Open Economy II

Question 1

What 2 assumptions do we make about the Theory of Open Economy?

Answer 1

• GDP is taken as Given

- Price Level taken as Given- Model of SR

Question 2

What 2 Markets are involved in Open Market Theory?

Answer 2

• S + D for Loanable Funds

- S + D for Foreign Currency

Question 3

What does S + D for Loanable Funds Coordinate?

Answer 3

Savings, Investments + NCO in Open Economy

Question 4

What does S + D for Foreign Currency Coordinate?

Answer 4

People who want to Exchange Domestic currency for Foreign currency

Question 5

What are Savings equal to in an Open Economy?

Answer 5

S = I + NCO

- S = Domestic Investment + Net Capital Outflow

Question 6

What can Savings be used to Finance?

Answer 6

Domestic or Foreign Capital Accumulation

Question 7

What is the Supply of Loanable Funds?

Answer 7

Domestic Saving - Public + Private

Question 8

What is the Demand for Loanable Funds

Answer 8

D = I + NCO

- Investments at Home or Abroad

Question 9

What does the Real Interest Rate (r) equilibrate?

Answer 9

S + D for Loanable Funds

Question 10

What does S(r) of Loanable Funds look like + why?

Answer 10

Increasing

Increased r –> Encourage Saving –> Increased S(r)

Question 11

What does D(r) for Loanable Funds look like + why?

Answer 11

Decreasing

Increased r –> Discourages I + Foreign Assets less Attractive –> Decreased D(r)

Question 12

How does NCO depend on r?

Answer 12

Increased Domestic r –> Domestic Assets more attractive –> Decreased NCO

Question 13

What does Negative NCO mean?

Answer 13

Economy has Net Inflow of Capital

Question 14

In the FX Market- what is the Demand for £s?

Answer 14

D for £s = NX

- Since NX is paid in £s

Question 15

In the FX Market- what is the Supply of £s?

Answer 15

Supply of £s = NCO

- Since people Buying Foreign Assets must Sell £s at FX market to buy the assets

Question 16

What does the Real Exchange Rate (E) equilibrate?

Answer 16

S + D for £s in FX Market

Question 17

Why is S in FX Market fixed?

Answer 17

Vertical Supply Curve

• S = NCO
• NCO determined by Market for Loanable Funds

Question 18

What does D for £s in FX look like + why?

Answer 18

Decreasing in E

• D = NX
• Increased E –> Decreased X + Increased M –> Decreased NX –> Decreased D for £s

Question 19

How is E determined in FX market, through Market for Loanable Funds?

Answer 19

Market for Loanable Funds –> Determines r

• r –> Determines NCO
• NCO = S –> Determines E with NX

Question 20

What do E + r adjust to?

Answer 20

E + r adjust to equilibrate Market for Loanable Funds + FX market

Question 21

What is Trade Policy?

Answer 21

Gov. Policy that directly Influences Q. of G+S a country Exports + Imports
- e.g. Tariffs, Quotas, Voluntary export restrictions…

Question 22

What does an Import Quota do?

Answer 22

Directly restricts M –> decreased M –> Increased NX

Question 23

Why is the Effect of an Import Quota on NX offset?

Answer 23

Increased NX –> Increased D for £s –> Increased E –> Decreased NX

Question 24

Do Import Quotas affect Trade Balance + why

Answer 24

NO- does NOT affect Trade Balance

• NX = NCO => S = I
• Trade Policies do NOT alter S or I –> E adjusts to keep Trade Balance the same, regardless of Trade Policy

Question 25

What are the Micro Effects of Trade Policy?

Answer 25

Can affect Specific Firms / Industries

- e.g. Import Quota- benefits Domestic Firms– BUT Increased E- hurts Exporters –> Decreased X

Question 26

What can Political or Economic Instability lead to?

Answer 26

Capital Flight

Question 27

What is Capital Flight?

Answer 27

large Sudden Decrease in D for Assets located in a country

Question 28

How does Capital Flight affect r + E?

Answer 28

Capital Flight –> Increased NCO –> Increased NX –> Increased D for Loanable Funds –> Increased r
– Increased NCO –> Increased S of currency –> Decreased E- Depreciation

Question 29

What are the main effects of Increased r from Capital Flight?

Answer 29

• Decreased I
• Slows Capital Accumulation
• Slows Economic Growth

Question 30

What are the main effects of Decreased E from Capital Flight?

Answer 30

• Depreciation

- Increased NX –> Improves Trade Balance

Question 31

What is the relationship of Open Economy with PPP?

Answer 31

PPP assumes International trade responds instantly to changes in P ÷ P*
- i.e. Changes in Relative Prices

Question 32

What does the relationship of Open Economy with PPP mean?

Answer 32

FX Demand is Horizontal at E = 1

Question 33

What does Decreasing D for £s allow?

Answer 33

Allows E to differ from what PPP would have- Consistent with facts

Question 34

What is the Gov. Budget Deficit?

Answer 34

Gov. Spending > Gov. Revenue

Question 35

What does a Gov. Budget Deficit cause?

Answer 35

Decreased National Savings –> Decreased S of Loanable Funds

Question 36

How does an Increased Budget Deficit affect r + E?

Answer 36

Increased Budget Deficit –> Decreased S of Loanable Funds –> Increased r
–> Decreased NCO –> Decreased S of £s on FX –> Increased E- Appreciation