Core Macroeconomics, Hilary Term 2012
Week 5: The open economy
This week we focus on Carlin & Soskice' model of a small open economy. This combines the Mundell-Fleming model you studied last year with the C&S supply side story of the labour market. It has the important property that the equilibrium unemployment rate is not unique, due to the effect of the exchange rate on the purchasing power of wages.
Carlin & Soskice Chapters 9, 10
Your favourite first year macro text such as Blanchard or Mankiw will cover the Mundell-Fleming model, and this would be a good place to start.
You might find it useful to look at Krugman & Obstfeld, International Economics: Theory and Policy, Part III "Exchange rates and open-economy macroeconomics". The chapters in this section review the international material you learned last year as well as covering most of the topics in C&S in a different, and possibly more readable way. However, this treatment does not feature a dependence of the equilbrium unemployment rate on the real exchange rate.
The following questions are taken directly from the Department's problem set. In each tutorial group
the first student by alphabetical order of surname should answer 1, 5, and 7; the second 2, 6, and 8;
and the third 3, 4, and 7.
1. Explain the economics behind Uncovered Interest Parity (UIP). Suppose UK interest rates increased, but sterling depreciated in response. Could you explain this using UIP?
2. Under a fixed exchange rate regime, what would be the impact on output and inflation of an increase in government spending? How would your analysis differ if the Ricardian Equivalence proposition held?
3. When does UIP imply that domestic interest rates must equal overseas interest rates?
4. You have just heard that the central bank has unexpectedly announced a 1% point increase in interest rates. What percentage change would you expect in the exchange rate, and why?
5. During the period between the discovery of oil in the North Sea and its extraction, the UK current account moved sharply into deficit. Can you link these two events? What would you expect to have happened to the UK exchange rate over the same period, and why?
6. Using only algebra, demonstrate why fiscal policy will have no effect on output under flexible exchange rates if the monetary authorities fix the money supply.
7. What is the money neutrality and superneutrality? Why might the latter not hold?
8. If the monetary authorities use interest rates to target the money supply, how does this compare with a monetary policy based on a Taylor rule?