TERM 2 Notes on most of the important concepts PDF

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Table of Cont Contents ents Equilibrium of the Open Economy: Ch9.1, 9.2.1................................................................. 2 Supply side, demand side and real exchange rates: Ch9.2.2-3 ........................................... 5 The 3-equation model in the Open Economy: Ch9.2.4-5, 9.3-4 ........................................... 9 Demand Side and Trade Balance in the Open Economy: 10.1, 10.2.1 ................................17 The Supply Side and the AD-BT-ERU Model: Ch10.1.2, 10.2.2, 10.3, 10.4 ..........................22 Oil Shocks: Ch11.1.1-2, 11.2.1-2, 10.1.1 ...........................................................................27 External Imbalances: Ch11.1.2-4, 11.2.3-5, 11.3 ...............................................................34 Economics of a Common Currency Area: Ch12.1-4 ...........................................................40 Crises, macroeconomic models and policy regimes: Ch12.5-6, 7 .......................................44 Eurozone – essay questions .............................................................................................47 Questions .............................................................................................................................. 47 Information ........................................................................................................................... 48

Formulae ........................................................................................................................53

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Open Economy Equilibrium of the Open Economy: Ch9.1, 9.2.1 The foreign exchange market Just like the Central Bank, trades in the foreign exchange market are assumed to be forward looking and rational. We assume interest rates and real exchange rates affect the economy with a one period lag. The CB takes into account the forex market reaction when setting interest rates. The forex market moves when policy expectations change. Investors will buy government bonds in another country depending on different rates of return. This drives demand for that country’s currency. The exchange rate depends on supply and demand in the forex market. This is based on desire to buy and sell government bond, which comes from differences in the exchange rates. Profit opportunities based on different rates of return (arbitrage opportunities) on bonds in different countries will be short-lived. E.g. if the Bank of England increased the UK interest rate such that return on UK bonds were higher than returns on US bonds, there would be a rush into UK pounds and out of US dollars until the profit opportunity had vanished. Exchange rates Nominal exchange rate is the amount of home currency that can be bought with one unit of currency. It is therefore valued in terms of the foreign currency. e≡

no.units of home currency one unit of foreign currency

home’s nominal exchange rate

e increases → one unit of foreign currency can buy more units of home currency → depreciation e decreases → one unit of foreign currency can buy fewer units of home currency → appreciation Real exchange rate measures the price competitiveness between two economies: Q≡

price of foreign goods expressed in home currency price of home goods

=

P∗ e P

home’s real exchange rate

Q increasing would be a depreciation of the real exchange rate, boosting competitiveness, net exports and AD, and would occur because of: • A fall in the price of home goods (P) relative to foreign goods (P*) • An increase in e (depreciation of the nominal exchange rate) Demand in the open economy: y = C + I + G + (X – M) Two stabilisation channels in the open economy: interest rate and exchange rate The response to a shock will be a combination of interest rate set by CB and a change in the exchange rate due to forex traders.

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E.g. a positive inflation shock: the CB raises interest rates to depress next period’s output level and bring inflation down. In the open economy, forex traders take advantage of the interest differential so there is a rush into UK pounds and out of, say, US dollars. The result is an appreciation in the UK pound. The appreciated currency (strong pound) reduces demand for exports and increases demand for imports, making the British economy less competitive, depressing AD. Therefore, inflation is brought down in two ways: • Interest rate channel • Exchange rate channel The exchange rate channel means the CB has to raise interest rates by less than they would’ve in a closed economy to achieve the same negative output gap. This assumes rational expectations of CB and forex traders. Assumptions: 1. Perfect international capital mobility – home residents can hold domestic currency but can trade foreign bonds with the fixed nominal world (foreign) interest rate, i*, in unlimited quantities and at low transaction costs 2. Home country is too small – its behaviour cannot affect i* 3. Households can hold only two assets – bonds (foreign/home) and money (home) 4. Perfect asset substitutability – foreign and home bonds have identical default risk and investors don’t care about portfolio composition, only difference is expected return The 3-equation model curves in the Open Economy IS Curve • Higher marginal propensity to import: households, firms and government spend on imports and domestic goods. Foreigners buy domestically produced goods. Because home agents spend on imports, some additional income will leak abroad and the multiplier will be lower → IS curve is steeper • Changes in competitiveness: depreciation of real exchange rate will increase home’s competitiveness → shifts IS to the right PC Curve • As in closed economy, domestic inflation is used in wage-setting calculations, so imports have an impact, and there is a unique equilibrium unemployment rate MR Curve • CBs have the same loss function as in a closed economy and target domestic inflation rather than CPI which incorporates import prices Uncovered Interest Parity (UIP) Condition Only difference between holding home and foreign bonds is expected return. Expected return depends on: 1. Expected different in interest rates 2. Expected development of exchange rates over same time i – i∗ =

E et+1 – et et

UIP Condition: interest gain = expected depreciation

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This equation tells that the interest gain/loss from holding the home currency = the depreciation/appreciation to offset any potential arbitrage opportunities. E.g. suppose UK (home) and US (foreign) initially have a 4% rate on bonds. Suppose the Bank of England raises interest rates to 6.5%. The interest rate rise makes UK bonds more attractive so investors sell US dollars and purchase UK pounds in order to buy bonds. The move out of dollars and into pounds increases the strength of the pound. Investors try to maximise their returns, so the UK pound will appreciate by exactly 2.5% (the change in interest rate). At the end of the year period for which the US investor holds the bond, they will have to convert their money back to US dollars. However, the pound will depreciate by 2.5% over this time period as we assume the underlying expected exchange rate is constant. Therefore, the investor loses 2.5% to this depreciation which offsets the 2.5% gain they made from holding the bond.

Fig 9.2: Arbitrage in the international bond market UIP: the exchange rate will jump so as to eliminate differences in expected returns on bonds Interest gain from holding home currency = loss from expected home currency depreciation Using approximations: i – i∗ =

E et+1 – et et

E = log(et+1 ) – log(et )

UIP condition

Rewriting the UIP condition allows us to draw the UIP condition as a line with a -45° slope (because the change in interest rate must lead to the exact same change in exchange rate).

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Fig 9.3: The uncovered interest parity condition Point A: i = i*, exchange rate expectations are fulfilled, log(eE1 ) = log(e0 ), exchange rate does not change Point B: i1 > i*, assuming expected exchange rate remains fixed, the actual exchange rate must change from log(e0) immediately to log(e1) such that expected depreciation = interest rate differential Key features of UIP diagram: • UIP curve has a slope of -45° and crosses [log(eE), i*] • Change in home’s interest rate causes a movement along the curve • For a given expected exchange rate, a change in the world interest shifts the curve • For a given world interest rate, a change in expected exchange rate shifts the curve E.g. suppose there is a fall in the world interest rate that lasts one period but no change in home’s interest rate. The UIP curve will shift left. The economy is initially at A. The fall in world interest rate and relatively higher home interest rate creates arbitrage which leads to an appreciation of the home exchange rate (e falls). This leads to point B on the new UIP curve. At the end of the period, i* reverts to its initial level as does the exchange rate, and the UIP curve shifts back to A. If the CB in the home country were to immediately follow the interest rate move by the foreign CB, the economy would shift from A to C and the exchange rate does not change. This move would be reversed at the end of the period if the home CB followed the foreign CB’s interest rate rise.

Supply side, demand side and real exchange rates: Ch9.2.2-3 Medium-run equilibrium in the open economy and the AD-ERU model Equilibrium on the supply side occurs at constant inflation at the intersection between the WS and PS curves where wage and price setters have no incentive to change their behaviour. This pins down the equilibrium rate of unemployment (ERU).

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The ERU curve captures the supply side of the economy where inflation is constant. The demand side is represented by the aggregate demand curve, where the goods market is in equilibrium and the real interest rate equals the world real interest rate (r = r*). The medium-run equilibrium (MRE) applies to both fixed ( e is chosen and maintained by government through forex buying and selling) and flexible ( e is determined by forex market, i is set by CB) exchange rates. The only difference arises in how the MRE is determined. We focus here on flexible exchange rates and assume inflation is domestic. Supply-side (ERU):

Fig 9.5: Supply-side equilibrium and the ERU curve The ERU curve shows the combinations of the real exchange rate and output at which there is supply-side equilibrium. The WS and PS curves are the same as in the closed economy. y = ye(zW, zP) ERU curve zw: factors shifting the WS curve (unionisation, labour regulations, unemployment benefits) zP: factors shifting the PS curve (tax rate, labour productivity, competition) Demand-side (AD): The AD curve is derived from the IS curve. The IS curve capture that AD responds negatively to a rise in r (real interest rise) and q (depreciation), both with a one-period lag: yt = At – art-1 + bqt-1 open economy IS curve

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A includes the multiplier and demand variables such as world trade, Government spending, investment and consumption. The AD curve also incorporates the UIP condition: UIP Condition i – i∗ = log(eEt+1 ) – log(et) E ∗ Real UIP Condition r – r = qt+1 − qt y = A – ar* + bq AD curve given r = r* The AD curve is derived by finding the output level for different levels of q at r*.

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Shocks

Fig 9.6: What determines the medium-run real exchange rate? Whereas in the closed economy there is a new stabilising real interest rate at MRE following a permanent demand/supply shock, in the small open economy r is set at r* so real exchange rate varies instead. Supply shock A positive supply shock (e.g. new technology) raises productivity, shifts PS up, shifting ERU to the right, causing a higher real exchange rate (depreciation to q’) and higher equilibrium output, y’e. Demand shock A positive demand shock (e.g. an investment boom) shifts the AD to the right. At the new equilibrium there is a lower real exchange rate (appreciated to q’), but the same equilibrium output, ye. Exchange Rate Regimes MRE is determined by supply side which is unaffected by exchange rates, so the MRE is independent of the exchange rate regime. 1. Flexible → e determined in forex, no intervention, CB chooses i 2. Fixed → e chosen by government who buy and sell forex to maintain the peg E = et = ePEG et+1 Flexible: πMRE = π* Fixed: πMRE = πT In between regimes: Dirty float, pegged by adjustable, ceiling, etc. → some controls on trading 8

Arbitrage is not complete → not PCM Reasons for nominal and real exchange rate deviations: • Nominal exchange rate is volatile so the real exchange rate is too • Relative prices/costs change significantly

The 3-equation model in the Open Economy: Ch9.2.4-5, 9.3-4 Policymaking in the Open Economy 1. Which exchange rate regime? a. Fixed b. Flexible i. Is monetary policy available? 1. No – due to ZLB/liquidity trap: use QE or forward guidance 2. Yes – interest rate adjusts and q jumps Difference between open and closed economies

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e.g. “The dollar rose the most against the euro in a month on speculation government reports tomorrow will show faster inflation in the U.S., underscoring the potential for the Federal Reserve to raise interest rates more than some traders had expected.” • Higher expected inflation → US interest rates likely to remain relatively higher → people buy dollar The 3-equation model In the closed economy: • CB minimises its loss function (which is based on its objectives) subject to the Phillips Curve (which is a constraint from the supply side) to produce the monetary rule function, pinning down the optimal output gap, which is then implemented by setting the interest rate r using the IS equation (best response Taylor-rule) In the open economy: • CB minimises its loss function (which is based on its objectives) L = (yt – ye)2 +  (πt – πT)2 subject to the Phillips Curve (which is a constraint from the supply side) πt = πt–1 + (yt – ye) to produce the optimal monetary rule function, pinning down the optimal output gap (yt – ye) = – (πt – πT) which is then implemented by setting the interest rate r using the IS equation which now includes q) yt = At – art–1 + bqt–1 and by taking account of the reaction of forward-looking agents in the forex market (best response Taylor-rule for the open economy) Comparing inflation shocks in the closed and open economy Because shocks will affect both the central banks and the forex market, instead of adjusting back to equilibrium along the IS curve as in the closed economy, the CB will adjust along a flatter ‘interest rate – exchange rate’ curve called RX. Smaller interest rate changes will be needed as the exchange rate channel also operates.

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Fig 9.8: Inflation shock; closed and open economies Closed Economy: • Period 0 – economy starts at A (bliss point). Inflation shock hits, shifts PC up to PC(inflation shock) and the economy moves from A to B. B is not on the CB’s MR curve, so the CB forecasts next period’s PC(𝜋𝐸1 = 𝜋0 ) such that they will be able to locate back on the MR curve at C – this PC is the same as PC(inflation shock). They therefore set interest rate r0 to affect the economy with a one-period lag. Period 0 ends with inflation π0, output ye, interest rate r0. • Period 1 – the new, higher interest rate has come into effect, dampening investment and reducing output, moving the economy to point C. Output is now below equilibrium at y1 and inflation is at π 1. The CB forecasts next period’s PC based on period 1’s inflation; PC(𝜋𝐸2 = 𝜋1 ). The CB would like to locate on point D, so they set interest rate r1. Period 1 ends with inflation π1, output y1, interest rate r1. • Period 2 and onwards – the economy moves to point D as the lower interest rate stimulates demand. This process repeats as the economy gradually moves down the MR curve, back to point Z

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Open Economy: • Period 0 – economy starts at A and, as before, an inflation shock pushes up the PC curve. The CB determines the best response at C, on their MR curve. The forex market foresees the interest rate rise and the UIP condition implies an immediate appreciation of the home currency as a result. This allows the currency to depreciate the whole period during which there is a positive interest differential between home and foreign bonds. The CB therefore sets r0 on the RX curve (taking into account the appreciation which makes the IS curve shift to the left). Period 0 ends with inflation π0, interest rate r0, exchange rate q0. • Period 1 – the new interest and exchange rates have had time to affect AD. Higher interest dampens investment, appreciated exchange rate reduces exports. Therefore, output falls to point C. The CB forecasts next period’s PC, on which they would like to locate at D. They set the interest rate according to this and the depreciation that will hold in every period. They set interest at r 1 and exchange rate depreciates to q1. Period 1 ends with inflation π1, interest rate r1, exchange rate q1. • Period 2 and onwards – economy moves to D as the lower interest rate and depreciated exchange rate stimulates demand. Output rises, inflation falls. IS curve shifts right towards the original point due to the depreciation, down the RX curve. This process continues until the economy is back at its original point at MRE and the interest rate equals the world interest rate. The open economy differs in that we must now consider the real exchange rate effects, but the initial interest rate rise is smaller because of this. Also note that the IS curve shifts in each period in the open economy due to the exchange rate change associated with the interest rate change, whereas in the closed economy the interest rate change causes only a movement along the IS curve. The RX curve shows the adjustment path of a small open economy with flexible exchange rates along which the UIP condition always holds. The RX curve: • Crosses the r* and ye intersection so shifts only when one of these changes • Slope reflects the interest and exchange rate sensitivity of the AD curve, CB preferences and the PC slopes o Flatter than the IS curve o The flatter the IS curve, the flatter the RX curve o The steeper the MR curve, the flatter the RX curve Permanent Demand Shocks to the Open Economy CB reaction to a permanent demand shock: 1. Use AD-ERU model to work out new equilibrium q Permanent negative demand shock causes a leftward shift of the AD curve. It brings about a reduction of A in the IS curve, which tells the CB how much the AD curve shifts up by and shows the new real exchange rate at equilibrium, so the CB knows what interest rate to set satisfying UIP. 2. Use 3-equation model to work out CB’s response and dynamic adjustment to shock

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Fig 9.11: Dynamic adjustment to a negative permanent demand shock The above graph shows a permanent negative demand shock • Period 0 – economy starts at A (bliss point) and is hit by a negative permanent demand shock. IS curve shifts far left, output and inflation fall to y0 and π0. Economy moves from A to B, but B is not on the CB’s MR curve. CB forecasts next period’s PC in line with current period’s inflation and the equilibrium output level, on which the CB would like to locate at C on the MR curve. At C, output is above equilibrium, so the CB reduces interest rate to stimulate investment and boost output in the next period, which the forex market foresees so there is an immediate depreciation in the real exchange rate so that it can appreciate for the rest of the period. The CB sets the interest rate at r0 to get back onto the MR curve the next period. Note that because the interest rate set is below r*, C is slightly off the AD curve as the AD curve is for r = r*. Period 0 ends with inflation at π 0, output y0, interest rate r0, exchange rate q0 • Period 1 and onwards – the lower interest rate has boosted investment, the depreciated exchange rate has increased exports, so the economy moves to C. The...