The open economy

Question 1

What factors must be considered in an open economy?

Answer 1

Domestic vs foreign goods and domestic vs foreign assets

Output depends on both domestic and foreign demand.

Question 2

What is the formula for Gross National Product (GNP)?

Answer 2

GNP = GDP + NI

NI denotes net income—payments received from the rest of the world minus income paid to the rest of the world.

Question 3

What does a Trade Balance (TB) greater than zero indicate?

Answer 3

Trade surplus

This has been observed in the Euro area in recent years.

Question 4

Define nominal exchange rate (E).

Answer 4

The price of domestic currency in terms of foreign currency.

Question 5

What is nominal appreciation?

Answer 5

An increase in the price of the domestic currency in terms of a foreign currency.

Question 6

What is nominal depreciation?

Answer 6

A decrease in the price of the domestic currency in terms of a foreign currency.

Question 7

Define real exchange rate (ε).

Answer 7

The price of domestic goods relative to foreign goods, accounting for inflation.

Question 8

What are fixed exchange rates?

Answer 8

A system in which two or more countries maintain a constant exchange rate between their currencies.

Question 9

What is the difference between GDP and GNP?

Answer 9

GDP measures value added domestically, while GNP measures the value added by domestic factors of production.

Question 10

What does the current account in the Balance of Payments include?

Answer 10

Exports minus imports of goods and services, and net income balance (NI).

NI is the difference between income received from the rest of the world and income paid to foreigners.

Question 11

What does a current account surplus indicate?

Answer 11

Positive net lending to the rest of the world.

Question 12

What is the financial account in the Balance of Payments?

Answer 12

Net capital flows, representing the difference in capital given and received.

Question 13

What condition must hold for interest rate parity?

Answer 13

The domestic interest rate must equal the foreign interest rate minus the expected depreciation rate of the foreign currency.

Question 14

What happens when aggregate demand increases in an open economy?

Answer 14

Demand for foreign goods increases, leading to a trade deficit.

Question 15

In the IS model of an open economy, how is the demand for domestic goods represented?

Answer 15

Z = C + I + G - IM/ε + X

Question 16

What is the implication of a real appreciation of the domestic currency?

Answer 16

Foreign goods become cheaper, increasing imports.

Question 17

What happens to exports when the price of domestic goods increases relative to foreign goods?

Answer 17

Exports decrease.

Question 18

What does the distance between the ZZ and AA lines in the IS model represent?

Answer 18

The difference between domestic demand and the demand for domestic goods.

Question 19

What is the equilibrium condition in the goods market?

Answer 19

Y = Z, where domestic output equals demand for domestic goods.

Question 20

True or False: In an open economy, imports are negatively related to domestic income (Y).

Answer 20

False

Imports are positively related to domestic income.

Question 21

What does an increase in the real exchange rate imply?

Answer 21

An increase in the relative price of domestic goods in terms of foreign goods.

Question 22

What is the formula for trade balance income Y?

Answer 22

Y = TB/B

TB represents trade balance, and B is a variable related to balance.

Question 23

What happens to the trade balance when aggregate demand increases?

Answer 23

An increase in output leads to a trade deficit

This occurs because demand for foreign goods also increases.

Question 24

In an open economy, how does the multiplier effect compare to that in a closed economy?

Answer 24

The multiplier is smaller in the open economy

This is due to part of the benefits going to foreign economies.

Question 25

What effect does an increase in government spending have on production?

Answer 25

It leads to an increase in production from Y to Y' ## Footnote This is due to the fiscal multiplier effect.

Question 26

What is the impact of an increase in foreign demand on domestic output?

Answer 26

It leads to an increase in exports X and an improvement in the trade balance ## Footnote This results in a new equilibrium with higher output Y'.

Question 27

True or False: Higher domestic demand improves the trade balance.

Answer 27

False ## Footnote Higher domestic demand increases output but deteriorates the trade balance.

Question 28

What are the three separate channels through which a real depreciation affects the trade balance?

Answer 28

1. Exports X increase 2. Imports IM decrease 3. The relative price of foreign goods increases ## Footnote These effects can lead to an improvement in net exports if the conditions are met.

Question 29

How can a government reduce the trade deficit without changing output?

Answer 29

1. Implement a real depreciation 2. Decrease public spending G ## Footnote This involves increasing demand for domestic goods and decreasing demand for foreign goods.

Question 30

What is the relationship between saving, investment, and the current account balance?

Answer 30

CA = S + T - G - I ## Footnote Where CA is the current account balance, S is savings, T is taxes, G is government spending, and I is investment.

Question 31

What must an increase in investment reflect?

Answer 31

An increase in saving or a deterioration of the current account balance ## Footnote This is necessary to maintain equilibrium.

Question 32

What is the ambiguous effect of tariffs on inflation?

Answer 32

Tariffs can raise costs for consumers but de-globalisation can put downward pressure on inflation ## Footnote Thus, the net effect on inflation is uncertain.

Question 33

What is the effect of increased public spending G on imports?

Answer 33

It causes an increase in imports while exports remain unchanged ## Footnote This leads to a deterioration of the trade balance.

Question 34

Fill in the blank: A real depreciation leads to a shift in demand toward _______.

Answer 34

domestic goods ## Footnote This shift can improve the trade balance.

Question 35

What occurs if the trade balance is initially in equilibrium and foreign demand increases?

Answer 35

A trade surplus will appear ## Footnote This is due to increased exports outpacing imports.