed economy?

A

No, the CB faces the same PC in an open economy as the PC is anchored in the labour market which is domestically impacted

51
Q

What are the key features of the RX curve?

A

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

52
Q

How is the RX impacted if r* or ye change?

A

It will shift

53
Q

How will an open economy respond to a -ve demand shock?

A

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

54
Q

How will a closed economy respond to a -ve demand shock?

A

A lower r will be set to stabilise demand by increasing investment and hence AD until the economy is back at ye

55
Q

For an advanced permanent -ve demand shock in an open economy:

A

Check notes

56
Q

What is exchange rate overshooting?

A

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

EC204 Macro Notes (8 decks)

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