week 6

• floating exchange rates are free to change in response to changes in the economy
• Fixed exchange rates remain fixed by having a countries central bank participate in the Foreign Exchange market to keep rates at the desired level
• an increase in real interest rate in an economy with a floating exchange rate will cause output to decrease due to both reductions in investment and net exports
• changes in real interest rates will change real income more in an open economy with a floating exchange rate compared to a closed economy
• a fixed exchange rate regime makes the IS curve steeper
• monetary policy with a fixed exchange rate limits the central banks ability to follow the Taylor rule, as changes in r will change the exchange rate, and the central bank has limited reserves to manage exchange rate on the foreign exchange markets
• fixing exchange rate restricts monetary policy
• To fix an exchange rate, the central bank will participate in the foreign exchange market by buying or selling domestic currency for foreign currency to keep exchange rates at the desired level
• a central bank controls domestic money supply and can provide domestic currency easily, however must hold reserves to sell a foreign currency
• the reserve gain (RG) is the difference between the Central banks purchases and sales of a foreign currency
• a central bank can easily buy foreign currency, but not easiily sell/ supply them
• a negative reserve gain mans the central bank is selling more reserves than its buying, and the bank is losing reserves of currency
• net capital flow = private capital flows (households) + reserve gains (RG, Central banks)
• CF = PCF + RG
• private net capital outflow (PCF) is a decreasing function of r, and are households outflows
• RG = NX - PCF
• NX- PCF refers to the difference between total sales to foreigners and total purchases from foreigners
• sticky prices mean the prices are fixed
• flexible prices means that the prices change as a result of a change in M, where some prices adjust quicker than others
• when prices are fixed, there is no reason for anyone to expect inflation
• when prices are fixed, i = r
• when there are sticky prices and the central bank increases money supply, interest rates must fall or output (Y) must increase to increase the amount of real money balances people want to hold
• when there are sticky prices, a change in nominal money supply causes changes in the real interest rate
• when there are sticky prices, the central bank is able to control real interest rates via changes in money supply
• completely flexible prices increase immediately when money supply is increased, reducing the increase in real money supply
• prices that are sluggish rise slowly in after money supply is increased, meaning price level rises by a smaller proportion than M
• when prices are flexible, an increase in money supply resultss in price level increasing to a high level
• when prices are level and money supply is increased, real money supply also increases, as some prices will take longer to adjust so the price level increases by a smaller proportion than money supply
• when there are flexible prices and money supply increases, expected inflation increases
• when there is an increase in money supply and fully flexible prices, in the long run the MP curve shifts to its initial point, and the real interest rate is not changed
• when prices are fully flexible, the central bank cannot control the real interest rate, as the long term MP curve doesnt move. this is unrealistic and not relevent in practice
• planned expenditure of an open economy = E = C (Y-T) + I(r) + G + NX(real exchange rate)
• an increase in real exchange rate involves the domestic currency appreciating, and the foreign currency depreciating
• if the real exchange rate increases, foreign goods become relatively cheaper, resulting in more imports and less exports, and lower net exports
• net exports are a decreasing function of the real exchange rate
• the nominal exchange rate is the number of foreign currency in exchange for one unit of domestic currency
• the real exchange rate is the nominal exchange rate including the effect of relative domestic and foreign price levels
• the foreign exchange market condition is that IM + CO = X + CI
• IM + CO is Imports + Capital Outflows, and is the demand of foreign currency
• X + CI is Exports + Capital Inflows, and the supply of foreign currency