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MacroEconomics > Week 8 A small open economy model > Flashcards

Week 8 A small open economy model Flashcards

1
Q

What do we mean by small?

A

Effectively our economy cannot impact the rest of the world- view us as price takers not price makers.

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2
Q

What are our 3 starting assumptions?

A
  • Endowment economy (i.e income is exogenous)
  • Two periods
  • SOE (so r = r∗)
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3
Q

What does r = r∗?

A

In a small open economy- the domestic real interest rate is the same as the world real interest rate.

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4
Q

Define a country’s current account balance.

A

The change in the value of its net claims on the ROW (the change in net foreign assets, NFA)

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5
Q

Is the CA in surplus if positive or negative? What does this mean?

A

Positive, and it means that the country is a net lender.

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6
Q

If an economy borrows from abroad, when does it have to pay it back?

A

In the next period.

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7
Q

What does the CA represent?

A

Trade over time.

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8
Q

How many periods does NX focus on?

A

A single period

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9
Q

If we assume optimality, what must be true of the current account surplus in period 1?

A

CA surplus period 1 = CA deficit period 2

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10
Q

What is a government budget surplus?

A

Taxes- Government spending

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11
Q

What is total domestic saving equal to?

A

Private saving + Government saving

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12
Q

What preferences does a representative curve have its indifference curve over?

A

(C + G and C’ + G’) where private consumption and government consumption are perfect substitutes.

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13
Q
  • What is the effect on the current account surplus following an increase in current income?
  • Why?
A
  • The current account surplus rises with an increase in current income.
  • Because consumption smoothing means that as income rises more than expenditure, the current account surplus rises
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14
Q

What is the CA equal to?

A

CA= Y-C-G

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15
Q
  • What is the effect on the current account surplus following an increase in future income?
  • Why?
A
  • The current account surplus falls following an increase in future income
  • As an increase in Y’ will increase consumption now, thus as CA = Y-C-G, but Y stays the same whilst C and G fall, the CA surplus falls.
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16
Q
  • What is the effect on the current account surplus following a change in taxes?
  • Why?
A

There is no impact as Ricardian equivalence holds, private and government savings just change by equal and opposite amounts.

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17
Q

What will happen to the 2 period small-open economy diagram following an increase in interest rates?

A

An increase in world interest rate will make the BC steeper and it will pivot around the endowment point

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18
Q
  • When CA<0, what is the effect of an increase in the real interest rate?
  • Why?
A
  • When CA<0, an increase in the real interest rate increase CA (reduces the deficit)
  • As increase in the real interest rate reduces consumption and increases savings
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19
Q
  • When CA>0, what is the effect of an increase in the real interest rate?
  • Why?
A
  • When CA<0, an increase in the real interest rate has an ambiguous effect on the CA
  • As for net lenders, an increase in the real interest rate could increase or decrease savings, so as C+G could rise or fall, so could the CA.
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20
Q

What do credit market imperfections allow?

A

The Home economy the possibility of defaulting on its debts

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21
Q

If a nations debt to the world in the current period is B, what is its CA?

A

CA= B- B’/1+r’

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22
Q

What is limited commitment?

A

When a country can default on its debt in either the future or current period.

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23
Q

Can a government post collateral against its debt?

A

No

24
Q

What does v represent?

A

A penalty for defaulting in the future period, which captures the cost the country will suffer from being denied access to “future” credit markets.

25
Q

What is the limited commitment constraint that implies that a nation’s indebtedness cannot be so large that defaulting will occur?

A

-B’ ≤ v

26
Q

Following the introduction of v, what is the first period budget constraint?

A

C + G ≤ Y + (ν/1+r) − B

27
Q

If a nation defaults on its debts in the current period, what does B’ =?

A

B’ = 0

28
Q

At what point should a nation default on its debt?

A

When B > v/1+r

29
Q

What is the effect of the world interest rates on defaulting?

A

As B > v/1+r, the higher the world interest rate is, default is more likely.

30
Q

What happens to NX if domestic demand for a good is higher than domestic supply?

A

Net exports are negative, as these goods are imported.

31
Q

When goods can be freely traded, what is the new income-expenditure identity?

A

Y= C + I + G + NX

32
Q

Does an increase in the world interest rate increase or decrease output?

A

An increase in the world interest rate increases output and the current account surplus?

33
Q

What happens to output demand and supply following an increase in government spending?

A
  • Output supply increases a small amount due to the negative wealth effect associated with an increase in govt spending (which means higher taxes)
  • Output demand increases as a direct result of the increase in G
34
Q

What are the effects of an increase in technology?

A
  • The direct effect is an increase in output supply
  • Since interest rates cannot change, output demand increases (via NX)
  • As output increases, consumption also rises
  • Given that the change in Z is temporary, investment does not change
35
Q

What are the effects of a future increase in technology?

A
  • With ‘news’ about a future increase in TFP consumption rises
  • As does investment
  • However, Ys does not shift as current production • technologies have not yet changed
  • This implies no effect on current output so NX must fall
  • CA falls
36
Q

What does e denote?

A

The nominal exchange rate

37
Q

How do we calculate the value of purchasing a foreign good?

A

eP*
Eg if I want to buy a book in dollars which is worth £10 and 2 = £1
2x10 = $20

38
Q

How do we calculate the real exchange rate?

A

eP*/P

39
Q

If it is costless to transport goods between foreign countries and the domestic and there’s no trade barriers, when would it be cheaper to buy foreign goods than domestic goods?

A

When eP* < P

40
Q

If it is cheaper to purchase foreign goods, what would we expect to happen to the price of domestic goods, and what relationship would this result in?

A
  • We would expect P to fall until P=eP*
  • This relationship is called purchasing power parity
  • Here, the real exchange rate =1
41
Q

Does PPP hold?

A

It depends on the kind of good, for example crude oil is shipped globally for low cost, so could hold. Whereas the cost of going to another country for a haircut is relatively far larger, so the “law of one price” may not hold in this case.

42
Q

What is PPP also known as

A

The law of one price.

43
Q

Would we expect PPP to hold in the long run?

A

Yes, as if it didn’t consumers would generally purchase the good from the cheaper location. However it is fairly unrealistic in the short-run.

44
Q

What is an alternative way of writing PPP, what does this imply?

A

∆ ln et = πt − π∗t
This implies that the rate of depreciation is equal to the difference of inflation between the home country and the foreign country

45
Q

What is Uncovered interest parity (UIP)?

A

rt = r∗t + st+1

ie if the UK pays 5% interest and the US pays 6%, it is because the pound is expected to appreciate by 1%.

46
Q

Does the UIP often hold?

A

No

47
Q

What are the 2 types of exchange rate regimes?

A
  • Fixed exchange rates

* Flexible exchange rates

48
Q

In an open economy, what will a young agent in country a be able to do?

A
  • Sell some of her endowment ya to the old in a, obtaining qa
  • Sell some of her endowment to the old in b, obtaining qb
  • Then, when old she will be able to purchase output from the young in countries a and b
49
Q

If a government imposes currency controls, and prevents a young person transferring foreign currency from one period into the next, what will the young person do?

A
  • They will transfer the foreign currency to their home currency whilst they are still young.
  • As a result, for a young a agent, qa = ya and qb = 0
50
Q

What is the nominal value of the b money (euro) compared to a money (dollar)?

A

et= (pat/pbt)

51
Q

What is therefore the nominal exchange rate = to?

A
  • et = (Mat/Mbt)(yb/ya)

* The exchange rate is determined by relative money supplies and relative output

52
Q

After removing currency controls, what is an agents budget constraint when they are old?

A

ct+1 = c = Πa^−1 qa + Πb^−1 qb

53
Q

As agents are trying to maximise utility, what must be true?

A
  • Expected inflation rates must be the same across the two countries
  • Πa = Πb
54
Q

After currency controls are removed, what must be true about the 2 currencies?

A
  • The two currencies are viewed as perfect substitutes by the young
  • All agents will have q = qa + qb = y
  • But any value of qa, qb satisfying the above will be an equilibrium
55
Q

What is the only market with a market-clearing condition?

A
  • The only market-clearing condition we have is for the world money market (use qa + qb = y )
  • Ma + etMb = 2pat Ny
  • Any values of e and pa that satisfy the equation above will yield the equilibrium exchange rate.
56
Q

Why is there indeterminacy?

A

All the money supplied by each country will be

held, but our model does not tell us by whom

MacroEconomics (8 decks)

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