Topic 14: Open Economy Financial Markets & Trade

Question 1

Draw a diagram showing how the real interest rate and level of investment is determined in a closed economy.

Answer 1

Question 2

Show the savings supply equation for the open economy, and all the deal it is equal to.

Answer 2

S = S + (T-G) + SNF - ΔR = S + (T-G) + KA = I

Question 3

Why doesn’t international arbitrage occur for long term interest rates?

Answer 3

• Countries subject to different shocks
• Monetary policy in countries are different

So we get variations in:

• Expected future inflation, expected future exchange rate
• The riskiness of expected future inflation & future exchange rate

Question 4

Why does Australia have a relatively high real interest rate?

Answer 4

• Because it has a relatively volatile exchange rate, due to the regional & commidity based composition of the trade shocks it suffers.
• Not due to unsteadiness in monetary policy.

Question 5

Give the net savings inflows equation

Answer 5

SNF = a_FS + b_FS ( r + e_r^e) / r*

Question 6

Give the NFI function, broken down to investment and savings functions, with the direction of changes in variables labled.

Answer 6

Question 7

Draw the open economy financial market diagram with shifters labeled.

Answer 7

Question 8

Explain how an acceleration in accumulation of foriegn reserves shocks the financial market.

Answer 8

• Demand side shock so Y, MP_K are unaffected.
• We can think of the central bank exchangeing home bonds for foreign bonds.
• Home bonds are in excess supply at the old interest rate
• Net inflows would be much lower at the old interest rate
• So the the home interest rate increases, offsetting the increased outflow - but not enought to stop net increased outflow of capital.
• So there is a lower balanbce on the capital account.

Question 9

Explain how a fiscal expansion affects the financial market.

Answer 9

• Demand shock, no effect on output
• Government savings and so domestic savings decrease
• At the old interest rate there is an excess supply of bonds.
• Foreign saves will finance some, but only at a higher interest rate.
• The price of home bonds fall and r increases.
• When the demand for investment matches the total supply of funds, the equilibrium is restored.
• The result is a larger net inflow on the capital account.

Question 10

Give the function for exports and imports with the sign of derivatives labeled.

Answer 10

X = X(Y_N* (+), e_R (-) )

M = M (Yd(+), Φ(+), e_R(-))

Question 11

Show a diagram demonstrating the market for foreign exchange.