CH19: Equilibrium in the Goods Market

What is the equation for net exports (NX) in an open economy?

NX= X- IM/e

Under fixed prices, how do changes in the REER relate to the NEER?

EP/P*=E (real exchange rate changes equal nominal exchange rate changes)

What condition determines exchange rate equilibrium in financial markets?

The Uncovered Interest Parity (UIP) condition

How does an increase in the domestic interest rate affect the exchange rate?

It leads to an appreciation of the exchange rate

What happens to the exchange rate if the foreign interest rate increases?

The domestic currency depreciates.

What are the effects of a higher interest rate in an open economy?

1) Lower investment due to costlier borrowing; 2) Appreciation → ↓exports, ↑imports → ↓output

What transmission channel is added in the open economy compared to the closed one?

The exchange rate channel via interest parity

How does the exchange rate channel affect the IS curve?

It flattens the IS curve, strengthening the effect of monetary policy

What are the two main effects of an interest rate increase?

Higher borrowing costs & currency appreciation → both reduce output

What happens when government spending increases but interest rate remains constant?

Output increases, but the trade balance deteriorates (↑imports, unchanged exports)

What real-world example reflects the Mundell-Fleming model?

U.S. in early 1980s: high interest rates + fiscal expansion → twin deficits

What must hold under fixed exchange rates and perfect capital mobility?

Domestic interest rate = Foreign interest rate

What policy tool does a country give up under fixed exchange rates?

Independent monetary policy.

Why can’t a central bank set its own interest rate under fixed exchange rates?

Doing so would cause capital flows and force the central bank to intervene, affecting money supply

What is the “Unholy Trinity” (Impossible Trinity) in macroeconomics?

A country can only choose two of the following:

1. Free capital movement,

2. Fixed exchange rate,

3. Independent monetary policy.

What happens to a central bank’s balance sheet under perfect capital mobility and fixed exchange rates after an open market operation?

Only the composition changes, not the monetary base or interest rate