topic 9- open economy Flashcards
how do we modify the IS curve for the open economy?
We need to modify the IS curve to take into account the effect of Exports and Imports. assuming that the Marshall-Lerner conditions hold and that therefore a real depreciation (a rise in competitiveness) in the real exchange rate brings a net increase in the demand for domestically produced goods and service
the new IS equation is given by the equation:
y(t)=A(t) -ar(t-1) + b[EP*/P(t-1)]
where both the interest rate and real exchange rate may take one period to affect the current level of output demanded
what is the chief result that is retained from the mundell fleming because of the marshall lerner condition holding for the IS curve?
the IS curve must return at least to its original position with exchange rate depreciation/appreciation given an initial negative/postive shock to autonomous expenditure
how can the equillibrium in the capital account be modelled using a key feature of the mundell fleming ?
the capital account is modelled with the UIP which shows the interest rate and exchange rate for which fulfils the uncovered interest parity condition.
what is the equation of the UIP curve
i - i* = [E^e (t+1) - E(t)] /E(t)
what is the interest rate considered to be i the UIP curve?
the rateof return on standardised bonds
what is the uncovered interest parity condition?
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.
what are the three parts of the open economy three equations model?
the top left quadrant is the uncovered interest parity curve (UIP) which has the y axis nominal interest rate and the x axis as the exchange rate. the curve is a downward sloping curve that starts off steep and then flattens as exchange rate increases. there is a broken line from this equilibrium point on the UIP curve to the top right quadrant which has the open economy IS curve. this quadrant has a y axis of real interest rate and the x axis as the output. the IS curve is downward sloping still.
the bottom right quadrant includes the IAPC which is upwards sloping and the monetary rule which is downward sloping. the y axis is the rate of inflation whilst the x axis is the output.
