Carlin & Soskice: Macroeconomics

The Open Economy in the

Short Run

Solutions to questions set in the textbook

Please email w.carlin@ucl.ac.uk with any comments about the questions and
answers. We would also be pleased to receive suggestions for additional questions
(along with outline solutions), which can be added to the website resources.

OXFORD
Oxford University Press, 2006. All rights reserved.

Higher Education

Chapter 9. The Open Economy in the Short Run

1.1

Checklist questions

1. What is the difference between the real and the nominal exchange rate? Give an example to
explain this to a non-economist. Is an improvement in the terms of trade the same as an improvement in price competitiveness? Is an increase in the real cost of imports an improvement or a
deterioration in the terms of trade?
price of foreign goods expressed in home currency
= PP e , while the
price of home goods
no. units of home currency
one unit of foreign currency . The real exchange rate is the rate at which

ANSWER: Real exchange rate:

nominal exchange rate e =

home and foreign goods exchange for each other. While the nominal exchange rate only tells
how many units of home currency are needed in exchange for one unit of foreign currency. The
real exchange rate of a can of coke between the US and UK is the price of the drink in the US
in terms of GBP divided by the 50 pence the can of coke cost in the UK. Under the simplifying
assumptions set out in the chapter (where only manufacturing goods are imported and exported
and prices are set in each country by home costs), the terms of trade and price competitiveness
are each the inverse of the other. An increase in the price of imports is a deterioration of the terms
of trade.
2. Explain two ways of measuring the real exchange rate. How well correlated would you expect
them to be, and why?
ANSWER: Two standard measures of the real exchange rate are in terms of relative prices and
relative costs. Relative prices: RER =

eP =P , where P is an index of world prices; e is the

nominal exchange rate de ned as units of home currency per one unit of foreign currency; and P
is an index of home prices. This measures the relative price of goods in a common currency. A
second commonly used measure is relative costs: RULC

e(ULC =ULC), where ULC is unit

labour cost. If prices are set as a mark up on home costs, then they will be very closely correlated.
At the other extreme, if rms are pricing to market (using so-called world pricing), then changes
in relative costs will not be re ected in changes in relative prices (but rather, in changes in pro t
margins and therefore in non-price rather than price aspects of competitiveness).
3. Explain the sense in which an improvement in price competitiveness might be considered a `good
thing' for the economy. Might it also be considered a `bad thing'?
ANSWER: An improvement in price competitiveness means that home goods are cheaper relative to foreign ones and this is obviously a good thing in terms of net exports. However, an

improvement in price competitiveness can also re ect an increase in the price of imported goods.
Since agents consume both domestic and foreign produced goods, this reduces real (consumption)
wages and hence, living standards.
4. Is the behaviour of the volume of exports a satisfactory measure of a country's competitiveness?
ANSWER: It is sometimes said that a country with strong export performance is very `competitive'. As we have seen, the growth of exports depends on the real exchange rate (de ned in terms
of relative prices), on the growth of world trade and on non-price factors. Hence export growth
does not simply re ect price competitiveness. The question hints at a broader use of the term
competitiveness than when it is de ned by the real exchange rate. The World Economic Forum,
for example, de nes competitiveness as the `collection of factors, policies and institutions which
determine the level of productivity of a country and therefore the level of prosperity that can be
attained by a country'. In this sense, a country may have strongly performing exports but weak
domestic demand and high unemployment, which impairs its competitiveness de ned broadly.
Equally, exports may be booming because of a devaluation but this comes at the cost of reduced
real wages (Question 3) and may only be a temporary boost to the economy as is explained further
in Chapter 10.
5. Construct a numerical example to show how the Marshall-Lerner condition works. Why might
its predictions not hold in the very short run?
ANSWER: See Section 1.6 and the Appendix to the Chapter. It might not hold in the very short
run since it takes time for volume effect to actually work. Some contracts have already been
signed, etc. Furthermore, the price elasticity of demand for exports and imports in the short-run
is low (as mentioned above). The export receipts are unchanged (in domestic currency) while
import bills (in domestic currency) are higher given a depreciation of the nominal exchange rate.
6. Explain what is meant by the passage in italics in the statement that the MarshallLerner condition
relates to the impact on the trade balance of a change in the real exchange rate, holding the level
of output constant. Apart from the price-elasticity of demand what extra information do you need
to work out the effect on the trade balance of a change in the exchange rate?
ANSWER: Output is held constant because the aim is to see the partial effect of a change in the
real exchange rate. For the partial equilibrium analysis, it is assumed that prices do not change as
a consequence of volume sold (in nite elasticity of supply). It is also assumed that the initial trade
balance is known. The MarshallLerner condition assumes an initial position of trade balance.
With these assumptions and assuming the sum of the price elasticity of demand for exports and
2

imports exceeds one, the volume effect will exceed the terms of trade effect (which increases
the import bill for a given volume of imports) and the trade balance will improve. Once the
assumption that output is constant is relaxed, the full effect of a change in the real exchange
rate on the trade balance can be calculated. Holding the interest rate constant, given the marginal
propensity to save and the tax rate, the increase in output associated with the rise in net exports can
be calculated; this will be less than the increase in the level of output associated with trade balance.
Hence there is a trade surplus in the new equilibrium. Output rises by more than absorption.
7. A small open economy has a government budget surplus and a trade de cit. Explain whether
there is a private sector surplus, de cit or balance. Examine the consequences in the short run for
output, the trade balance and the budget balance of a sudden fall in private consumption in this
economy under (a) xed exchange rates, (b) exible exchange rates.
ANSWER:
s(y disp )
Using the above, if (t

c0

I) + (t(y)

g) > 0 and (x

g = (x

m(y))

m) < 0 then the private sector nancial balance

must be in de cit. Fall in consumption under xed exchange rates leads to fall in output.
Trade balance must increase (no change in exports; fall in imports) and government surplus
(t

g) must decrease (no change in g; fall in t). Under exible exchange rates, there

is a depreciation and in the new short-run equilibrium, output is unchanged with higher
net exports and lower consumption. With
(t

y = 0 and increase in e ,

BT > 0 and

g) = 0.

8. What would it mean to describe an economy as a `small, open economy with imperfect capital
mobility'; a `large, open economy with perfect capital mobility'?
ANSWER: In the rst case, the economy trades on the world market, and takes world output
and the world interest rate as exogenous. However, imperfect capital mobility means there is
a wedge between the domestic and the world interest rate. In the second case, the economy
is large enough to in uence the level of world output and to in uence the world rate of interest,
which small countries take as given. With perfect international capital mobility (plus perfect asset
substitutability), the UIP condition holds.
9. In an open economy, home residents can hold home or foreign bonds in their portfolio. What
assumption allows us to write the demand for money in the open economy in the same way as in
the closed economy, i.e. as a function of domestic output and the home nominal interest rate?
3

ANSWER: Perfect capital mobility and they only hold home money.
10. What is meant by arbitrage in international nancial markets? Give a numerical example to
explain the concepts of the covered and uncovered interest parity conditions.
ANSWER: By arbitrage is meant the possibility of making a pro t without bearing a differential
risk. There would be an arbitrage opportunity if two equally risky assets or bonds provided a
different return; this is ruled out in a well functioning international capital market as expressed
in the UIP condition. The UIP states that any differential in terms of interest rate between home
country and the world is compensated by an identical difference between the nominal exchange
(spot) rate and its expectation. See footnote 15 for covered versus uncovered.
11. What assumptions must be made for the uncovered interest parity condition to hold? Explain what
you would expect to happen to the domestic interest rate and the exchange rate in a small open
economy following a rise in the demand for money, making clear the role of the UIP condition in
this chain of events.
ANSWER: Assumptions: perfect capital mobility and perfect substitutability between domestic
and foreign bonds. For the world interest rate to be exogenous, the economy must also be small.
A rise in money demand would shift the LM curve to the left. However a home interest rate
higher than the world one is not an equilibrium so there will be an immediate appreciation (or
pressure to) of the nominal exchange rate as suggested by UIP. And depending on the exchange
rate mechanism, the equilibrium will be re-established at the world interest rate by adjustment in
the goods market as the ISXM curve shifts left ( exible ER) or by an induced increased in the
money supply as foreign exchange reserves rise to maintain the exchange rate peg ( xed ER).
12. Suppose that there is less than perfect capital mobility. Explain why in the interest rate-output
diagram the i = i line is replaced by the balance of payments equilibrium condition: BT ( ; y)+
F (i) = 0. Why does this `BP ' curve in the interest rate-output diagram shift with a change in ?
ANSWER: See Section 6.2 Example 2.
13. Devaluation cannot affect the trade de cit because the latter must equal the difference between
investment and saving, and neither of these magnitudes is affected by the exchange rate. What is
wrong with this argument in the context of an open economy with sticky prices?
ANSWER: It is wrong since devaluation affects savings via its effect on output.
14. Explain the concept of exchange rate overshooting and develop two different examples using
private sector shocks in one of which, the equilibrium adjustment of the exchange rate is an
4

appreciation and in the other, the equilibrium adjustment is a depreciation.

ANSWER: See Section 5.1.3.

1.2

Problems and questions for discussion

QUESTION A: Assume that wages, prices and the exchange rate are xed. (a) Will a fall in the budget de cit due to a cut in government spending always improve the trade balance? Explain your
answer. (b) What is the impact on output and the trade balance of a balanced budget increase
in government spending? (For simplicity, consider a lump-sum tax.) Does the change in output
differ from that in a closed economy following a balanced budget increase in government spending if so, in what way? In the open economy case, what happens to private savings net of
investment? Summarize what has happened to the sector nancial balances.
QUESTION A: ANSWER: This question would normally be set as an exercise for the material in
Sections 1.1 and 1.2. It can obviously also be answered using the fuller model from later in the
chapter. (a) Yes. The key is what happens to output. Using the assumptions in Sections 1.1 and
1.2 + xed exchange rates, then
y

=
)

1
g < 0;
sy + my
(x m) = my y

)
Also,

(t

g)

<

(x

m) > 0:

0:

Hence, the trade balance improves and so does the government de cit.
(b) A balanced budget increase in government spending with a lump-sum tax means that

g=

t. So
y =
=
Hence

y <

1
sy + my
sy
sy + my

cy t

g:

g: the BBM is less than one (its closed economy value), because of the extra

leakage to imports.
Sector nancial balances:
sy y disp

c0

I) + (t
5

g = (x

my y)

Because of the balanced budget assumption, the public sector de cit is unchanged. Since y rises,
the trade balance deteriorates. Hence in the new equilibrium, there is a private sector nancial
de cit, which is being nanced by borrowing from abroad (the counterpart of the trade de cit).
We therefore have to show that savings have fallen, i.e. that disposable income has fallen although
y has risen:

y disp =
=
=

sy
g
t
sy + my
sy
1
g < 0:
sy + my

QUESTION B: Find out what happened to the nominal interest rate set by the Federal Reserve in
the US and by the ECB in the euro-zone, and to the $-euro exchange rate following September
11th 2001 (to the end of 2001) [plot the data] See the resources below for sources of data and
discussion. The relevant interest rates are the Federal Funds Rate (US) and the minimum bid rate
in the main re nancing operations (ECB). Is this behaviour consistent with the predictions of the
UIP condition?
ANSWER: According to the UIP, a change in the interest differential (e.g. an increase in the amount
by which the US interest rate lies below the eurozone interest rate) should be associated with an appreciation of the euro against the dollar. This does not happen there is a depreciation of the euro against
the dollar. Very short term depreciations of the euro can be observed in September and in December
after US rate changes but these are soon reversed. Possible reasons: The UIP suggest the following either it is expected that the ECB will soon follow the FED so that the new interest differential will be
short-lived; or changes in interest rates lead to a reassessment of the expected exchange rate. Points
that can be made: immediately after September 11, the dollar depreciated agains the euro as would
have been expected (expectations about the US economy worsened) but the Fed reacted quickly to cut
the interest rate. The ECB followed immediately and this seems to have reassured the markets that the
shock to the US is transitory. The Fed's actions through the rest of 2001, which open up a larger interest
rate gap are met with an appreciation of the dollar. It seems that the markets believe that the Fed knows
what it has to do to boost the growth prospects of the US. There is less certainty that the ECB knows
what it is doing. In particular, the rhetoric of the ECB focuses on the nominal anchor role (in ation)
whereas the Fed emphasizes the need to stabilize growth expectations.

QUESTION C: Use the Mundell-Fleming model and assume perfect capital mobility. Suppose there
is a fall in the world interest rate. (a) Does this have an expansionary or contractionary impact
on output in a small open economy? (b) Does the trade balance improve or deteriorate? Explain
your answer. Look at both xed and exible exchange rate regimes.
QUESTION C: ANSWER: (a) It depends on the exchange rate regime. Under exible exchange rates,
the effect is contractionary. The fall in the world interest rate means that the domestic interest
rate is above the world interest rate and therefore, there will be an immediate appreciation of the
home currency which will lead to a fall in net exports and the ISXM shifting to the left until the
new equilibrium where i = i and ISXM 0 intersects LM . Under xed exchange rates, it has an
expansionary effect: given i > i there will be an increase in foreign exchange reserves due to
the higher demand for home bonds from holders of foreign bonds and given that the central bank
is committed to maintain the peg. This leads to an expansion in money supply so the LM curve
shifts rightwards to the new equilibrium (short-run) i = i and LM 0 intersects ISXM . (b) In
both cases BT deteriorates. In the rst case because of the appreciation and under xed exchange
rates because the larger output results in higher imports.
QUESTION D: Consider two economies: the home country is Norway (currency is the Krone), and
the foreign country is the US. State the Uncovered Interest Parity condition, assuming that the
default risk is identical between the two countries. For each of the scenarios discussed below,
assume that initially the US and Norwegian interest rates are identical and that the US interest
rate remains unchanged throughout.
Scenario 1. The Norwegian interest rate is expected to remain above the US rate for one year.
What relationship between the interest rate differential and change in the Krone exchange rate would be
observed on average during the year?
Scenario 2. At the beginning of the year, the Norwegian government introduces a permanent increase in government spending. By the end of the year, the Norwegian and US interest rates are identical. Provide an account of the adjustment of the Norwegian economy during the year. What relationship
between the interest rate differential and change in the Krone exchange rate would be observed on average during the year? You may assume that wages and prices do not adjust within the year.
What light do your ndings throw on the question of whether the UIP condition predicts exchange
rate changes?
QUESTION D: ANSWER: UIP: iN

iU S =

eE
t+1 et
et

Scenario 1. Since it is not possible in a well functioning market (non arbitrage condition) for two
identical assets to have different return. It has to be the case that the gain in terms of interest rate from
7

holding Norwegian Bonds has to be offset by the capital loss in terms of exchange rate. Hence given
the expected exchange rate, the Krone exchange rate appreciates immediately the interest differential
opens up and depreciates over the course of the year. The average relationship observed is that a positive
interest differential in favour of the Norwegian bonds is associated with the depreciation of the Krone.
Scenario 2. The increase in government expenditure in Norway causes aggregate demand to increase
in Norway, the ISXM curve shifts to the right and the domestic (Norwegian) interest rate is above the
US interest rate. The Krone appreciates and the ISXM returns to its initial position by the end of the
year. By the end of the year net exports must have fallen by the amount by which government spending
increased. A new short run equilibrium is established by the end of the year. The question suggests
slow adjustment of output and exchange rate expectations over the course of the year. The average
relationship observed is that a positive interest rate differential in favour of Norway is associated with
an appreciation of the Krone exchange rate. Hence the key difference is that the expected exchange rate
remains xed in scenario 1 but not in scenario 2.
QUESTION E: A new government is elected and as a consequence the country is considered to be
less risky. (a) Explain what is meant by `less risky'? (b) Would you expect this to have a positive
or negative impact on output in the short run in a xed exchange rate economy and a exible
exchange rate economy? You may assume that the economy is a small open one with perfect
capital mobility. (c) Now assume you are engaged in a discussion about your results in an international economics consultancy. Assess the plausibility of your results and explain how you
could introduce additional considerations into the model to enhance their plausibility.
QUESTION E: ANSWER: a) Less risky means that the new government is seen as less likely to
default on its debt. b) The starting point is to think of an economy where the UIP does not hold in
its original formulation since the assumption of perfectly substitutable bonds does not hold if there is
a different risk associated with the two countries. The UIP is then adjusted to take this into account:
i=i +

eE
t+1 et
et

+ where is a measure of the differential risk associated with the home country. Say

that with the newly elected government,

= 0 this means that i > i and therefore the analysis proceeds

as in QUESTION C. c) The result under xed exchange rates of an expansion in output somehow seems
more plausible than the contraction predicted under exible exchange rates. Other considerations are (i)
the riskiness of the previous government may have led to higher liquidity prefernce at a given interest
rate so the fall in riskiness may lead to a reversal of this, i.e. money demand may fall leading to a
rightward shift of the LM . Under exible exchange rates this will be expansionary. (ii) The fall in
the risk premium may boost con dence more broadly in the economy, shifting the ISXM to the right.
(iii) It is necessary to go beyond the short run. Can come back to this question following coverage of
8

the medium run in Chapter 10: the medium run equilibrium is independent of the exchange rate regime
and the fall in the risk premium will lead to a new medium-run equilibrium at higher output. This
highlights the fact that the government can relax monetary policy under exible exchange rates to offset
the appreciation and speed up the movement to the new higher output equilibrium.