The Open Economy Pt. 3 Flashcards
What is exchange rate overshooting?
The phenomenon that exchange rates (real and nominal) jump more than the equilibrium adjustment in response to shocks.
What causes overshooting?
- Internationally integrated financial market
- Rational expectations in the forex market
- Sluggish adjustment of wages and prices (repeated periods of r>r*)
How much does q overshoot, depending on the magnitude of the shock?
The larger the shock, the larger the rt - r* needed to restore balance, the larger qt will overshoot.
What is the initial rate jump?
initial rate jump = equilibrium change + exchange rate overshooting
The equilibrium exchange rate can change. However, if it does not (as in the example from the UIP lecture), the initial rate jump is solely the exchange rate overshooting.
What is the UIP condition once overshooting is incorporated (for a 2 year interest differential)?
(r0-r) + (r1-r) + equilibrium change = initial jump
During the adjustment period, how do the nominal and the real rate evolve (inflationary shock)?
The initial nominal appreciation is smaller than the real appreciation.
During adjustment, nominal depreciation is bigger than real depreciation. Why? Because the nominal rate depreciating needs to offset a counter force, q appreciating, due to rising in P (this can be seen in the formula Q = p*e/p).
Overshooting summary:
Initial rate jump > equilibrium rate change because of overshooting.
This is coming from a persistent difference between world and home interest rates due to inflation persistence and a rational forex market.
Where is the BT curve plotted and what does it indicate?
The BT curve is plotted in the q-y space, and is slightly upward sloping, depicting a positive relationship between q and y (because of Marshall-Lerner condition).
The BT curve is a component of demand.
Points on the BT curve indicate trade balance (X=M).
Points above the BT curve indicate a trade surplus (X>M).
Points below the BT curve indicate a trade deficit (X
What are the two opposing effects of q on the BT? Which one is bigger?
- the volume effect; because q increases, home goods are more competitive, thus BT improves
- the terms of trade effect (or price effect); because q increases, given volume of M is more expensive, thus BT worsens
The volume effect is dominant (Marshall-Lerner condition), thus a real depreciation improved the trade balance. -> IS shifts right
What is the slope of the BT curve?
The BT curve is flatter than AD (because the marginal propensity to import is less than 1).
What are the assumptions between a downward sloping ERU curve?
That wage setters and employees care about the consumer price index, which includes imports, not only demand goods.
What are the assumptions between a downward sloping ERU curve? What are the implications of a downward sloping ERU curve?
If wage setters use the full basket of goods (including imports) to define the price level and set the wage demands, w = W/Pc.
The implication is that ye would be changed by shifts in AD too. Shifts in the AD can move the economy to a new combination of y, U and q.
Multiple inflation - y combinations are possible in the MR with a downward sloping ERU.
However, inflation is constant along any ERU curve.
Can current account imbalances persist in the medium run equilibrium?
Yes. This is modelled by the BT curve, flatter than the AD curve.
How does the open economy IS curve differ from the closed economy IS curve?
In the open economy, the IS curve is steeper because the multiplier in the open economy is smaller. The implications are that y responds less to a change in r in the open economy than in the closed economy.
What is the open economy multiplier? What is the closed economy multiplier? Compare them.
- Open economy multiplier: 1 / (1 - c1(t-1) + m)
- Closed economy multiplier: 1 / (1 - c1(t-1))
because m > 0 (where m is the marginal propensity to import)
