open economy in the short run (the IS-TR-IFM or Mundell-Fleming model)

Question 1

what does IS-TR-IFM model allow

Answer 1

to extend IS-TR to consider international trade and international capital flows (trade in financial assets)

Question 2

Being small and open economy, assumptions

Answer 2

Small- changes have no effect on the rest of the world, BoE changing r had little effect on Row

Open- no restrictions on how much trade, no restrictions on borrowing and lending to the RoW

UK is roughly this

Question 3

Capital Flows- perfect capital mobility

Answer 3

if unrestricted capital will flow between countries where it is expected to achieve the highest return (at times least risk e.g US, Japan)

To invest in another country, need to exchange out domestic currency for the foreign currency (capital flow into switzerland increases demand for swiss francs, swiss exchange rate appreciates

Question 4

perfect capital mobility (meaning)

Answer 4

means that the economy can lend or borrow as much as it likes from the global market

the domestic interest rate is therefore determined by the world rate of return i*

i* is not an interest rate

Question 5

if domestic CB attempted to increase interest rates (decrease the money supply) what would happen

Answer 5

domestic investment (govt bonds) looks attractive vs the rest of the world, foreigners want to lend

increased demand for bonds, pushes prices, pushing yields down

increased supply of capital would put downward pressure on domestic interest rate until it returned to i*

inflow of capital increases demand for domestic currency leading to appreciation

Question 6

CB cut interest rates (increase money supply)

Answer 6

domestic investment looks less attractive

making foreign bonds more attractive and there would be massive capital outflows

agents sell domestic bonds (move capital abroad)

selling of domestic bonds reduces bond prices, pushing up bond yields (interest rates)

reduced supply of capital puts upwards pressure on domestic interest rate until it returns to i*

selling domestic currency to buy foreign currency leads to depreciation

Question 7

IFM stands for

Answer 7

IFM- International Financial Markets

Question 8

Fixed exchange rate

Answer 8

central bank stands ready to buy or sell as much domestic currency as necessary to maintain fixed rated or peg

practice requires large amounts of foreign exchange reserves

Question 9

examples of fixed exchange rates

Answer 9

Dollarization (currency substitution)- ecuador and panama (have own currencies as well)

The Euro- group of countries form a currency union, within the union inter country exchange rates are legally fixed e.g 1 german euro = 1 french euro

Question 10

Fixed exchange rates, Monetary policy

Answer 10

CB can’t choose the interest rate

monetary policy is ineffective under a fixed exchange rate

only one point on the money demand curve consistent with i* point A

CB tried to set lower interest rate i

incompatible with IFm equilibrium so capital flows out, putting downward pressure on the exchange rate

To maintain fixed exchange rate, CB needs reserves to buy and support domestic currency reducing money supply

Question 11

Demand Shock under Fixed Exchange Rates

Answer 11

increase in G shifts IS to right

upward pressure on the interest rate, due to increased money demand (C)

triggers massive capital inflows

International investors buy domestic currency to buy domestic bonds

increased demand for domestic bonds pushes up bond prices, pushing down yields until interest rate returns to i*

demand for domestic currency puts upward pressure on the exchange rate

CB forced to defend currency peg by buying foreign currency at fixed rate therefore increasing money supply

fiscal policy is very effective

(unlike IS-TR fiscal expansion is no longer partially crowded out by lower investment due to a higher interest rate)

Question 12

Increase in the foreign rate of return

Answer 12

domestic rate of return becomes too low, triggers capital outflows, downward pressure on the domestic exchange rate as investors sell domestic bonds and domestic currency

selling of bonds, pushes bond prices down and yeilds up (i-i*)

under fixed exchange rate, CB needs to intervene by buying domestic currency

higher domestic interest rate leads to lower Y economy ends up on point B

Question 13

monetary policy ineffective under fixed exchange, what is the exception to this

Answer 13

can choose to change the level of the fixed exchange rate under devaluation

Question 14

IS-TR-IFM and Euro

Answer 14

joining to make one currency is the ultimate way of fixing exchange rates

eurozone economies give up control of domestic monetary policy

IS-TR-IFM suggested that fiscal policy would be very effective in reducing national income

flexible exchange rate (fixed but adjusted)- route to full employment might come via rapid depreciation of the currency

euro only solutions are fiscal stimulus or years of depression and chronic unemployment

successful currency union requires consolidated fiscal policy as well as monetary policy

Question 15

Flexible (floating exchange rates)

Answer 15

CB gives up exchange rate as an instrument

exchange rate is determined by the supply and demand for the currency

CB conduct monetary policy

Exchange rate is endogenous adjusting to bring about equilibrium in the goods and money markets

examples of floating exchange rates

Question 16

expansionary monetary policy, Flexible exchange rates

Answer 16

CB reduces target interest rate i (bar) in its TR curve

AS in the IS-TR model the TR curve moves outwards

this is not a stable equilibrium

international returns look attractive capital flows abroad

this leads to depreciation

improving competitiveness and IS shifts rightwards due to improved equilibrium

CB conducts monetary policy without changing the equilibrium interest rate

policy is operating through exchange rate channel

money supply increases endogenously and satisfies the higher level income and i = i*

monetary policy is very effective under flexible exchange rates

Question 17

BREXIT

Answer 17

triggered an exodus of capital from UK

led to a large depreciation

according to model this is expansionary (improved competitiveness)

shows BREXIT vote should not necessarily have led to the imminent recession many predicted

Question 18

Fiscal policy- flexible exchange rates

Answer 18

exogenous increase in AD (increase G)

IS shifts rightwards, indicated by point B

i>i*

triggers capital inflows- demand for domestic currency leads to appreciation

Worsens competitiveness

NX deteriorate and IS shifts leftwards

Fiscal policy is ineffective under flexible exchange rate

Question 19

what id rest of world adopted monetary policy under international disturbances - flexible exchange rates

Answer 19

monetary policy abroad would lead to lower domestic output via an appreciation of domestic currency

Question 20

Beggar-thy-neighbour

Answer 20

stimulating the economy via increased competitiveness from devaluation (fixed) or monetary to trigger depreciation (flexible) versus the rest of the world

Question 21

Simple rule- fixed

Answer 21

equilibrium determined by IS and IFM

monetary policy (money supply) moves endogenously to maintain the fix and ensure equilibrium

Question 22

simple rule flexible

Answer 22

equilibrium determined by IFM and TR

IS curve (via exchange rate, competitiveness and NX) shifts to ensure equilibrium

Question 23

Impossible Trinity

Answer 23

nations can only choose one side

everything is driven by free capital flows

3 options

free capital flows and independent monetary policy- US (can’t have a fixed exchange rate)

Free capital flows and fixed exchange rate (can’t have independent monetary policy)

Independent monetary policy and fixed (managed) exchange rate (rather than perfect capital mobility free capital flows, restricts this move from one currency to another) -china- l

Question 24

why do interest rates differ between countries

Answer 24

exchange rate fluctuations- holders of foreign assets are exposed to exchange rate risk, holding foreign assets needs to compensate for expected changes in nominal exchange rate between domestic and foreign currencies

Country risk- some countries riskier

Question 25

Interest rate parity

Answer 25

domestic interest rate i must equal the rate of return that could be achieved by investing in international financial markets i* i* is a rate of return not an interest rate as need to consider expected movement in exchange rates

Question 26

uncovered interest rate parity (UIRP)

Answer 26

gaining an extra % point in yield from holding bonds in the foreign country is of no benefit if that foreign country's currency depreciates by more than one percentage point versus the domestic currency when holding foreign assets, we should take into account expected fluctuation in exchange rates

Question 27

Uncovered interest rate parity formula

Answer 27

1+ i_domestic = (1+i_foreign) s_t/e(s_t+1) The UIRP condition simply says that market forces should bring the two sides into equilibrium, so that any difference between the domestic and foreign interest rates is exactly offset by the expected change in the nominal exchange rate

Question 28

interest rate parity and IS-TR-IFM

Answer 28

from the URIP condition domestic interest rate is equal to the foreign interest rate allowing for the expected rate of exchange rate appreciation the IFM line will shift if the exchange rate is expected to change

Question 29

uncovered interest rate parity and IS-TR-IFM

Answer 29

expansionary monetary policy is the CB lowering i bar TR shifts right at point B (see diagram) interest rates are below IFM, leading to capital outflows, exchange rate depreciation, improvement in competitiveness IS shifts right (NX increases) economy point C exchange rate depreciation is likely to be anticipated, UIRP condition implies investors require a higher domestic interest rate before outflows stop IFM line is also endogenous to the change in expected exchange rate and temp shifts up the IFM monetary expansion is reinforced by further depreciation increasing competitiveness even further (IS' to IS'') D onlys sustainable if domestic currency keeps depreciating depreciation slows via UIRP IFM line shifts back down IS'' shifts back to IS' UIRP adds a temporary trip from C to D back to C.

Question 30

country risk

Answer 30

risker countries higher bond yields as investors unsure of repayment investors want compensation for being less certain about getting their money back although country risk is one part of the story, countries with safe debt the difference in annual rate of return is some combination of UIRP and the expected path of policy interest rates over the coming years + demand for a limited number of safe assets by large financial institutions

Question 31

flexible of fixed

Answer 31

flexible allows for freedom of monetary policy to be sued for goals such as inflation targeting and achieving full employment fixed, monetary policy must fulfil the goal of maintaining the chosen exchange rate fixed good for providing certainty for exporters and promoting competitiveness

Question 32

why can fixing be problematic

Answer 32

maintaining fix when there is depreciating pressure requires the CB to sell foreign exchange reserves to buy domestic currency only go on for as long as foreign exchange reserves don't run out led to black wednesday, ERM required certain exchange rate