Core Macroeconomics, Hilary Term 2017

Week 4: The Open Economy

This week we open up our 3-equation Keynesian model to the outside world. Now demand depends not only on domestic consumption and investment, which react to the real interest rate, but also foreign demand for exports, which depends on the real exchange rate. The real exchange rate and the real interest rate are related through a foreign exchange market equilibrium condition: uncovered interest (rate) parity.

The open economy model is not easy, so this week we will focus on the technical aspects of how the model works.

Readings

Lecture notes for lectures 9, 10, and (the beginning of) 11 by Rui Esteves.

C&S chapters 9-10.

Assignment

Prepare and bring to the tutorial answers to the following three questions from the C&S textbook. It is not necessary to submit your answers in advance by the usual Wednesday deadline on this occasion.

Ch. 9, Problem 3

Assume you are in a small open economy with flexible exchange rates. The economy experiences a permanent positive demand shock.
a. Draw the PC-MR, the IS-RX and the AD-ERU diagrams to help you explain the path back to medium-run equilibrium.
b. Draw a graph of the real exchange rate over time and give a brief explanation of its path.
c. How does the medium-run equilibrium vary from that which would occur in a closed economy subjected to the same shock?

Ch. 10, Question 7

Assume the home economy is a small open economy. It initially starts in trade balance with output at equilibrium. There is a sudden shift in preferences away from the home country's exports and towards the exports of its competitors (i.e. a reduction of σ in the home economy). Are the following statements about the new medium-run equilibrium true or false? Justify your answers and use AD-BT-ERU diagrams where appropriate.
a. This shock will increase the level of output in the home economy if you assume a downward-sloping ERU curve.
b. This shock will have no effect on world output.
c. This will lead to an improvement in the trade balance in the home economy.

Ch. 10, Problem 3

Consider the following excerpt from Martin Wolf's Financial Times article "Economic luck that cannot last," from 30 October 2003. "The governor [of the Bank of England, Mervyn King] emphasizes four underlying causes of the improvement in UK performance: a monetary framework that evolved from inflation-targeting, in 1992, to the Bank's operational independence, in 1997; fiscal consolidation; 20 years of supply-side reforms; and a series of shocks that averaged out over time, rather than cumulated in either an upward or downward spiral. Yet, as Mr. King notes, one benefcient shock did cumulate: to the terms of trade (the ratio of export to import prices), which improved by about 10% after 1996. Thi generated a substantial increase in real take-home pay without adding to employers' costs."
How can we use the open economy models to explain the evolution of the UK economy over this period? In answering the question, you are advised to take the following steps:
a. Link supply-side reforms to economic performance using the AD-BT-ERU model.
b. Use the three-equation model to explain how an inflation-targeting central bank can respond to a shock and return the economy to target inflation.
c. Use the AD-BT-ERU model to explain how a demand shock could have beneficent effects on economic performance and relate this to the UK.
d. Identify the reasons why this good luck cannot last.