Open economy, exchange rates and inequality

Question 1

Open Economy IS-LM – What’s different?

Answer 1

IS includes net exports: output equals consumption plus investment plus government spending plus net exports. Net exports depend on real exchange rate. Capital flows introduce interest rate parity condition.

Question 2

Interest Parity Condition

Answer 2

Domestic interest rate equals foreign interest rate minus expected appreciation of domestic currency. Ensures no arbitrage in financial markets.

Question 3

Real Exchange Rate

Answer 3

Real exchange rate equals nominal exchange rate times foreign price level over domestic price level. Measures competitiveness. A lower real exchange rate means domestic goods are cheaper and more competitive.

Question 4

Fixed vs Floating Exchange Rate Regimes

Answer 4

Fixed: central bank maintains exchange rate at target level. Floating: exchange rate determined by market forces. Fixed regime limits domestic monetary policy.

Question 5

Monetary Policy under Fixed Exchange Rate

Answer 5

Central bank must change interest rates to maintain fixed exchange rate. Cannot use monetary policy for domestic goals. Fiscal policy becomes more effective.

Question 6

Monetary Policy under Floating Exchange Rate

Answer 6

Allows monetary policy autonomy. Lowering interest rate leads to currency depreciation which raises net exports and output. Exchange rate amplifies policy impact.

Question 7

Mundell-Fleming Model Summary

Answer 7

Open economy version of IS-LM with interest parity. Under fixed exchange rate: fiscal policy effective, monetary policy not. Under floating: monetary policy effective, fiscal policy less effective.

Question 8

Exchange Rate Determinants

Answer 8

Influenced by interest rate differences, inflation expectations, trade balance, and central bank actions. Expected future exchange rate matters for current rate.

Question 9

Sources of Trade Imbalances

Answer 9

Caused by high domestic demand, overvalued currency, or weak competitiveness. Leads to current account deficits and borrowing from abroad.

Question 10

Inequality – Global vs Within-Country

Answer 10

Global inequality mostly from differences between countries. Within-country inequality has been rising in many advanced economies since the 1980s.

Question 11

Gini Coefficient

Answer 11

Measures income inequality from zero to one. Zero means perfect equality, one means total inequality. Useful for comparisons across countries and over time.

Question 12

Sources of Categorical Inequality

Answer 12

Inequality based on group identity like gender, race, location, or education. Often results from structural and institutional factors.

Question 13

Policies to Reduce Inequality

Answer 13

Include progressive taxes, investment in education and health, minimum wage laws, and social protection programs like universal basic income.

Question 14

Convergence Theory

Answer 14

Poorer countries grow faster than richer ones if institutions and policies are similar. Explains why income gaps between countries may narrow over time.

Question 15

Draw Mundell-Fleming Diagram (Floating)

Answer 15

IS curve slopes down, LM curve is vertical if interest parity holds. Expansionary monetary policy shifts IS right through currency depreciation which raises output.

Question 16

Exchange Rate Expectations Impact

Answer 16

If people expect currency to depreciate, it causes capital outflows and weakens the currency now. Makes fixed exchange rate regimes harder to maintain.