The Open Economy

Question 1

Nominal exchange rate definition

Answer 1

The price of one currency in terms of another

Question 2

Real exchange rate definition

Answer 2

The relative price of domestic goods in terms of foreign goods

Question 3

Real exchange rate formula and how to know which is cheaper

Answer 3

Exchange rate x Domestic price (P) / Foreign Price (P*)

If answer is less than one, domestic is cheaper than foreign

Question 4

What is a net exporter/importer

Answer 4

Net exporter-when exports>imports

Question 5

Balance of payments

Answer 5

Records financial transactions flowing in and out an economy

Question 6

Forms of transactions in BOP (3) and which account are they recorded in

Answer 6

Trade in goods/services-current account
Capital movements-capital account
Financial flows-financial account

Question 7

Capital account

Answer 7

Records capital transfers of non-produced, non-financial assets. E.g copyright, patents, trademarks

Question 8

Financial account components (5)

Answer 8

FDI
Portfolio investment
Transactions in financial derivatives
Reserve assets
Other

Question 9

Difference between FDI and portfolio investment

Answer 9

Control- FDI allows investor to have direct influence over firm

Question 10

Derivatives and examples

Answer 10

Financial instruments e.g options, futures and swaps.

Question 11

Reserve assets

Answer 11

Foreign exchange reserves that the central bank holds e.g bonds, other currencies etc.

Question 12

Is an increase in FCR a negative or positive entry on BOP

Answer 12

Negative as money going out in exchange for FCR

Question 13

What does other component include

Answer 13

Borrowing and lending

Question 14

Is borrowing and lending in other component positive or negative in BOP

Answer 14

Borrowing-positive-money inflow
Lending-negative-outflow

Question 15

Autonomous transactions and name them from each account

Answer 15

Autonomous transactions are for own benefit.

Current account items are autonomous as we import items for personal benefit
Capital account items are autonomous
Financial account (only FDI and portfolio are autonomous)

Question 16

Accomodating transactions and example

Answer 16

Undertaken for BOP purposes.

All other items on financial account are accomodating-essential to balance out the BOP

Question 17

Two ways an open economy interacts with other countries. and equation that links them

Answer 17

Buying/selling goods and services (net exports NX)-current account
Buying/selling assets (net capital outflow NCO)-capital/financial account

CA+KFA=0 (BALANCE EACH OTHER!)

Question 18

Closed economy identity vs Open economy national income identity

Answer 18

Total expenditure=total output
Vs
C+I+G+NX

Domestic spending can exceed output (import>exports)-trade deficit
Output can also exceed domestic spending (exports>imports)-trade surplus

Question 19

Net capital outflow formula (NCO)

Answer 19

Capital outflow (CO) -Capital inflow (CI)

Question 20

Capital outflow vs inflow

Answer 20

Outflow is purchase of foreign financial assets by domestics
Inflow is purchase of domestic financial assets by foreigners

Question 21

Capital and financial account (KFA) and net capital outflow (NCO) relationship and why

Answer 21

KFA=-NCO

Thus means NCO<0 so CI>CO, Payments from foreigners (CI) are positive in BOP, but enters NCO negatively. This is because it is money we owe to others as they purchased an asset from us therefore NCO negative

Foreigners BUYING OURASSETS=negative NCO

Question 22

Net buyer or seller of financial assets???

Answer 22

CO>CI. NCO Surplus-we buy more foreign assets
CI>CO. NCO Deficit-we sell more domestic assets (so saving>investment, so we lend out)

Basically opposite of how trade balances work.
Trade surplus-sell more than buy
NCO surplus-buy more than sell

Question 23

What domestic citizens need foreign currency for (2), and so what do they do

Answer 23

Imports
Capital outflows

So supply domestic currency
IM+CO

Question 24

What foreign citizens need domestic currency for (2)

Answer 24

Exports
Capital inflows (from domestic POV-BUYING ASSETS FROM DOMESTICS)

So demand domestic currency
EX+CI

Question 25

Supply and demand is IM+CO=EX+CI and can be rearranged as.. And how can it be seen in BOP formula

Answer 25

Ex-IM=CO-CI which is just NX=NCO BOP=CA+KFA=0 Where CA=NX KFA=-NCO

Question 26

NCO balance in a trade deficit

Answer 26

Trade deficit means import>exports so NX<0 As NX=NCO NCO is also < As a result of increased income from selling their exports, foreigners can spend more on domestic assets (CI). So NCO will mean CI>CO (we sell more domestic financial assets to foreigners) which is also a NCO deficit AND BECAUSE KFA=-NCO, it is a KFA surplus

Question 27

Loanable funds market for an open economy IN TERMS OF BORROWING AND LENDING (where NCO>0 or NCO<0)

Answer 27

NCO<0-more domestic assets are sold. So this is net borrowing-we are borrowing savings (in exchange for our assets) from foreigners (can then be invested) NCO>0-saving>investment we buy more foreign assets than we sell. So we are lending (in exchange for foreign assets) to foreign economy (which they can invest)

Question 28

Supply of funds in open economy formula

Answer 28

Supply= Savings (S)- NCO SUPPLY=INVESTMENT IN CLOSED ECONOMY, BUT IN AN OPEN ECONOMY THERE IS INFLOWS AND OUTFLOWS OF MONEY SO NCO INCLUDED. SO Savings-NCO=Investment Savings=Investment+NCO Savings-Investment=NCO

Question 29

S-i=NCO Significance

Answer 29

If NCO positive It means S>I, which means savings is left, which is lent abroad If NCO negative I>S, which means THEY WANT TO INVEST MORE THAN THEY SAVE, AND the difference in money wanted to invest is borrowed from abroad

Question 30

Relationship between NCO and interest rate r

Answer 30

As domestic interest rate goes up. Investment more attractive, creating CI>CO , so NCO falls. Inverse relationship-HIGHER INTEREST=LOWER NCO

Question 31

LFM diagram axes

Answer 31

R-interest rate y axis NCO-x axis

Question 32

Diagram to represent NCO and interest rate relationship

Answer 32

Downward sloping NCO Dotted vertical line through NCO Left of the line=NCO<0 as interest rate gets higher, more foreigners purchase domestic assets (CI>CO) so explains why NCO<0 Right of the line NCO>0 as lower interest means we buy more foreign assets so CO>CI, so explains why NCO>0

Question 33

LFM model diagram for open economy

Answer 33

Supply (saving) still vertical Demand=Investment+NCO As remember Saving=Investment+NCO

Question 34

Axis of foreign exchange market (FEM) model

Answer 34

Y axis- real exchange rate X axis- NCO/NX

Question 35

Where does the supply of domestic currency come from in the FEM model? And why?

Answer 35

NCO, as S-I=NCO. If NCO is positive, S>I, so economy saves more than invests, and so domestic currency is supplied. NCO is the supply of domestic currency, as S-I

Question 36

What is NCO determined by?

Answer 36

Real interest rate Higher r=lower NCO as more capital inflows (CI>CO)

Question 37

What does supply for FEM look like on diagram

Answer 37

Vertical line.

Question 38

What does demand for domestic currency depend on and why?

Answer 38

Because we assume homogeneity with goods and services, we say it depends on the real exchange rate. (Due to homogeneity we ignore possible things such as quality, trade restrictions etc).

Question 39

Relationship between exchange rate and demand for currency

Answer 39

Inverse. Strong rate=exports expensive, so export demand falls, demand for domestic currency falls.

Question 40

What does demand for domestic currency look like on diagram

Answer 40

Downward sloping, denoted NX

Question 41

FEM demand curve diagram

Answer 41

Dotted vertical line through the middle Left of the line=NXO, as a fall in exchange rate means we buy less imports and sell more exports.

Question 42

LFM and FEM axis’s and supply and demand denotations.

Answer 42

LFM-real interest rate and NCO Supply-Savings (vertical-fixed) Demand-Investment+NCO (depends on interest rate) FEM-real exchange rate and NX Supply-supply for domestic currency (vertical-fixed) Demand-demand for domestic currency. (Depends on exchange rate)

Question 43

Expansionary fiscal policy on FEM (hint:links to LFM too)

Answer 43

1.An increase in G will decrease saving in the LFM, pushing interest rate up. 2.Increased interest causes increases in capital inflows, so NCO falls 3.Fall in NCO reduces available pounds for NX (fall in supply), causing an appreciation, so exports get more expensive, so demand for NX falls.

Question 44

Effects of import quota on FEM model

Answer 44

Imports restricted, so we have a shift in NX curve to the right for any given exchange rate. (we demand domestic currency (NX) as we no longer can buy imports) The trade balance remains the same, as NCO is unchanged and so is NX, only change is an appreciation in exchange rate. Quota does not impact saving, investment or NCO. (Think about in real life, no additional goods are actually being sold to foreigners, the domestic consumers are just switching to domestic goods, so it is not an export, and so trade balance remains the same, despite us demanding domestic currency again) Remember demand for domestic currency is from G&S exports and capital inflows, but QUOTA doesn’t impact CI, hence why unchanged LFM model.

Question 45

FEM for a small open economy assumptions (3)

Answer 45

Too small to influence real interest rate, so have to accept a world interest rate. (R*) Perfect capital mobility Domestic and foreign bonds are perfect substitutes (financial assets yield same return)

Question 46

Domestic expansionary fiscal policy for small economy

Answer 46

As, small, real interest rate is unchanged. (r=r*) Fiscal reduces saving (S-I=NCO), so NCO falls. (CI>CO) Increased capital inflows appreciate currency, thus reducing export demand worsening NX.

Question 47

Expansionary fiscal policy by large economies on FEM for a small country

Answer 47

As large contribute to overall world saving, world real interest rate r* increases (unlike small) As small countries have to accept r*, Investment decreases in small economy, as more expensive to invest. NCO=S-I so NCO increases, CO>CI so we supply our currency. Therefore exchange rate depreciates and NX improves

Question 48

How do we find NX=NCO

Answer 48

Work out what domestic currency is demanded for, equated to what foreign currency is demanded for EX+CI=IM+CO