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In the absence of any imported materials, price setting in the open economy is same as in closed economy, ie prices are set as a mark-up on unit labour costs
When Î¸=1, wage setting curve is same as in closed economy.
A rise in Î¸ raises the real cost of imported goods and therefore reduces the price-setting real wage
Source: Carlin & Soskice, p353
The ERU curve is defined as the combinations of the real exchange rate and output at which the wage-setting real wage is equal to the price-setting real wage. At any point on the ERU curve, the real exchange rate, Î¸, is constant and inflation is constant.
On ERU curve, inflation constant; real exchange rate constant
At points above ERU curve, real wage below WS curve so upward pressure on inflation. Wages too low to satisfy wage setters at this level of employment. Home inflation above world inflation. Hence Î¸ falling, real wages rising
At points below ERU curve, real wage above WS curve so downward pressure on inflation. Wages too high for wage-setting equilibrium given low level of employment. Home inflation below world inflation. Hence Î¸ rising, real wages falling
AD curve shows combination of real exchange rate, Î¸, and level of output, y, at which goods market is in equilibrium with domestic real interest rate equal to world real interest rate
AD curve is positively sloped to the right on assumption that a more competitive exchange rate (high Î¸) raises aggregate demand and output
BT curve shows combination of real exchange rate (Î¸) and output (y) at which trade is balanced, ie x = m
BT curve positively sloped to the right. A more competitive exchange rate (high Î¸) raises exports and requires a higher level of output to drive up demand for imports to deliver trade balance
To left of the BT curve is a trade surplus; to right is a trade deficit
BT curve flatter than AD curve.
Suppose economy initially in equilibrium at A and then exchange rate depreciates.
Aggregate demand boosted by higher exports and economy moves to B on AD curve. There is now a trade surplus because output has not risen enough to boost imports by same amount as exports.
For a small open economy:
demand side is given by AD curve. On AD curve, goods market in equilibrium and r = r* (world real interest rate)
supply side given by ERU curve. On ERU curve, inflation is constant
balance of trade equilibrium represented by BT curve
In short run, economy in goods market equilibrium on AD curve. That is, for a given nominal exchange rate and a given price level, level of output is fixed by the AD curve
In medium run, economy must also be on ERU curve. Only then is labour market in equilibrium. So in medium run, AD and ERU curves intersect
In long run, trade balance must also be in equilibrium
Source: Carlin & Soskice, p362
A is short-run equilibrium (on AD curve but not ERU curve). Economy loses competitiveness and moves along AD curve to B.
B (and B’) is medium-run equilibrium in that there is stable inflation. But at B there is a trade surplus.
Z is long-run equilibrium. At Z, labour market equilibrium coincides with the balanced trade level of output.
What might shift the AD curve to intersect ERU and BT curves at Z?
Mechanisms to achieve long-run equilibrium
Wealth effects: At A, country is accumulating wealth. May raise permanent income and shift AD curve to right
Market pressure: Persistent trade surplus of trade deficit may lead to a change in credit conditions
Political pressure: Surplus countries may come under political pressure at home to boost activity and operate at a lower unemployment rate. Also may be political pressure from abroad to adjust policies
What are the key differences between an open and closed economy?
Trade in Goods
Output can now differ from domestic demand because of net exports
Net exports depends on the real exchange rate = national competitiveness C&S 9.1
Trade in Assets
Uncovered Interest Parity
Common Link is the Exchange Rate
Two alternative policy regimes
Flexible exchange rate
Fixed exchange rates or Monetary Union
Uncovered Interest Parity (C&S 9.2.2)
e=log real exchange rate
Rise implies real depreciation, or gain in competitiveness, due to
Lower home prices
Higher overseas prices
Extends IS/LM to open economy
Implies under flex rates, monetary policy effective, fiscal policy ineffective
Money demand: M/p=f(Y,r). If M and p are fixed, and r is fixed in steady state by UIP, then Y is also fixed in steady state – QED
If IS curve shifts in short run, higher interest rates imply real appreciation, crowding out next exports, returning IS curve to its original position in long run
Assumes fixed M – unrealistic today
Under fixed exchange rates, monetary policy ineffective, fiscal policy effective
Obvious – there is no independent monetary policy under fixed exchange rates
Equilibrium given by IS curve and overseas interest rates, LM curve endogenous
Monetary policy in an open economy under flexible exchange rates
UIP implies that there are now two transmission mechanisms through which interest rates influence demand
Through direct effects on investment and consumption
Through UIP, which changes the real exchange rate, which in turn influences net exports i.e. the demand for domestic production
Under UIP, the impact of an increase in interest rates on demand will depend on expectations about how long interest rates will remain high.
This gives policy extra leverage, but it also creates problems of ‘managing expectations’
However, if consumption is forward looking, then we have similar problems with direct interest rate effects.
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