Topic 10: The Open Economy 2 Flashcards
(15 cards)
What are the key variables in an open economy?
Output (Y), Interest rate (i), Exchange rate (E)
Exchange rate (E) is defined as the price of foreign currency in terms of domestic currency.
How is Net Exports (NX) defined?
NX = Exports - Imports = NX(Y, Y*, E)
NX decreases with domestic income and increases with foreign income and depreciation.
What happens to NX when domestic income (Y) increases?
NX decreases
An increase in domestic income leads to an increase in imports.
What happens to NX when foreign income (Y*) increases?
NX increases
An increase in foreign income leads to an increase in exports.
What is the goods market equilibrium condition?
Y = C(Y - T) + I(Y, i) + G + NX(Y, Y*, E)
C depends on disposable income, I depends negatively on the interest rate, G is exogenous.
What does the real exchange rate (ε) equal when prices are fixed?
ε = E
The real exchange rate is directly proportional to the nominal exchange rate.
What is Uncovered Interest Parity (UIP)?
(1 + i) = (1 + i*) × (E / E⁽ᵉˣᵖ⁾)
It indicates how domestic and foreign bonds are compared based on interest rates and exchange rates.
What happens if i > i* according to UIP?
Domestic currency is expected to depreciate
This reflects expectations based on interest rate differentials.
What is the effect of expansionary monetary policy under flexible exchange rates?
↓ i → E↑ (depreciation) → NX↑ → Y↑
The increase in NX leads to a larger increase in output compared to a closed economy.
What is the result of expansionary fiscal policy under flexible exchange rates?
IS shifts right → i↑ → E↓ (appreciation) → NX↓
This partially offsets the increase in output (Y).
What is the role of the central bank in a fixed exchange rate regime?
Fixes E by buying/selling foreign currency
This maintains the exchange rate but makes monetary policy ineffective.
What is the effectiveness of monetary policy under flexible and fixed exchange rates?
Flexible: Effective; Fixed: Ineffective
In fixed regimes, capital flows counteract any attempts to change interest rates.
What is the effectiveness of fiscal policy under flexible and fixed exchange rates?
Flexible: Less effective (NX ↓); Fixed: Effective
In fixed regimes, fiscal expansion raises output while maintaining the exchange rate.
What plays a central role in determining output in an open economy?
The exchange rate
It significantly influences macroeconomic dynamics.
Fill in the blank: Capital mobility and investor expectations are crucial for _______.
[macroeconomic dynamics]
