Topic 9: The Open Economy 1 Flashcards
(18 cards)
What are the three dimensions of openness in an economy?
- Goods Markets
- Financial Markets
- Factor Markets
Goods Markets involve choosing between domestic and foreign goods; Financial Markets allow choice between domestic and foreign financial assets; Factor Markets pertain to the movement of labour and capital.
What is the nominal exchange rate?
The price of foreign currency in domestic terms.
Example: E_{£/$} = 0.82, E_{$/£} = 1.21.
Define appreciation in terms of exchange rates.
Domestic currency strengthens (↑E).
This indicates that it takes fewer units of domestic currency to buy foreign currency.
Define depreciation in terms of exchange rates.
Domestic currency weakens (↓E).
This indicates that it takes more units of domestic currency to buy foreign currency.
What is the formula for the real exchange rate?
𝜀 = E × (P_{domestic} / P_{foreign})
The real exchange rate reflects relative prices of domestic versus foreign goods.
What does an increase in the real exchange rate (𝜀 ↑) indicate?
Real appreciation → foreign goods cheaper.
This means that domestic goods become relatively more expensive compared to foreign goods.
What is included in the current account of the balance of payments?
- Exports
- Imports
- Investment income
The trade balance is calculated as Exports – Imports.
What does the capital account record?
Financial flows (e.g., lending, investment).
The balance of payments must balance, with discrepancies accounted for by statistical adjustments.
What is the interest parity condition without exchange rate change?
1 + i_t = 1 + i_t^*.
This indicates that domestic interest rates equal foreign interest rates in the absence of exchange rate changes.
What does the approximate form of the interest parity condition state?
i_t = i_t^* - (E_{t+1}^e - E_t) / E_t.
Investors balance returns based on interest differentials and expected appreciation.
What is the total demand (Z) in an open economy?
Z = C + I + G + X - (IM / 𝜀)
C = consumption, I = investment, G = government spending, X = exports, IM = imports.
What determines imports (IM) in an open economy?
IM = IM(Y, 𝜀) → ↑Y or ↑𝜀 → ↑IM
An increase in income (Y) or the real exchange rate (𝜀) leads to an increase in imports.
What is the equilibrium output formula in an open economy?
Y = C(Y, T) + I(Y, r) + G - (IM(Y, 𝜀) / 𝜀) + X(Y^*, 𝜀)
Equilibrium occurs when total output (Y) equals total demand (Z).
How does domestic fiscal expansion (↑G) affect output and imports?
↑ Output, ↑ Imports → possible trade deficit.
The multiplier effect in an open economy is smaller than in a closed economy.
What happens to exports and imports when there is an increase in foreign demand (↑Y*)?
↑ Exports (ΔX) → ↑ Output, ↑ Imports, but less than ↑Exports → trade surplus.
This indicates that an increase in foreign demand boosts domestic output significantly.
What is the effect of real depreciation (↓𝜀) on exports and imports?
↑ Exports, ↓ Imports.
This improves net exports if the Marshall-Lerner condition holds.
What policy actions are suggested for a scenario of low output and trade deficit?
↑G + Depreciation.
This aims to increase output while addressing the trade deficit.
What is the relationship between policy coordination and trade balance?
Policy coordination is needed to manage output and trade balance.
Different scenarios require tailored policy responses to achieve desired economic outcomes.
