Topic 3 Flashcards
3 assumptions about capital flows in a small open economy? What do they imply?
1) Domestic and foreign bonds are perfect substitutes
2) Perfect capital mobility (ie. no restrictions on trade in assets)
3) Economy can’t affect world interest rate because it’s small
1 and 2 imply r=r, and 3 implies r* is exogenous
China X and M?
X=26%, M=23%
Germany X and M?
X=46%, M=40%
USA X and M?
X=13%, M=16%
Net outflow of loanable funds =?
net purchases of foreign assets
In a small open economy how is I, NCO and NX determined?
r* (exogenous) determines I, and the difference between S and I determines NCO and NX (see graph)
How does contractionary fiscal policy affect S, I and r in a small open economy?
See explanation and graph
How does expansionary fiscal policy abroad affect S, I and r in a small open economy?
See explanation and graph
How does an increase in investment abroad affect S, I and r in a small open economy?
See explanation and graph
Which equation explains the interaction between the current and capital account?
(S-I)=NX
Balance of payments equation?
BP=CA-NCO
Balance of payments = current account - capital account
3 things included in the current account?
Trade balance (NX)
Net factor income from abroad (NFIA)
Net unilateral transfers (NUT)
CA=NX+NFIA+NUT
What does NFIA equal?
NFIA = factor income from abroad - factor payments to foreigners
What is included in NUT?
Flows such as foreign aid and EU budget contributions
Simplifying assumption regarding NUT and NFIA?
NUT=NFIA=0
See:
big mac index slide and do calculation after
Key point when analysing a large open economy such as the US?
The interest rate is no longer exogenous since a large open economy influences global financial market conditions.
See and learn diagrams for large open economy model?
now
Learn diagrams and explanations for how, in a large open economy, the following scenarios will play out:
1) Exp. FP at home
2) Increase in investment demand
3) Trade policy at home (eg. protectionism)
4) Fiscal policy abroad
now, also see and learn table at end of topic 3 notes that summarises it all
What is the nominal exchange rate, e?
The relative price of domestic currency ITO foreign currency
What is the real exchange rate?
Relative price of domestic goods ITO foreign goods
In macroeconomics how can we view the real exchange rate? What does this then mean if there’s an increase in the exchange rate?
The relative price of one country’s output ITO another country’s output
This means domestic goods become relatively more expensive tf fall in X, increase in M, fall in NX
What is the relationship between NX and real exchange rate?
Negative
Why is the NCO curve vertical when plotted on a real exchange rate vs NX graph?
S+I don’t depend on the real exchange rate tf NCO curve is vertical
Explain how supply and demand act in the foreign exchange market?
Demand: Foreigners need x’s currency to buy x’s net exports
Supply: NCO is the supply of x’s currency to be invested abroad
Note:
Supply and demand of currency in foreign exchange market is not equal to demand of real money balances OR supply of money (see why in slides halfway down)
Learn 4 experiments for a small open economy. Effects on real exchange rate vs NX graphs and explanations of:
1) FP at home
2) FP abroad
3) increase in investment demand
4) trade policy to restrict imports
now
Note
For any given real ER, the growth rate of nominal ER is equal to the difference between foreign and domestic inflation rates
First definition for law of purchasing power parities and reasoning behind it?
Goods must be sold at the same currency adjusted price in all countries; reasoning is arbitrage (ie. if not same price people would sell between countries until prices are all equal)
Second definition for law of purchasing power parities and reasoning behind it?
The nominal ER will adjust to equalise the cost of a basket across countries; reasoning is Law of one price
PPP equation?
e.P=P*
where:
e=nominal exchange rate
P=cost of basket of domestic goods in domestic currency
P*=cost of basket of foreign goods in foreign currency
Note
Under PPP, changes in (S-I) have no impact on real or nominal ER (see why in notes)
Evaluation: 2 reasons PPP doesn’t hold in real world?
1) International arbitrage not always possible (nontraded goods, transportation costs)
2) Differen’t countries’ goods are not perfect subsititutes
Evaluation: 2 reasons PPP is still useful in analysis?
1) simple and intuitive
2) in real world nominal exchange rate does tend towards their PPP values in the long run
