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draw the trade defecit diagram following an increase in domestic demand
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draw the interest parity diagram (interest gives exchange rate)
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draw j curve
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draw unconventional mp (qe)
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what does arbitrage imply?
Arbitrage implies that the domestic interest rate must be (approximately) equal to the foreign interest rate minus the expected appreciation rate of the domestic currency.
what does the choice between domestic and foreign goods depend on?
what does the choice between domestic and foreign assets depend on?
- The choice between domestic goods and foreign goods depends primarily on the real exchange rate.real exchange rate is not just what we observe by looking at the newspaper wheat we observe i s the nominal exchange rate- need to know how much we can buy with our goods abroad.
- The choice between domestic assets and foreign assets depends primarily on their relative rates of return, which in turn depends on domestic interest rates and foreign interest rates, and on the expected depreciation of the domestic currency.
determinants of c, i, g in a closed economy
C + I + G= C(Y-T) +I(Y, i) +G
+) (+, -
equation for demand for domestic goods in a open economy
Z= C+I+G- IM/ ε+X
The first three terms—consumption, C, investment, I, and government spending, G
constitute the domestic demand for goods (DD) C+I+G is the output in a closed economy but in open economy the domestic demand for goods
equation for net exports
• First, we subtract imports (in terms of domestic goods)
• Second, we must add exports.
Imports divided by the real exchange rate- want the value of imports in terms of domestic goods. Difference between exports and imports can also be defined as net can just be plus net exports.
Note that N X= X(Y*,ε) -IM(Y,ε)/ε
determinants of exports
X=X(Y,ε)
(+ , -)
An increase in foreign income, Y, leads to an increase in X exports.
§ An increase in the real exchange rate, epsilon, ε, leads to a decrease in X exports because an appreciation makes domestic goods more expensive and foreign goods cheaper
open economy version of the is and lm relations:
IS curve Y= C(Y-T) +I(Y, i) +G +NX(Y, Y, 1+ i / 1+i ̅E^e)
IS curve nowhas income, ofreign income and the interest parity condition
LM curve i = ̅i
LM curve exactly the same as before
An increase in the interest rate (i) now has two effects: when the central bank changes i
§ The first effect, which was already present in a closed economy, is the direct effect on investment. (↑i → ↓I → ↓Y) reduction in investment and output
§ The second effect, which is present only in the open economy, is the effect through the exchange rate. (↑i → ↑E → NX↓→ Y↓)
IS-LM linked with the interest parity condition: what does an increase in the interest rate do to ouput?
an increase in the interest rate reduces output both directly and indirectly (through the exchange rate): The IS curve is downward sloping. Given the interest rate, an increase in output increases the interest rate: The LM curve is horizontal as before. The IP relation is upward sloping to reflect the fact that higher i will lead to higher E.
real exchange rate equation
ε = EP/ P*
In words: The real exchange rate, ε , is equal to the nominal exchange rate, E, times the domestic price level, P, divided by the foreign price level, P*
why do we need the marshall Lerner condition
NX= X (Y*, ε) - IM (Y, ε) / ε
When there is a change in the real exchange rate we can see that that change appears in 3 different places which makes it hard to understand.
As the real exchange rate, ε, enters the right side of the equation in three places, this makes it clear that the real depreciation (↓ε) affects the trade balance through three separate channels:
- Exports, X, increase.
- Imports, IM, decrease.
- The relative price of foreign goods in terms of domestic goods, 1/ε , increases. When epsilon goes down this ratio goes up. How do we know what the final impact is when these are all opposing?
Its ambiguous so we need to make an assumption: the marshall- Lerner condition
what is the marshall Lerner condition?
The Marshall-Lerner condition is the condition under which a real depreciation (↓ε ) leads to an increase in net exports (NX↑) because we are going to assume that one of the effects is going to dominate
Note that for this to happen:
o Exports must increase enough and Imports must decrease enough to compensate for the increase in the price of imports, i.e.,
(+ - + )
Change in X > change in IM * change in (1/ε)
Whenever we have a real depreciation net exports will go up because the change in exports is bigger than the rest
marshall lerner condition summary
Depreciation and the Trade Balance: The Marshall-Lerner Condition
Let’s summarise: The depreciation leads to a shift in demand, both foreign and domestic, toward domestic goods.
This shift in demand leads in turn to both an increase in domestic output and an improvement in the trade balance because there is going ot be more imports and less exports.
Marshall-Lerner condition: given output, a real depreciation leads to an increase in net exports.
explain the j-curve
Exchange rate and fiscal policy combinations
General lesson: if a government wants to achieve 2 targets it will need 2 instruments! Cant use just exchange rate changes.
Looking at Dynamics: The J-Curve
A depreciation may lead to an initial deterioration of the trade balance; e decreases, but neither X nor IM adjusts very much initially. Not instantaneous take along time to adjust. I fyou think about it when a company imports from china or us does so months in advance. So the firm doesnt pay until it gets there so the flows are fixed i nthe short run were placed many months before. When there is a decrease in the interest rate the impact is only going to be felt a year later. The quantity of imports and exports are not going to change very much initially
Initially: ε↓ → (X-IM/ε) ↓ price of imports grow immediately quantity of exports and imports don’t change much so net exports are going to go down.
Eventually, exports and imports respond, and depreciation leads to an improvement of the trade balance.
Eventually: ↑X, IM↓, ε↓ → (X-IM/ε) ↑
Eventually net exports will go up
what is the equation for investment and savings in the open economy
CA= S +(T-G) - I
Current account= private savings public savings - investment
From the equation above, we conclude:
• An increase in investment must be reflected in either an increase in private saving or public saving, or in a deterioration of the current account balance. One of the other three have to go down. Decrease in current account. Investment could only go up if public or private saving went up but in an open economy you could make your current account worse to increase investment- borrowing from the rest orf the world
• An increase in the budget deficit must be reflected in an increase in either private saving, or a decrease in investment or a deterioration of the current account balance.
• A country with a high saving rate (private plus government) must have either a high investment rate or a large current account surplus.eg china high domestic and public savings so can have very large trade surpluses
what happens in expansionary fiscal policy in an open economy in terms of exchange rate
The Effects of Fiscal Policy in an Open Economy
↑G = ?
Higher the interest rate the higher the exchange rate
Increase in public spending will shift the IS curve to the right. Assuming the bank does not change the interest rate the exchange rate is unchanged.
The increase in government spending leads to an increase in output so shifts the IS curve to the right. It shifts neither the LM curve nor the interest-parity curve.
An increase in government spending leads to an increase in output. If the central bank keeps the interest rate unchanged, the exchange rate also remains unchanged.
This is the same as a closed economy but
write out the 5 equations for is-lm-pc-ws-ps graphs
see booklet
explain crowding out
investment is a function of both output and interest rates, so in MR interest rates lead to lower investment - public spending corwds out investment because of a rise in interest rates
current account equa
draw the deflationary spiral diagram
notes
inflation targeting equation
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interest rate rule/taylor rule equation
and what is it
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what is the divine conincidence?
keeping inflation stable so output is at potential because when inflation is equal to target, unemployment is at the natural level
why are m and z special cases
a change in m or z will have a permanenet effect on both the Un and Yn such that MR equilibirum is not the same as intial equilibirum
Un = m+z/a
explain expansionary fiscal policy in terms of investment
in summary: an increase in public spending will crowd out investment because r (interest rate) increases
(increase) in G, (increase) in r, (decreases) in Y back to Yn in MR
Investment is a function of both Y (positive) and i (negative) that is I = I (y,i)
Because in MR, Y = Yn (as it was initially), Y doesn’t change
The increase in i (interest rate) therefore must lead to a decrease in I (investment)
However, even though Y is back to Yn, composition of Y is now different (increase in G, decrease in I)
