Open Economy

Question 1

What is the direct (American) quotation?

Answer 1

A quotation system for nominal exchange rates, whereby the price of the foreign currency is quoted in units of the domestic currency

Question 2

What is the indirect (European) quotation?

Answer 2

A quotation system for nominal exchange rates, whereby the price of the domestic currency is quoted in units of the foreign currency

Question 3

What is currency appreciation?

Answer 3

an increase in the value of a currency. For the domestic currency corresponds to an increase in the indirect exchange rate and a decrease in the direct exchange rate

Question 4

What is uncovered interest parity (UIP)

Answer 4

UIP displays a relationship between interest rates and exchange rate movements. UIP suggests that the returns on financial assets are the same when converted to the same currency.

Question 5

What is merchandise?

Answer 5

tangible goods that change their economic ownership between a resident and a non-resident (excluding a few categories to do with direct reselling of goods (merchanting), construction, and some more). Examples are agricultural and manufactured goods, fuels and mineral products

Question 6

What is purchasing power parity (PPP)?

Answer 6

When we assume efficient markets with free and costless cross border movements of goods, 1 domestic set can be exchanged for exactly 1 foreign set. Equivalently, in an efficient market for goods, the real exchange rate equals 1. This is PPP. 1 = P/Pe * E

Question 7

What is relative purchasing power parity (rPPP)?

Answer 7

a weaker version of aPPP, allowing for the possibility that the real exchange rate can be different from 1, but is still constant

Question 8

What is a current account (CA)?

Answer 8

a summary of transactions between an economy and RoW to do with trade in goods and services and flows of primary income (labour income, investment income) and secondary income (various transfers, including benefits, remittances, scholarships, transactions with international organisations)

Question 9

What is a capital account (KA)?

Answer 9

a summary of transactions to do with the acquisition and disposal of non-produced non-financial
assets (natural resources, contracts, leases, licences, marketing assets) and capital transfers (debt forgiveness, debt assumption, non-life insurance claims, investment grants)

Question 10

What is a financial account (FA)?

Answer 10

a summary of financial transactions between an economy and RoW, comprising direct investment, portfolio investment, investment in financial derivatives and operations with international reserves

Question 11

What is currency pegging (currency peg)?

Answer 11

A fixed exchange rate regime

Question 12

Describe revaluation?

Answer 12

a deliberate increase in the value of domestic currency under a fixed exchange rate regime

Question 13

Describe devaluation?

Answer 13

a deliberate reduction in the value of the domestic currency under a fixed exchange rate regime

Question 14

International trade?

Answer 14

goods, services, commitment of production factors

Question 15

International finance?

Answer 15

financial assets in the international financial markets

Question 16

What assumptions do we take in the Open Economy?

Answer 16

Efficient FX markets: there are no fees, taxes, bid-ask spreads. There are no restrictions on cross border capital movements. Investors are risk neutral

Question 17

When would we have a higher and lower domestic return on foreign investment?

Answer 17

a higher domestic return on foreign investment when we have a higher return on foreign assets and a stronger domestic currency today. We have a lower domestic return on foreign investment when we have a stronger expected domestic currency.

Question 18

What are the open economy assumptions?

Answer 18

no fees, taxes, bid-ask-spreads, no restrictions on cross border capital movements, risk neutral investors

Question 19

Why would’t we expect PPP to hold in the short run?

Answer 19

In the short run prices are fixed, additionally the exchange rate is determined by financial markets, not markets for goods. Exchange rate adjusts so that the rate of return abroad and domestically are exactly the same.

Question 20

PPP: performance

Answer 20

relies on strict assumption of efficient markets and costless movement of goods.
Therefore cannot accommodate important features of real life markets - transport costs, trade barriers, different degrees of market competitiveness

Question 21

Describe balance of payments (BoP)

Answer 21

Financial markets and international trade are interlinked. To keep track of both financial assets and goods and services is through BoP. BoP records transactions between an economy and RoW

Question 22

What does BoP represent, and how does it connect international receipts, liabilities and financial claims?

Answer 22

The BoP tracks a country’s transactions with the RoW including money received from exports and income from abroad. Countries can borrow from the RoW (creating liabilities) or lend to the RoW (creating financial claims). These funds can be used for imports, paying income to RoW, or creating new financial assets. BoP ensures that all these flows balance out net values.

Question 23

What is the structure of BoP?

Answer 23

Splits info on NX, NI and NIIP between 3 accounts
Current Account (CA)
Capital Account (KA)
Financial Account (FA)

Question 24

How can we achieve balanced trade under a floating rate regime and a fixed rate regime?

Answer 24

Floating rate - mix of fiscal and monetary policies

Fixed rate - only fiscal policies are feasible

Question 25

What do floating rate regimes enable?

Answer 25

Independent monetary policies, an appropriate change in the policy rate can counter a shock, while the exchange rate adjusts freely

Question 26

What can a fixed rate regime prevent?

Answer 26

Prevents policy driven stabilisation and implies substantial periods of over or under production

Question 27

Summarise devaluations and revaluations

Answer 27

While they are policy instruments, they cannot be used routinely for shock countering without destabilising the fixed exchange rate regime.

Question 28

How can an economy under a fixed rate regime return to the medium run equilibrium through shocks?

Answer 28

Suppose output rises above its potential level. This translates into a real appreciation, since domestic prices will increase more than prices abroad. Real appreciation lowers net exports and so output drops until inflationary pressure is removed, Y = Yn

Question 29

What is internal balance?

Answer 29

stabilisation of output at the potential level and low inflation (through inflation targeting) and relies on the ability to counter various shocks.

Question 30

What is the external balance?

Answer 30

CA approx. = 0 (less formal) Do not borrow too much, and direct most of domestic savings to funding domestic investment.

Question 31

What is the self fulfilling prophecy of a currency crisis.

Answer 31

Investors expect the CB to devalue a currency, and this can lead to the very outcome predicted.