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Chapter Analysis
Intermediate22 pages • EnglishQuick Summary
The chapter 'Open Economy Macroeconomics' discusses how an economy interacts with other countries through various channels, such as trade in goods and services, financial assets, and labour. It explores the concepts of exchange rates, balance of payments, and the impact of international trade on national income. The chapter also explains different exchange rate systems, including fixed, flexible, and managed floating rates, and their implications on monetary policies.
Key Topics
- •Open Economy and Trade
- •Balance of Payments
- •Exchange Rate Systems
- •Purchasing Power Parity
- •Managed Floating Exchange Rate
- •International Trade Effects on National Income
- •Autonomous and Induced Expenditures
Learning Objectives
- ✓Understand how an open economy functions in terms of trade, investment, and labor markets.
- ✓Comprehend the mechanisms and implications of different exchange rate systems.
- ✓Analyze how international trade influences aggregate demand and national income.
- ✓Gain insights into the balance of payments and its components.
- ✓Apply the concept of the open economy multiplier to different economic scenarios.
Questions in Chapter
Differentiate between balance of trade and current account balance.
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What are official reserve transactions? Explain their importance in the balance of payments.
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Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.
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Explain the automatic mechanism by which BoP equilibrium was achieved under the gold standard.
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Suppose C = 40 + 0.8Y D, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.05Y (a) Find equilibrium income. (b) Find the net export balance at equilibrium income (c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 and 50?
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Additional Practice Questions
What is the impact of a managed floating exchange rate system on a country's monetary policy?
mediumAnswer: A managed floating exchange rate, also known as 'dirty floating', allows a country’s central bank to intervene and smooth out volatility in the exchange rate. This means that the central bank can influence the exchange rate to achieve specific economic goals, such as curbing inflation or boosting exports. However, the need for intervention can also limit the central bank's ability to conduct domestic monetary policy independently.
How do changes in foreign income affect a country's exports according to the open economy model?
mediumAnswer: In the open economy model, a rise in foreign income increases the demand for a country's exports, as foreign consumers have more money to spend on goods. This positive relationship means that as foreign economies grow, they can import more, which boosts export-driven domestic income and production.
Describe how interest rate differentials influence exchange rate movements.
mediumAnswer: Interest rate differentials affect exchange rates by making investments in higher interest rate currencies more attractive, leading to increased demand for that currency. As investors seek higher returns, they tend to shift capital towards countries with higher interest rates, resulting in currency appreciation in those countries and depreciation in countries with lower interest rates.
What are the implications of a current account deficit for a country's economy?
hardAnswer: A current account deficit indicates that a country is importing more goods and services than it is exporting, which can lead to higher borrowing from foreign sources to finance this deficit. While a deficit isn't inherently problematic, excessive reliance on foreign capital might lead to unfavorable economic conditions, such as currency devaluation or increased vulnerability to external economic shocks.
Explain how purchasing power parity (PPP) theory applies to exchange rates in the long run.
hardAnswer: Purchasing power parity theory suggests that in the long run, exchange rates should adjust to equalize the purchasing power of different currencies. This means that identical goods should cost the same in different countries when prices are expressed in a common currency. Divergences from this equilibrium, caused by factors such as tariffs or market speculation, are expected to be temporary.