EC201 Macroeconomics 2, Spring 2016University of WarwickThijs van Rens

Open economySeminar questions - short run

Short-run equilibrium in the open economy As we saw last week, equilibriumin the open economy is described by six equations: a production function, an ‘IS’curve, an equation describing central bank policy, the definitions of the real interestrate and the real exchange rate, and an interest parity conditions.

1. There are too many endogenous variables in the six equations described aboveto solve this system, so we must make additional assumptions. The textbookassumes that in the short run, prices and expectations are fixed. Explain whythese additional assumptions are a reasonable way to define the ‘short run’.

2. Show that the short-run equilibrium of the open economy can be determined bysix equations in six endogenous variables.

3. Show that the short-run equilibrium can be summarized by three equations inoutput Yt, the nominal interest rate it, and the nominal exchange rate et.

4. The next step depends on the exchange rate regime. First, assume that thecentral bank keeps the exchange rate fixed (also called a ‘peg’). Show that inthis case, the equilibrium conditions can be reduced to a single equation in oneunknown (output). Explain how you would use this equation to solve for theresponse of output and other variables in response to shocks.

5. Second, assume that the exchange rate is allowed to float, and the central bankperforms monetary policy as in the closed economy. Show that in this case, theequilibrium conditions can be reduced to to equations in two unknowns (outputYt and the nominal interest rate it). Explain how you would use these equationsto solve for the response of output, the nominal interest rate, and other variablesto shocks.

Using the model Use the solution for the short-run equilibrium of the open econ-omy derived above to answer the following questions.

1. A country has a fixed exchange rate. Production is on the natural level andinflation is the same as in the rest of the world. Now the government decides todevalue the currency by 10 percent in order to raise production and employment.What are the short run effects of this policy? What will happen in the long run?

2. Consider a country with a fixed exchange rate. Production is on the naturallevel and inflation is the same as abroad. Now, domestic demand increases andspeculators start to believe that the country will revalue its currency. Whatwill happen to the exchange rate if the central bank keeps the interest rateconstant? What interest rate must the central bank set in order to defend thefixed exchange rate? What happens to production?

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3. Is it theoretically possible for a country to have a fixed exchange rate and stillset the interest rate independently? Is it possible in practice?

4. Consider a country with a floating exchange rate and an inflation target equal to2 percent. The output gap is zero and inflation is 2 percent. Now the governmentdecides to permanently raise the inflation target to 3 percent. What is the effecton production and inflation if the interest rate is kept unchanged?

Fiscal policy in the open economy

1. “Expansionary fiscal policy is useless because an increase in government expen-diture will just crowd out private demand.”True, false, or uncertain? Explain.

2. “Fiscal policy is less powerful in the open economy compared to the closedeconomy.”True, false, or uncertain? Explain.

Monetary union

1. What are the advantages and disadvantages of a fixed exchange rate comparedto membership of a monetary union?

2. Inside a monetary union, countries are unable to adjust by changing their ex-change rates. What alternative adjustment mechanisms are available? Willthese adjustment mechanisms improve or deteriorate as time goes by?

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