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Economics Notes Macroeconomics Notes

Open Economy Notes

Updated Open Economy Notes

Macroeconomics Notes

Macroeconomics

Approximately 65 pages

These notes contain a full, clear and descriptive summary of Undergraduate Economics material. The notes of each sub-topic outline the key theories and models, including diagrams, with full explanations both algebraically and in words, and then set out the key applications of the models, with extensions included that would be helpful in formulating essays on the topic. The notes also include the relevant authors and readings relating to each topic....

The following is a more accessible plain text extract of the PDF sample above, taken from our Macroeconomics Notes. Due to the challenges of extracting text from PDFs, it will have odd formatting:

Open Economy

  • FX market and the AD side in the open economy

  • Monetary policy in a small open economy – responding to inflation shocks and domestic AD shock

  • Assume a small open economy with rational agents, consider both short and medium run equilibriums. Short-run IS-PC-MR model is assumed, modified IS curve to include exchange rate. In medium run, PS-WS model assumed. In short-run, prices assumed to be fixed in each period; in medium run, prices are flexible but uneven balances of trade are possible. In long run, imports equal exports and prices are flexible.

  • Assume 2 currencies: domestic (D) and foreign (F). nominal exchange rate is price on FOREX of one unit of F in terms of D, denoted e. Real exchange rate q is e adjusted for the relative price levels in the foreign and domestic blocs. p* and p are foreign and domestic price levels. So p is a measure of the relative purchasing powers of foreign and domestic currency. q is measure of competitiveness of the economy, variances in its value imply changes in cost to foreign markets of buying domestic goods. High q (depreciated D, takes more units of D to purchase one of F) = domestic sector is competitive/cheap to foreign markets

  • Simplifying assumptions:

  1. Perfect international capital mobility

  2. Home economy is small so cannot affect the world interest rate

  3. Households hold 2 assets bonds (home and foreign) and money

  4. Perfect substitutability between home and foreign bonds (can only differ in expected returns, not default risk) – big assumption eg. Argentina as reliable as UK, but required for endogenising arbitrage opportunities

  5. In medium/long run, r is fixed by the world level r*

  6. The exchange rate is either floating or fixed, assume it’s floating to begin with as we assume there is inflation targeting which there cannot be with a fixed rate

  7. Assume home’s inflation target is equal to the world inflation level which is constant

  • Open vs. closed IS: in the open IS curve output is increasing in the real exchange rate. A high q implies a competitive economy, so foreign demand increases (depreciation of the currency) so the IS curve shifts right.

  • When modelling the FX market, there are 3 parity conditions: purchasing power parity, covered interest rate parity and uncovered interest rate parity

  • Uncovered Interest Rate Parity (UIP):

    • Basically says shocks to interest rates in one sector must be immediately matched by a change in q in the opposite direction. Domestic CB sets rate expected to prevail for 3 periods. If q stays as it is = arbitrage opportunity, one can hold an amount of D and then turn it into F after a period of interest accumulation, making the interest pure profit. So after the rate change, demand for D goes up, so D appreciates until point at which benefit of extra interest compensated for by additional cost of units of D. short-run model so prices are fixed (exchange rates not), so increase in e which implies an increase in q. Size of arbitrage depends on how long interest rates expected to stay at higher level and size of the interest rate shift.

    • Interest rate differential in favour of bonds denominated in domestic currency must be equal to the expected exchange rate depreciation of the currency over the period for which the interest rate differential is expected to persist:

$$i_{t} - i_{t}^{*} = \ \frac{E_{t + 1}^{e} - E_{t}}{E_{t}}$$

When interest rate differential opens up, there is an initial jump in the exchange rate to eliminate the interest rate gains, then over period for which differential remains, exchange rate will gradually depreciate until it returns to its correct level

  • Gives you a 45 degree downwards sloping UIP curve in the i and e space, where e = ln(E). curve is pinned down by the world interest rate and expected exchange rate (goes through them), and a change in the home interest rate causes a movement along the UIP curve. Relationship links perfectly deviations from the world interest rate with deviations from the equilibrium exchange rate, so a change to the nominal interest rate will lead to an offsetting change to the expectations of the exchange rate.

  • Real interest rate in a small open economy will be equal to the world real interest rate when the expected change in the real exchange rate, or q, is equal to zero. For nominal interest rate, it is when expected change in nominal exchange rate, e, is zero. So they are different

  • Given domestic citizens can hold foreign bonds, UIP allows us to consider what influences choice of bonds. There cannot be different expected returns on assets with the same risk, two things affect the expected return on home bonds relative to foreign bonds: differences in interest rates and expectations about the exchange rate. UIP connects these two ideas

  • Example: UK compared to US bonds, where the interest rate in the UK is 6% and in the US it is 4%. If investor holds a UK bond instead of a US bond, they get an additional interest rate return of 2%, so can make profit by selling a US bond and buying a UK bond. This requires switching dollar to pounds, causing increased demand for the pound, so pound appreciates.

Exchange rate expectations influence this, question of what expectation about the change in the exchange rate would be required for investors not to want to switch from dollars to pounds even with the 2% difference in interest rate. Investor would need to believe pound would depreciate by 2% over the period for which the difference in interest rate differential persist, meaning the 2% gain from a higher interest rate on the pound is counteracted by the expected loss from the depreciation of the pound

  • Short run: in the short run, prices and wages fixed, so CB can use r to stabilise output as exchange rates can’t do anything

  • Medium run: prices of factors and output adjust, so they go to market clearing rate defined by productive capacity.

  • This is in the nominal form, in the real form, if home’s real interest rate is higher than the world’s, home’s real...

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