Week 6 - Open Economy Macroeconomics

Question 1

Break down the meaning of a “Small Open Economy”

Answer 1

• Small means that the countries decisions will not affect world prices (world prices are exogenous)
• An Open economy has trade and financial links to other countries (foreign economies) which will impact the domestic economy

Question 2

What is a Foreign Exchange Market

Answer 2

Where the currency of one country is exchanged for the currency of a different country

Question 3

What is the Exchange Rate

Answer 3

The number of units of foreign currency that are needed to purchase 1 unit of domestic currency

Question 4

How do you calculate an Exchange rate

Answer 4

e = foreign currency / domestic currency

Question 5

What is Appreciation

Answer 5

Appreciation of domestic currency refers to an increase in the exchange rate

Question 6

What is Depreciation

Answer 6

Depreciation of domestic currency refers to a decrease in the exchange rate

Question 7

The Supply of pounds in the foreign exchange market can come from which 2 sources

Answer 7

1. Firms, households and government purchases of foreign goods and services
2. Central monetary authority for the purpose of influencing the exchange rate

Question 8

How can the Central bank change the exchange rate in the foreign exchange market (diagram)

Answer 8

Increase exchange rate - shift supply curve to the left
Decrease exchange rate - shift supply curve to the right

Question 9

What is an Exchange Rate Regime

Answer 9

The government’s policy on how exchange rates are determined

Question 10

What is a Fixed exchange rate regime

Answer 10

Actions are taken by the central bank to fix exchange rates at a pre-determined level

Question 11

What is a Floating exchange rate regime

Answer 11

The exchange rate is determined by the market for foreign exchange equilibrium

Question 12

What are the Benefits and Costs of a Fixed exchange rate regime

Answer 12

Benefits:
- Provides stability (attractive to foreign and domestic investors)
- Can be used to avoid inflation (gives the central bank a money-supply target)
Costs:
- Central bank must keep a large stock of foreign reserves at all times
- If capital is perfectly mobile, a country will lose control of its interest rate

Question 13

What is the difference between the Nominal and Real exchange rate

Answer 13

Nominal exchange rate - the rate at which one currency can be exchanged for another
Real exchange rate - adjusts the nominal rate for price levels, reflects the relative purchasing power of currencies and price of goods and services across countries

Question 14

What is the Real exchange rate formula

Answer 14

Real exchange rate = (e x P) / Pf
e - nominal exchange rate
P - domestic price level
Pf - foreign price level

Question 15

What is Purchasing Power Parity (PPP)

Answer 15

PPP is the theoretical nominal exchange rate at which a basket of goods would cost the same in 2 countries, equalizing purchasing power across currencies

Question 16

What is the Balance of Payments

Answer 16

The BoP is a record of all transactions between the residents of one country and the rest of the world, made up of 3 main accounts: current, capital, and financial account

Question 17

What does the Current account measure in the BoP

Answer 17

The current account measures the value of a country’s net exports (X-M) plus net income from abroad and transfers. It has 4 main components: trade in goods, trade in services, net primary income, net secondary income (current transfers)

Question 18

What is the difference between the Capital account and the Financial account

Answer 18

Capital account - records one off transfers of non-produced, non-financial assets
Financial account - records cross border transactions in financial assets and liabilities

Question 19

What is a Current Account Deficit and a Current Account Surplus

Answer 19

CA Deficit (CA < 0) - when imports and transfers exceeds exports and income from abroad (net borrower)
CA Surplus (CA > 0) - when exports and income from abroad exceeds imports and transfers (net lender)

Question 20

What factors affect the Current Account (x3)

Answer 20

1. Domestic income increases, decreasing the CA (higher imports)
2. Foreign income increases, increasing the CA (higher exports)
3. Exchange rate increases (appreciation), decreasing the CA (exports less competitive, imports cheaper)

Question 21

What determines Capital account flows

Answer 21

The capital account depends on the interest rate differential:
- If domestic IR > foreign IR (r - rf > 0), capital inflows, capital account increases
- If domestic IR < foreign IR (r - rf < 0), capital outflows, capital account decreases

Question 22

What is Capital mobility

Answer 22

How easily an investor can move financial capital in and out of a country

Question 23

What is Perfect capital mobility

Answer 23

There are no impediments to financial capital flowing from one currency to another

Question 24

What does the BP curve reflect

Answer 24

The BP curve reflects combinations of domestic interest rates and domestic output for which the balance of payments equals 0

Question 25

What determines the slope of the BP curve

Answer 25

- Perfect capital mobility is reflected by a horizontal BP curve (where r = rf) - Perfectly immobile capital is reflected by a vertical BP curve

Question 26

What happens to the IS curve when the domestic currency appreciates and depreciates

Answer 26

Appreciation - SPICED, IS curve shifts left Depreciation - WPIDEC, IS curve shifts right

Question 27

Describe Fiscal Policy with a Fixed Exchange regime (expansionary fiscal policy)

Answer 27

- Increase in government spending - IS curve shifts right - Point A to point B, at domestic equilibrium B r > rf - Increase in domestic interest rates, attracts foreign investors, increased demand for domestic currency, appreciation of the domestic currency - To stop appreciation the bank increases the supply of the domestic currency - MP curve shifts right, to new equilibrium C - Output increases overall, fiscal policy effective

Question 28

Describe Monetary Policy with a Fixed Exchange regime (expansionary monetary policy)

Answer 28

- Does not work - In a fixed exchange regime the money supply is endogenously determined by the economy - The policy maker gives up control of the money supply in exchange for control of the exchange rate

Question 29

Describe Fiscal Policy with a Floating Exchange regime (expansionary fiscal policy)

Answer 29

- Increase in government spending - IS curve shifts right - Point A to point B, at domestic equilibrium B r > rf - Increase in domestic interest rates, attracts foreign investors, increased demand for domestic currency, appreciation of the domestic currency, SPICED - Net exports fall (NX), IS curve shifts left - The economy shifts back to equilibrium A - Fiscal policy is completely ineffective (crowds out exports)

Question 30

Describe Monetary Policy with a Floating Exchange regime (expansionary monetary policy)

Answer 30

- Money supply increases, shifting MP curve right - Point A to point B, at domestic equilibrium B r < rf - Decrease in domestic interest rates, lose foreign investors, decreased demand for domestic currency, depreciation of the domestic currency, WPIDEC - Net exports increase (NX), IS curve shifts right, to new equilibrium C - Output increases overall, monetary policy is effective

Question 31

Describe a decrease in foreign interest rates with a Fixed Exchange regime (world shock)

Answer 31

The BP curve is horizontal at the point where domestic and foreign interest rates are equal - rf decreases, rf < r (holding exchange rates and foreign income constant) - Higher r attracts foreign investors, demand for domestic currency increases, currency appreciates - Central bank responds by increasing the supply of the domestic currency in the foreign exchange market - Domestic interest rate falls to foreign interest rate - Investment and household consumption increases in response to lower r - Output increases

Question 32

Describe a decrease in foreign interest rates with a Floating Exchange regime (world shock)

Answer 32

The BP curve is horizontal at the point where domestic and foreign interest rates are equal - rf decreases, rf < r (holding exchange rates and foreign income constant) - Higher r attracts foreign investors, demand for domestic currency increases, currency appreciates, SPICED, net exports fall (NX), IS curve shifts left - Money demand decreases, until domestic and foreign interest rates are equal, output falls overall

Question 33

What are the implicit assumptions of the IS-LM-BP model (x3)

Answer 33

1. Supply is perfectly elastic and responds immediately to changes in demand 2. Imports and exports are perfectly interchangeable 3. Prices do not respond to shifts in demand (no inflation)