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ECO2102 Macroeconomics > ECO2102 The open economy (6) > Flashcards

ECO2102 The open economy (6) Flashcards

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1
Q

How does openness affect the goods market?

A

Exports and Imports + exchange rates all effect goods market

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2
Q

How is the labour market affected by openness?

A

Immigration can effect supply of labour
Price of goods taken into account in wage setting includes imported goods

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3
Q

What are assumptions we make about the IS-PC-MR and the open economy?

A

We assume:
Wage setters only look at domestic price expectations
Price setters do not have imported inputs
CB targets domestic inflation rather than consumer price inflation CPI (which includes imported goods).

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4
Q

generally explain traders in the forex market

A

Traders want to hold high return assets
e.g. if UK bond interest rates increase relative to French bonds they sell French bonds and buy UK bonds.
In the process they sell euros to buy pounds which affects exchange rate (depreciate)

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5
Q

What does the exchange rate on forex markets also effect?

A

Importers and Exporters, therefore AD

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6
Q

What do we assume about the central bank and forex traders?

A

That they are well informed and have RE (rational expectations)

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7
Q

What is the relationship between the Central Bank and the forex market?

A

The CB forms expectations about the forex market
The forex market watches the central bank because they set the policy interest rate, which drives other rates including those on bonds

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8
Q

What is the Nominal Exchange rate?

A

Notation - e
It represents the price of foreign currency in domestic currency

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9
Q

What is the Real exchange rate?

A

Notation - Q
It represents the price of domestic goods in terms of foreign goods
Q=eP/P
where
P=price of domestic goods
P= price of foreign goods
e=nominal exchange rate

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10
Q

In our model which way round does e represent?

A

e is the number of home currency units that can be bought with one unit of foreign currency

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11
Q

What is happens when e increases and decreases?

A

e increases - domestic currency depreciates
e decreases- domestic currency appreciates

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12
Q

What is the equation for real exchange rate?

A

Q=eP/P
e = nominal exchange rate
P= foreign price of goods
P=domestic price of goods

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13
Q

What does it mean if Q increases?

A

foreign goods have become relatively more expensive, domestic price competitiveness increases.
This means a real exchange rate depreciation

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14
Q

Summarise what a real depreciation is?

A

A fall in domestic prices relative to foreign prices.

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15
Q

How do we include the open economy in the IS?

A

We take into account net exports on the IS line.
y=C+I+G+NX
where NX=net exports which is
Exports - Imports

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16
Q

What is the relationship between net exports (NX) and domestic income (y)?

A

As y increases net exports decreases
because higher domestic income means more goods demanded (import increase)
However unless foreign countries also see increase in y, their demand for imports (domestic exports) wont increase

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17
Q

How does NX depend on y?

A

NX depends negatively on y

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18
Q

What is the net exports function?

A

NX=b0-b1y+b2q
y = income
q = logQ (real exchange rate)
b0= determinants of NX other than y or q e.g. business cycle fluctuations, trade barriers
b1= marginal propensity to import MPS
b2 = sensitivity of NX to changes in q

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19
Q

Solve the open economy IS equation including the open economy.

A

Check PowerPoint

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20
Q

What is different about the spending multiplier (k) when the economy is open?

A

The denominator now includes b1, meaning it is smaller than in the closed economy if b1>0

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21
Q

What can we infer from a smalling spending multiplier in the open economy?

A

AN exogenous increase in spending, e.g. higher G, has a smaller impact because part of the stimulus seeps abroad and stimulates other economies that export to the UK.

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22
Q

What is the difference between the open economy IS and the closed economy IS when it comes to shocks?

A

There are additional shocks to the IS in the open economy. e.g. changes in b0 such as brexit which caused an increase in trade barriers.
Changes in q also shift the IS e.g. a real depreciation of the exchange rate makes domestic goods cheaper.

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23
Q

What is the slope of the IS in the open economy?

A

-(1-c1(1-t)+b1)/a1

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24
Q

How is the slope of the IS different in the open economy and what does this tell us?

A

In the open economy the slope is steeper.
This tells us that interest rate changes have a smaller impact on y than in a closed economy because some of the spending multiplier effect falls outside the country.

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25
List a chain of reasoning why interest rate changes have a smaller effect on y in the open economy (reduction in r)
reduction in r initially increases y because of higher demand higher y stimulates consumption, however some of this consumption is from imported sources so there is a leakage y increases by less in the second round and so on until equilibrium is reached
26
What is the simplified version of the IS in the open economy?
y=A-ar+bq check PowerPoint for A,a,b values
27
What is the time structure of the IS in the open economy?
There is a 1 year lag in the reaction of demand to interest rate changes There is a 1 year lag in the reaction of demand to changes in the real exchange rate check PowerPoint for equation
28
What are some assumptions about the open economy that relate to Forex markets?
There is perfect international capital mobility The domestic economy is small (can't influence word interest rate or foreign prices) There are only two assets, money or bonds Foreign and domestic bonds are perfect substitutes (same risk)
29
What does Uncovered interest parity model?
It models the behaviour of forex traders ( choice between domestic and foreign bonds).
30
What happens when Uncovered interest parity (UIP) is in equilibrium?
Traders are indifferent between holding domestic and foreign bonds
31
What are the two things that matter for Forex trader profits?
Interest rate differential and the expected change in exchange rate.
32
What is the uncovered interest parity (UIP) equation?
it=i*+(e^E(t+1)-et)/et where: it = domestic nominal exchange rate i*= foreign nominal exchange rate et=nominal exchange rate at time t e^E(t+1)=expected nominal exchange rate at time t+1
33
What does (e^E(t+1)-et)/et represent in the UIP equation?
Expected depreciation of the domestic currency
34
What is an important assumption when using the UIP equation?
After interest rates change (increase) assume all profit making (trading) opportunities are exhausted so UIP goes back to equilibrium
35
What does exogenous mean?
originating from outside the model
36
What variables are endogenous and exogenous in UIP?
i* (foreign nominal exchange rate) is exogenous it (set by central bank) so exogenous e^E(t+1) is exogenous as its determined by IS-PC-MR (tendency to head to MRE) et is endogenous
37
What happens at the time of the shock that opens up interest differential (interest rate increase)?
e falls (appreciation of domesti currency) e then increases (depreciates between t and t+1
38
What are some reasons currency depreciates after appreciating?
Trade Deficits: exports become more expensive which increases trade deficits and then lowers demand for the currency Capital flows reverse: If the appreciation was driven by short-term capital inflows (interest rate increase) those inflows slow or reverse. As capital leaves the economy currency demand drops causing depreciation
39
Draw graphs showing a UK interest rate gain and its effect on the exchange rate
Check PowerPoint
40
How do forex traders see when there is profit to be made?
When they spot any departures from UIP
41
What approximation do we make when graphically representing UIP?
we log expected depreciation e.g. it-i*=loge^E(t+1)-loget
42
Draw a graph showing UIP with logs.
Check PowerPoint
43
What causes shifts in UIP?
expected exchange rate e^E or foreign interest i*
44
Draw what would happen if the world interest rate falls for one period only on a UIP diagram.
Check PowerPoint
45
What is the graph added to the IS-PC-MR curve in the open economy?
The AD-ERU AD - aggregate demand ERU - equilibrium rate of unemployment
46
What are the units of the axis of the Equilibrium Rate of Unemployment (ERU) graph?
Horizontal - output (y) Vertical - log of real exchange rate (q) q=logQ=log(eP*/P)
47
How is the ERU curve shaped?
ERU doesnt depend on real exchange rate so it is vertical.
48
What do we assume about the relationship between WS/PS and q (log of the real exchange rate)?
WS and PS are not affected by q
49
What are the two reasons wages change in the WS equation?
WS: πt^E + 𝝰(yt-ye) πt^E - expected inflation- 𝝰(yt-ye) - output gap
50
What does money wage growth equal?
inflation
51
What is y, expected π and money wage growth rate along the ERU line?
yt=ye πt^E = π(t-1) money wgae growth (changeW/W)t = π(t-1)
52
Along the ERU at what rate do money wages and prices grow?
At a constant rate driven by target inflation set by CB (2%)
53
Draw the ERU graph and show how it works alongside the WS and PS graphs.
Check PowerPoint
54
What are the effects of being on the right/left of the ERU line on y and π?
On the right: yt>ye wages grow faster than inflation from previous period so inflation increases over time On the left: yt
55
What is the AD equation?
The same as the IS equation: AD/IS: yt=A-ar(t-1)+bq(t-1)
56
What is the difference between the AD and IS lines?
IS is represented in the (y,r) space AD is represented in the (y,q) space
57
What does an increase in q show?
Depreciation
58
How do we express UIP in real terms?
rt-r*=q^E(t+1)-qt where rt= domestic real interest rate r* = world real interest rate qt = logQt
59
in MRE what is the interest rate and exchange rate?
in MRE: rt=r*(r* becomes the stabilising interest rate) q^E(t+1)=qt
60
What notation do we use for q in MRE?
q̅
61
Draw the effect of a positive supply shock in the open economy at MRE
Check PowerPoint
62
Draw the effect of a positive demand shock in MRE in the open economy
Check PowerPoint
63
What are the two channels of transmission of monetary policy in the open economy?
Interest rates: change in interest rates affects investment and output Exchange rates: interest rate changes affect exchange rates which effect net exports and changes output
64
What replaces the IS as a modelling guide for setting interest rates in the open economy?
RX replaces the IS RX now takes into account exchange rates aswell
65
Is the RX curve steeper or flatter than the IS curve and why?
It is flatter because the forex reaction to shocks tends to help the CB achieve its targets so the interest rate doesn't change by as much.
66
Draw a graph showing an increase in interest rates (positive inflation shock) in the open and closed economy.
Check PowerPoint
67
Where are the points on the AD after a positive inflation shock?
The points lie above the AD curve and get closer until equilibrium is reached. This is because AD is for AD(r*) and not the other interest rates which change as we work back to equilibrium
68
What is the effect of a negative demand shock in the open/closed economy?
In a closed economy a negative demand shock reduces output and inflation and prompts the CB to reduce the interest rate. In the open economy forex traders are aware of this and reduce holdings of domestic bonds leading to a depreciation. This boosts net exports and AD meaning that the CB doesn't have to reduce the interest rate so strongly.
69
70
What is important to remember about AD when analysing shocks?
As interest rates(r) change so will the AD curve, this means points don't reach the AD curve till back in equilibrium.
71
Why is overshooting needed in the IS-PC-MR?
Because of the differential adjustment speeds in goods and labour markets vs asset markets e.g. sluggish adjustment of wages and prices
72
How do forex traders respond to overshooting?
The gap that opens between domestic and world interest rates creates a profit opportunity. Traders sell domestic and buy foreign bonds (if domestic interest rates decrease). This depreciates the domestic currency
73
What is the equation linking change in nominal exchange rate and change in real exchange rate?
change(e)/e= π+changeQ/Q -π*
74
How does the nominal exchange rate change in MRE?
change(e)/e= π+changeQ/Q -π* changeQ/Q=0 in MRE so the nominal exchange rate changes in line with the inflation differential change(e)/e= π -π*

ECO2102 Macroeconomics (7 decks)

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