EC2B3 Topic 10: International Macroeconomics

Question 1

How does a small open economy with perfect capital mobility faces world real interest, and goods market clear

Answer 1

By adjusting net exports

Question 2

How do capital controls adj how the economy operates

Answer 2

Behaves more like a closed economy

Question 3

Are nominal exchange rates more or less volatile than goods prices

Answer 3

More volatile

Question 4

How dos sticky good prices effect nominal exchange rate

Answer 4

Mean they have a real impact on competitiveness

Question 5

What does MP autonomy and perfect capital mobillity require

Answer 5

flexible/floating exchange rate regime

Question 6

What does a fixed exchange rate require

Answer 6

Abandoning monetary policy autonomy unless capital mobility is restricted

Question 7

What kind of exchnage rates is fiscal policy effective with

Answer 7

Fiscal policy is effective with fixed exchange rate

but not flexible ER

Question 8

What do you assume when adding trade to the macroeconomic model

Answer 8

• Assume flexiblle prices and wage
• Assume all economies produce and consume the same basket of goods
• World financial: can buy/sell bonds with real IR r *
• Perfect capital mobility: no restrictions on trading assets internationally
• Small open economy: does not influence r *

Question 9

Are Nd and Ns and Ys curves same in open and closed economy

Answer 9

work in the same way

Question 10

If r doesn’t equal to r * , what does perfect capital mobility mean

Answer 10

Extremely large outflows or inflows of capital (FA imbalances)

BP equilibrium (BP = CA + FA = 0) needs r = r *

Adjustment of net exports NX to get goods-market

Question 11

Draw thegoods market equilibrium in an open economy

Answer 11

• Open economy Yd and BOP requires r = r * , represented by horizontal BP line at r *

Capital flows until Yd and Ys meet at r = r *
- FA adjusts, requiring changes in NX so that CA = -FA which shift Yd curve

Question 12

Draw a (temp. negative) supply shock in an open economy

Answer 12

In open economy, r cannot rise above r *

• NX declines instead, shifting Yd further to the left to match the shift off Ys
• Y falls by more than in the closed economy

Question 13

Draw fiscal policy (temporary fiscal stimulus) in an open economy

Answer 13

In open economy; r cannot go above r * :

• NX declines instead, shifting Yd to the left so it matches the shift of Ys overall
• Real GDP Y still rises but by less

some of D goes to buying importts instead

Question 14

How do you note target exchange rate for fixed ER

Answer 14

e = ē

Question 15

What do foreign exchange market interventions make the domestic money supply

Answer 15

M(s) becomes endogenous

analysis with fully flexible prices (PPP holdss)

Question 16

Who is Forex done by and what assets do they have

Answer 16

Forex intervention:

• Domestic gov. bonds (from OMO)
• FX reserves

liability of CB is domestic currency (fiat money)

Question 17

How do following inteventions affect domestic money supplpy and stock of FX reserves:

Purchase of domestic currency, sale of foreign currency

sale of domestic currency, purchase of foreign currency

Answer 17

Purchase of domestic currency, sale of foreign currency

–> Shrinks domestic Ms and stock of FX reserves

sale of domestic currency, purchase of foreign currency

–> expands domestic money supply and stock of FX reserves

Question 18

Intervention needed to maintian fixed ER, when there is an increase in foreign prices

Answer 18

Increase in P * –> e = P/P * –> pivots Md rightwards –> need increase of Ms to keep equiilibrium ER

means higher P, inflation imported to domestic economy

Question 19

Consequences of an increase in foreign prices with flexible exhange rates

Answer 19

Increase in P * –> e = P/P * –> pivots Md rightwards –>exchange rate falls

P unaffected, no imported inflation

Question 20

Draw a one off permanent increase of the money supply, when there is MP autonomy with flexible ER

Answer 20

P also rises as e rises in prop to Ms increase

Question 21

What are capital controls

Answer 21

Restrictions on foreign purchases of domestic assets or domestic purchases of foreign assets

makes FA less sensitive to r - r *

Question 22

Result of msot extreme form of capital controls

Answer 22

Same outcome as autarky

Question 23

Draw a negative supply shock with capital controls

Answer 23

Capital controls:

• GDP falls by less
• Real interest rises from r0 to r1

Households better off with perfect capital mobility because can smooth consumption with cheaper international borrowing at rate r *

Question 24

what do we use for prices of imports relative to domestically produced goods

Answer 24

q = prices of imports relative to domestically produced goods

higher q (imports more expensive) –> improving export competitiveness

Question 25

How are net exports measured

Answer 25

NX = X - qZ

Question 26

How does increaseing Q impact quantities of X and Z

Answer 26

* Quantity of exports X demanded increases with q as competitiveness increases * Quantity of imports Z demanded increases with q as domestically produced goods become more competitive **Higher q raises NX**; volume effects of q on X and Z dominate import value effect

Question 27

How does terms of trade work with flexible prices

Answer 27

q is flexible: changes to get required NX

Question 28

How does a flexible q with flexible prices help the economy; assume a temporary fiscal simtulus with an increase in G

Answer 28

Higher G --> need lower NX in equilibrium --> lower q --> raises purchasing power of w --> shifts Ns curve and Ys curve to right smaller change in NX requuired to reach BP at r = r * (capital controls)

Question 29

What does evidence suggest instead of PPP

Answer 29

suggests sticky rather than flexible prices of goods in short run PPP only for long run

Question 30

do nominal exchange rate fluctuations impact the terms of trade when nominal good prices are sticky int he domestic currency

Answer 30

Yes they alter the terms of trade in short run; economy responds differently to shocks when prices sticky; MP has real effects

Question 31

What is q equivalent to in terms of P * , P and e

Answer 31

P = price of domestic goods in domestic currency P * = price of foreign goods in foreign currency e = nominal exchange rate

Question 32

Effect of higher e with sticky prices

Answer 32

Higher e --> Depreciation of domestic currency --> increase competitiveness (higher q) --> raising NX --> shifts Yd to the right

Question 33

Assuming capital mobility is perfect and investors holding bonds are risk neutral. Describe the process of exchange rate adjustment

Answer 33

If 1 + i < (1 + i * ) e' / e, then foreign bonds offer higher expected returns: Sell domestic and buy foreign --> causes loss of value --> higher e' ---> higher e implies return on foreign bonds declines relative to domestic bonds --> continues until RHS = LHS until 1 + i = (1 +i * ) e' / e

Question 34

What is UIP - Uncovered interest parity

Answer 34

With risk-netural investors and perfect capital mobility in a SOE; BOP needs 1 + i = ( 1 +i * ) e' / e

Question 35

If delta is not too large relative to i * , what is UIP approx.

Answer 35

i = i * + delta i is domestic nominal IR i * as future nominal IR Delta; any expected future depreciation

Question 36

If consumer price inflation is approx. 0, what is UIP

Answer 36

r = r * + delta

Question 37

What are the 3 components of the INternational New KEynsian sitcky-price model

Answer 37

1. Y(d) incl net exports; position depends on nominal exchange rate e 2. MM line represents CB monetary policy 3. BOP: horizontal BP line at r = r * _+ delta

Question 38

Draw an economy with a flexible exchange rate NK sticky prices

Answer 38

Floating rate --> CB has MP autonomy --> chooses position and shape of MM line exchange rate adjusts so that Y(d) curve shifts to where BP and MM lines intersect

Question 39

Draw economy with fixed exchange rate Sticky NK

Answer 39

CB uses MP to achieve fixed rate --> Competitiveness doesnt change --> MP to shift M to intersect Yd on BP line No MP autonomy

Question 40

What is the Trilemma

Answer 40

Limits of policy choice in an open economy. Can only have two of the following three: 1. **Fixed exchange rate** 2. **MP Autonomy** 3. **Free capital flows** so UIP holds

Question 41

Draw free capital flows with fixed exchange rate

Answer 41

* MP must adjust MM line to intersect BP and Yd(e fixed) perf cap mobility --> on r = r * no exchange rate adjustment --> canot shift Yd cannot have independent monetary policy

Question 42

Draw monetary autonomy and fixed exchange rate

Answer 42

MP autonomy --> r differntial --> Cannot be on perfect capital mobility line can use sterilised fx interventions to get e = e fixed. Interventions replace private capital flows

Question 43

Draw monetary autonomy and free capital flows assume monetary loosening

Answer 43

MM line downwards Free capital flows --> exchange rate adjusts so Yd intersects MM and BP cannot havea fixed exchange rates effectiveness based on change in comeptitiveness

Question 44

What policy can substitute for lack of an autonomous monetary policy when a governemnt wants fixed FX abd capital mobility

Answer 44

Can use fiscal policy to shift Yd curve for a given exchange rate e can substitue well for MP

Question 45

Draw fiscal policy, fixed ER and free capital flows

Answer 45