Open economy macro

What is the basic set‑up of the open economy model in this lecture?

Two countries, Home and Foreign, each with its own currency, trading goods, services, and financial assets.

In the examples, which country is Home and which is Foreign?

Home is the UK (pounds, £); Foreign is the US (dollars, $).

What does 'perfect international capital mobility' mean?

Home residents can buy and sell unlimited foreign bonds at the world interest rate without restrictions.

What does it mean that the home country is 'small'?

Its actions do not affect the world (foreign) interest rate.

What financial assets can households hold in the model?

Home bonds, foreign bonds, and money.

What is assumed about home and foreign bonds?

They are perfect substitutes; they differ only in expected return, not in risk.

Who are the main participants in the forex market in this model?

Forward‑looking traders with rational expectations seeking arbitrage profits.

What are the two key roles of the forex market?

It links interest rates to exchange rates and shapes how the economy reacts to shocks via capital flows.

What is the nominal exchange rate?

The rate at which one currency is exchanged for another, e.g. £ per $.

In notation, what does e represent?

The nominal exchange rate, expressed as units of home currency per unit of foreign currency (e = £ per $).

When does the home currency depreciate in nominal terms?

When e rises (you need more home currency to buy 1 unit of foreign currency).

When does the home currency appreciate in nominal terms?

When e falls (you need less home currency to buy 1 unit of foreign currency).

What is the real exchange rate conceptually?

The nominal exchange rate adjusted for relative price levels between home and foreign.

What happens to competitiveness when the real exchange rate rises?

Home experiences a real depreciation; home goods become cheaper and more competitive, boosting net exports.

What does 'uncovered' mean in Uncovered Interest Parity (UIP)?

Positions are not hedged against exchange‑rate risk; no forward contract is used.

State the UIP condition in words.

The extra interest from home bonds equals the expected loss from home‑currency depreciation against foreign currency.

What are the key assumptions behind UIP?

Risk‑neutral investors, no capital controls, and home/foreign bonds are perfect substitutes.

How does a rise in the home interest rate affect the exchange rate under UIP (with unchanged expected future e)?

It causes an immediate appreciation of the home currency, followed by gradual expected depreciation.

Why does arbitrage eliminate profit opportunities after a home rate hike?

Traders buy home currency and bonds until expected depreciation just offsets the higher interest rate.

In the UIP diagram, what does a point on the UIP line represent?

A combination of interest‑rate differential and expected depreciation where returns on home and foreign bonds are equal.