Open Economy in IS-MP

Question 1

How can the external sector of the economy be modelled?

Answer 1

• Planned Expenditure: C(Y-T) + I(r) + G + NX(ε)
• RER [ε] responds to the real interest rate => You want to remove ε, to ensure NX are more than shift factors
• As £ increases, $ falls (Depreciation), Foreign goods are cheaper, EX fall, IM rise, NX Falls

Question 2

What is the difference between the nominal and real exchange rate?

Answer 2

• Nominal Exchange Rate: Number of foreign currency required to exchange for one unit of the domestic currency
• Notation: USD/GBP
• Real Exchange Rate: Nominal, including the effect of relative/domestic price level

Question 3

What is the equilibrium in the external economy?

Answer 3

• Demand = Supply, but demand = Imports + Capital Outflows and supply = Exports + Capital Inflows
• The price in this market is RER
• If demand for a foreign currency outweighs the supply; this leads to a depreciation in the domestic currency
• Net outflows (CO - CI) respond to the real interest rate, Net exports (EX - IM) respond to the real exchange rate
• Changes in cash flows will affect the real exchange rate and therefore the net exports

Question 4

What is the difference between floating and fixed exchange rates?

Answer 4

• FLOATING: Determined by demand and supply of foreign exchange; this means PE = C(Y-T) + I(r) + G + CF(r)
• FIXED: Keeping the exchange rate within a specific band through central bank means

Question 5

How does the diagram depicting the IS-MP in the open economy look

Answer 5

• Draw an IS-MP to find r* and Y*
• Interest rate and CF Schedule (downward sloping)- this determines the cash outflows
• This cashflow is a vertical line down that meets the NX schedule (also downward sloping) to determine ε
• ε adjusts so that NX(ε) = CF(r)
• This shifts the planned expenditure curve down

Question 6

How can changes in the interest rate affect planned expenditure (2 channels)?

Answer 6

• If r increases, this reduces investment and reduces output => However, this is only in a closed economy
• Coincidently, r increasing reduces cash flows. This appreciates the exchange rate, reducing NX and Y
• Thus creating a further effect on r

Question 7

What does fiscal policy do to an open economy?

Answer 7

• Fiscal Policy expansion shifts IS curve out, Y increases and r increases
• This increases capital inflows, reducing cashflows
• This shifts the CF curve in, reducing NX(ε)

Question 8

What does monetary policy do to an open economy?

Answer 8

• Monetary policy tightening shifts MP Curve in, Y falls and r increases
• This increases capital inflows, reducing cashflows
• This shifts the CF curve in, reducing NX(ε)

Question 9

How does trade policies, such as quotas, impact an open economy?

Answer 9

• Barriers to imports make net exports increase
• At a given ε, there is disequilibrium as NX>CF
• This means that there are lower demands for forex, ε increases and NX falls until an equilibrium occurs
• This would make exports more expensive
• Thus, there is a self-defeating prospect where a protectionist policy designed to boost exports does not do so

Question 10

What happens when a Central Bank fixes the exchange rate?

Answer 10

• C.B. participates in ForEx market, enough to affect ε
• C.B. can easily control MS, providing domestic currency but not foreign without reserves or borrowing

Question 11

What is the Reserve Gain (RG)? What equation concerns RG?

Answer 11

• Reserve Gain: Difference beetween C.B. purchase/sale of foreign currency
• If C.B. is selling more than it is buying, RG is negative- LOSING Reserves
• CF = Private Net Capital Outflow (PCF)+ RG
• Therefore, RG = Total Purchases (NX) - Total sales (PCF)

Question 12

How does an open system affect the IS Curve?

Answer 12

• The initial IS curve does not include exports
• IS Curve follows the same properties, however includes another chanel
• Increased r no longer has the same effect on ε/NX
• Therefore, a fixed exchange rate system makes the IS Curve steeper

Question 13

How does Monetary policy work in fixed exchange rate systems?

Answer 13

• MP schedule is based on the Taylor Rule
• With a fixed exchange rate, there are limits on the Taylor Rule => δr = δε, even though ε must be fixed
• C.B. must ensure ε is fixed, but cannot lose too much
• If r falls, PCF increases, ε depreciates
• BUT: ε is fixed, so C.B. increases spending, reducing the RG further
• If RG </= 0, C.B. cannot reduce interest rates further, so it chooses the lowest functional level

Question 14

How does the MP curve look with a fixed exchange rate? What does expansionary monetary policy mean for this?

Answer 14

• RG is an increasing function of real IR
• If RG > 0, we have the usual function of MP
• If RG <0, we have a fixed r
• This means that there is a fixed curve
• Expansionary MP would shift MP curve to the right, meaning r falls
• However, the kink moves, meaning that a new equilibrium is found that is lower than the equilibrium would have been due to the kink