IS-LM in open economy (topic 6) Flashcards
Focus: domestic vs foreign goods and assets? Output depends on both domestic and foreign demand. Effects of fiscal and monetary policies depend on the exchange rate regime. (31 cards)
What is the the goods market in open economy?
The goods market = the proportion of domestic and foreign products within total consumption.
What is the financial market in open economy?
The financial market = the proportion of domestic and foreign bonds within total bond holding.
Explain trade openness.
Trade openness = the ability for consumers and firms to choose between domestic and foreign goods (there are restrictions to trade such as tariffs and quotas).
Smaller countries will tend to be more open, as they depend more on their trade with other nations.
What is the balance of payments?
Balance of payments/balance of international payments = a record of all payments or monetary transactions between a country and the rest of the world in a specific period.
Encompasses all transactions between residents and non-residents of the country (involving goods, services and income, financial claims on and liabilities to the rest of the world (i.e., transfers and gifts)).
What does the balance of payments consist of?
Current account: Trade balance (export – import)
Net income (income received – income paid) Salaries, income from asset holdings, etc.
Net transfers received (Aids, donations, workers remittance, etc.)
Capital account:
Capital account balance (purchases of domestic holdings by foreigners – purchases of foreign assets by the domestic country)
Statistical discrepancy (lack of balance)
Why is it hard to balance the current and capital accounts?
The current account and capital account should balance (but as there often is statistical discrepancies, it rarely happens).
Explain trade deficit.
If a country’s imports are larger than its exports, there is a current account deficit (trade deficit), and the country is a net debtor to the rest of the world as it is investing (borrows) more than it saves.
Explain a trade surplus.
If imports are smaller than exports, there’s a current account surplus (trade surplus), and the country is a net creditor to the rest of the world as it is providing an abundance of resources to other economies.
What determines the nominal exchange rate, E?
Is determined on the foreign exchange market by supply and demand.
When the demand for domestic currency is high, the nominal exchange rate tends to increase and vice versa.
Explain the flexible exchange rate regime.
Flexible exchange rates = the central bank lets the exchange rate adjust freely on the foreign exchange market.
in the flexible exchange rate regime can the domestic currency,
- Appreciate (i.e., the nominal exchange rate increases)
- Depreciate (i.e., the nominal exchange rate decreases)
Explain a fixed exchange rate regime.
Fixed exchange rates = the central bank has an explicit exchange rate target and uses monetary policy to achieve this (e.g., Denmark and the ERM2)
In the fixed exchange rate regime can the domestic currency,
- Revaluate (i.e., the nominal exchange rate increases)
- Devaluate (i.e., the nominal exchange rate decreases)
What is the function of the real exchange rate, epsilon, as the price of domestic goods in terms of foreign goods? And the price of foreign goods in terms of domestic goods?
The real exchange rate = the price of domestic goods in terms of foreign goods (denoted by epsilon)
∈=EP/(P*)
Epsilon = the price of domestic goods in terms of foreign goods.
1/∈= the price of foreign goods in terms of domestic goods.
Real exchange rate determines the choice between consuming domestic or foreign goods (as it takes the price difference across countries into account).
Changes in epsilon = real appreciations/depreciations.
- It is not observable (the one you get in the newspaper is the nominal exchange rate).
What is the function for demand for domestic goods and what values can import consist of?
Z = C (Y-T) + I (Y,i) + G + X (Y*,ϵ) - IM(Y,ϵ) IM = the value of imports in terms of foreign goods.
Z = C (Y-T) + I (Y,i) + G + X (Y*,ϵ) - IM(Y,ϵ) / ϵ IM/ϵ = the value of imports in terms of domestic goods
What does imports, IM, depend on?
IM = IM (Y,ϵ)
(+,+)
Y = domestic income (positive relation i.e., the higher the domestic income, the higher the demand for (foreign and domestic) goods).
ϵ = real exchange rate (positive relation i.e., the higher the price of domestic goods in terms of foreign goods, the higher level of imports).
Explain the determinants for exports, X.
X = X (Y*,ϵ)
(+,-)
Y* = foreign income (positive relation i.e., the higher the foreign income, the higher the demand for (foreign and domestic) goods.
ϵ = real exchange rate (negative relation i.e., the higher the price of domestic goods in terms of foreign goods, the lower the level of exports).
Explain the effects of an expansionary fiscal policy.
G increases or T decreases
demand increases
increase in output (more than the increase in G through the multiplier effect
the increase in output will lead to an increase of imports (X is unaffected)
increase in trade deficit or decrease in trade surplus (deterioration of the trade balance)
Explain the multiplier in open economy.
The larger the sensitivity of imports to changes in income, the smaller is the multiplier.
Countries that are more open (not self-sufficient) are more sensitive and have a smaller multiplier.
• Example: increase in G,
• Increase in demand -> increase in supply -> consumption increases, but as we are in open economy, this does not only concern domestic goods, but foreign as well, i.e., that in closed economy the effect on demand for domestic goods would have been larger (the multiplier is smaller in open economy).
This means that the slope of the demand relation (graphically) is smaller in open economy as well.
Explain what happens when there is changes in foreign demand, Y*.
Increase in Y* =
Increase in exports and through the multiplier effect, output will increase by more.
Graphically the ZZ line shifts upwards and the same will happen to the NX curve.
Decrease in Y* =
Decrease in exports and output.
ZZ line and NX curve shifts downwards.
Why should trade openness be taking into account?
As the multiplier is smaller in open economy, fiscal policies are also less effective.
Expansionary fiscal policies deteriorate the trade surplus and thereby accumulates debt (in the rest of the world).
There is no control of foreign demand i.e., a shock to demand in one country will affect other countries (if your trade partner has a decrease in Y*, this will affect the GDP in this country and in the domestic country as well, which is how economic crisis spread).
Explain the Marshall-Lerner condition.
Marshall-Lerner condition: exports increase, and imports decrease enough to compensate for the increase in the price of imports (and therefore a real depreciation leads to an increase in net exports)
What are the effects of changes in the nominal exchange rate in a flexible exchange rate regime?
Depreciation – nominal exchange rate decreases:
Direct effects:
- Exports increases.
- Import decreases.
The relative price of foreign goods in terms of domestic goods (1/epsilon) increases.
Indirect effects:
- NX increases (Marshall-Lerner) – NX and ZZ line shifts upwards.
- Domestic output goes up (through the multiplier effect) and the ZZ curve shifts upwards.
- Improvement of the trade balance (despite imports increasing)
Appreciation – nominal exchange rate increases:
- Import increases.
- Export decreases.
- 1/epsilon decreases.
- Output will decrease.
- NX and ZZ will shift downwards.
- Trade balance deteriorates.
How do you choose between domestic and foreign bonds?
Example – the domestic currency is euros, and you want to invest in the US:
You have €1 and can invest it in your domestic country where the interest rate from period t to period t+1 is it, or you can exchange your euros to dollars and invest in the US where the interest rate from period t to period t+1 is i*t.
If you invest in your domestic country, your expected return at the end of the period will be: 1+i_t euros.
If you invest in the U.S.:
You convert your euros to dollars at the rate: Et and thereby get Et dollars.
You invest for the period and your return will be: (1+i_t^*)E_t dollars.
You then convert the dollars back to euros, where you expect to get: (1+i_t^* ) E_t/(E_(t+1)^e ) euros.
What is arbitrage?
Arbitrage = when investors take advantage of a price difference and buy the bonds with the highest expected rate of return.
I.e., if he US investment brings a higher expected return, then investors will only invest in the US the demand for dollars will be high/the demand for euros will be low -> Value of dollars increase/value of euros decrease -> exchange rate depreciates (Et decreases) -> expected return of investments in the US will decrease until the expected returns in the US and domestic country are equal.
Explain the interest parity condition.
1+i_t=(1+i_t^* ) E_t/(E_(t+1)^e ) or
i_t ≈ i_t^*-〖E_(t+1)^e-E〗_t/E_t
Return on domestic bonds = return on foreign bonds.
Domestic interest rate must be equal to the foreign interest rate minus the expected appreciation rate of the domestic currency. (Because of arbitrage)
