The 3-Equation Model in The Open Economy - Answers: 9.1 Checklist Questions

Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Chapter 9
The 3-equation Model in

the Open Economy –
Answers
9.1 Checklist questions

1. Use a U IP diagram to illustrate the following cases. Discuss the adjust-
ment process in each case and show how it relates to the U IP equation.
(a) Home’s interest rate falls below the world interest rate for one period.
(b) The world interest rate increases for one period and the home econ-
omy raises their interest rate in line.
(c) The foreign exchange market changes their expectation of the ex-
change rate in a year’s time to a more depreciated exchange rate.
ANSWER:
(a) As shown in Fig. 9.1, the fall in home’s interest rate below world’s
level for one period, implies that the nominal exchange rate will have
to depreciate. From the point of view of the home country, it is more
profitable to buy foreign bonds, given the negative interest rate differential.
According to the UIP, this must equal the expected appreciation of the
home currency. For the equation to hold therefore, the exchange rate
et must immediately depreciate (as people buy foreign currency to buy
foreign bonds).
(b) Nothing happens.
(c) The exchange rate immediately depreciates when the foreign exchange
market changes their expectation of the exchange rate in a year’s time to
© Wendy Carlin and David Soskice 2015. All rights reserved.

2CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS
UIP condition:
it − i* = log etE+1 − log et
i
A
log e2E − log e1
i*
= i0 = i2 i1 − i*
B
i1
−45o
log e0 = log eE loge1 log e

depreciation →
Figure 9.1: Home’s interest rate falls below the world interest rate for one period
a more depreciated exchange rate. The reason for this is shown by the
UIP condition:
i − i∗ = log eE − log et ,
t t+1
interest gain (loss) expected depreciation (appreciation)
In this scenario home and world interest rates are unchanged. Hence the
left hand side of the equation is equal to zero. The change in expectations
can be represented as an increase in log eE t+1 . For the UIP condition to
hold, it must be the case that log et also increases, which in reality means
an immediate depreciation of the exchange rate. If this did not happen
then home investors would be able to make more money by holding foreign
bonds for the next year than by holding home bonds (upon converting
them back into pounds). This invalidates the UIP condition. See Fig.
9.2.
2. Answer the following questions about the supply and demand sides in the
medium-run model:
(a) What does the ERU curve represent? What would happen to the
ERU curve if unemployment benefits were raised? What would you
expect to happen to inflation?

9.1. CHECKLIST QUESTIONS 3
i UIP′ UIP
A Z
i*
−45o
log e0E log e1E log e

depreciation →
A change in the expected exchange rate in a year’s time

to a more depreciated exchange rate leads to an immediate
depreciation of home’s exchange rate.
Figure 9.2: A change in expected exchange rate
(b) What does the AD curve represent? Derive the AD curve graphi-
cally from the IS curve. [Hint: draw the IS diagram below the AD
diagram and think about how changes in the real exchange rate affect
the IS curve. To derive the AD, map the combinations of q and y
on each IS curve at r = r∗ .]
c. How does a rise in the world real interest rate affect the AD curve?
What is the effect on the medium-run real exchange rate.
ANSWER:
(a) The ERU curve captures the supply side of the economy. On the
ERU curve, inflation is constant. It is pinned down by the intersection
between the W S and P S and the term ERU stands for equilibrium rate of
unemployment. It shows the combinations of the real exchange rate and
output at which there is supply-side equilibrium (i.e. constant inflation).
A rise in unemployment benefits shifts the W S upwards, because at any
level of output and associated unemployment rate, a higher UB reduces the
cost of job loss. Because the outside option has improved, the expected real
wage that can be negotiated is higher. In turn, the ERU is shifted to the
left. Therefore, there is a change in the equilibrium level of unemployment.
Under flexible exchange rates, the medium-run inflation rate is equal to
the central bank’s inflation target. When the W S curve shifts, the P C

r = r*
IS (q0 ) IS (q1 ) IS (q2 )
y0 y1 y2 y
q
depreciation AD(r = r* )
q2
q1
q0
y0 y1 y2 y
Figure 9.3: Deriving the AD curve
indexed by expected inflation, which equals world inflation, shifts to go

through the new equilibrium output level. Hence at the initial output
level, inflation goes up.
(b) The AD curve represents the demand side in open economy. The
AD curve shows the combinations of the real exchange rate, q, and level
of output, y, at which the goods market is in equilibrium with the real
interest rate equal to the world real interest rate.
The equation for the AD curve is:
∗
yt = A − art−1 + bqt−1 (AD curve)
∗
where yt represents output, rt−1 is the world real interest rate in the last
period, qt−1 is the real exchange rate in the last period and A includes
other demand shift variables such as world trade, home’s share of world
exports and government spending.
We know that r must be equal to r∗ on a given AD curve, so to derive the
AD curve from the IS curve we need to vary q and see what happens to
the intersection of the r = r∗ line and the IS curve. The top panel of Fig.
9.3 shows how the IS curve shifts to the right with a more depreciated
exchange rate, where q2 > q1 > q0 . If we trace these combinations of q
and y onto the bottom diagram of Fig. 9.3 we can derive the AD curve.
(c) A rise in the world real interest rate shifts the AD curve to the left.
There is no change in the supply side of the economy so in medium run
the new MRE for the economy displays the same output and a depreci-
ated real exchange rate. Thus the reduction in demand through reduced

consumption and investment associated with the higher real interest rate
is compensated by an increase in net exports through increased compet-
itiveness due to the depreciated exchange rate in the medium run. The
result is independent of the exchange rate regime.
3. What conditions need to hold for a small open economy to be in a medium-
run equilibrium?
ANSWER:
For a small open economy to be in a medium run equilibrium the economy
has to be on both the AD curve and the ERU curve. We know from the
definitions of these two curves that:
On the AD curve: The goods market is in equilibrium and r = r∗ .
On the ERU curve: Inflation and the real exchange rate are constant.
At any medium-run equilibrium – i.e. at a point on the ERU curve –
the real exchange rate is constant.
4. In a small open economy, is a negative supply shock or a negative demand
shock more damaging for medium-run output? Explain in words and use
AD − ERU diagrams to back up your argument. Compare the effects on
the real wage, unemployment and the real exchange rate in medium-run
equilibrium of an increase in unemployment benefits.
ANSWER:
A supply shock will be more damaging to output. At the new equilibrium,
after the negative shock to supply (e.g. a decrease in product market
competition), there will be a lower level of output and an appreciated
exchange rate. In the case of a negative demand shock there will be no
change in output in the medium run; instead the real exchange rate will
depreciate to offset the effect of the contraction in demand. Fig. 9.4 shows
this graphically.
The real wage will be unaffected after a demand shock, whereas it may
change after a supply shock to the extent that the latter affects the P S
curve. For instance, a decrease in product market competition will lower
the real wage.
5. Use the 3-equation open economy model to answer the following questions:
(a) Explain what the following statement means: "after a demand shock
in a small open economy, the exchange rate often overshoots". Use
an AD − ERU diagram to help explain your answer.
(b) What causes exchange rate overshooting?
(c) What problems, if any, would you expect exchange rate overshooting
to cause?
(d) How could you modify the 3-equation open economy model so that
exchange rate overshooting does not occur? Explain in words.

↑ depreciation
q q ͛

q
q′

q′

q
Zh͛ Zh Zh
y′e ye y ye y
Ă͘ EĞŐĂƚŝǀĞƐƵƉƉůǇƐŚŽĐŬ ď͘EĞŐĂƚŝǀĞĚĞŵĂŶĚƐŚŽĐŬ
→ ƌĞĂůĂƉƉƌĞĐŝĂƚŝŽŶ → ƌĞĂůĚĞƉƌĞĐŝĂƚŝŽŶ
Figure 9.4: Small open economy: Negative supply and demand shocks
ANSWER:
(a) Overshooting refers to the phenomenon of the nominal and real ex-
change rate jumping by more than the equilibrium adjustment in response
to economic shocks. If we take the example of a permanent negative de-
mand shock, then this shifts the AD curve to the left and in the new
medium-run equilibrium there is a depreciated exchange rate, as shown
by the AD − ERU diagram in slide in Fig. 9.5. The exchange rate over-
shooting occurs because the initial depreciation (from q̄ to q0 ) is larger
than that required for the new medium-run equilibrium. The economy
must then appreciate from q0 to q̄ ′ on the path back from C to Z.
(b) Exchange rate overshooting in response to a shock in the small open
economy requires two assumptions. The first is rational expectations in
the foreign exchange market, as this allows for jumps in the exchange
rate. The second is that prices and wages are slow to adjust in the real
economy, such that a period where interest rates are set higher or lower
than world interest rates is required to achieve the central bank inflation
target after a shock. After a negative demand shock, the foreign exchange
market knows that there will be a depreciated exchange rate in the new
medium run equilibrium, but also that several periods where output is
above equilibrium output will be required to increase inflation back to
target. This means there will be a negative interest differential between
home and foreign bonds for a number of periods. For the UIP condition

ϭ͘ /ŶŝƚŝĂůĚĞƉƌĞĐŝĂƚŝŽŶ
Ϯ͘ ZĞĂůĞǆĐŚĂŶŐĞƌĂƚĞŽǀĞƌƐŚŽŽƚŝŶŐ
ϯ͘ ƋƵŝůŝďƌŝƵŵĚĞƉƌĞĐŝĂƚŝŽŶ
Depreciation
q ERU
AD′
ϭ Ϯ ϯ
q0 C
Z
q′
B
AD
q A
y0 ye y1 y
Figure 9.5: Exchange rate overshooting
to hold, the exchange rate must appreciate over the period where home’s
interest rates are below world interest rates. Hence, the exchange rate
initially over-depreciates to allow for gradual appreciation thereafter.
(c) Overshooting can lead to a misallocation of resources before the new
medium-run equilibrium is reached. A historical example dates back to
UK exchange rate overshooting in 1979, which damaged the price com-
petitiveness of the home economy and reduced net exports. The excessive
shrinkage of the tradeables sector (as a result of overshooting) was said
to have had lasting damage on the UK manufacturing industry. Secondly,
exchange rate overshooting adds to volatility and uncertainty in the econ-
omy, which can harm economic activity, especially through its effects on
investment and consumption decisions.
(d) If wages and prices adjusted immediately then the economy would
move instantly from the initial equilibrium to the new equilibrium and
there would be no exchange rate overshooting. Perfectly flexible wages
and prices could be represented by a model with a rational expectations
Phillips curve. In this scenario, output would react to changes in the real
exchange rate and the real interest rate within the same period. Hence,
there is no interest differential and no exchange rate overshooting occurs.
6. Is the following statement true or false? Explain your answer. “Central

banks have to be more aggressive when making interest rate changes in
the open economy because the IS curve is steeper than in the closed
economy.”

ANSWER:
The statement is wrong. The IS curve is indeed steeper in an open econ-
omy. But the central bank will adjust interest rates less aggressively be-
cause it knows that the exchange rate will take on some of the burden of
adjustment.
7. Consider a large negative demand shock that hits two small economies.
The economies are identical except that one is closed and the other is
open. Answer the following questions:
(a) Briefly explain how a large negative demand shock can lead to a
deflation trap.
(b) Which of the economies is more likely to fall into a deflation trap
following the shock? Justify your answer.
(c) What initial conditions would make it likely that both economies
would fall into a deflation trap?
ANSWER:
(a) A large negative demand shock causes output to fall upon impact and,
given the negative output gap, inflation will fall too. The central bank
works out the required positive output gap to be back on the M R curve
and calculates the required real interest rate to achieve this new point. If
the negative demand shock is so large that requires a cut in the interest
rate below the zero lower bound, then the economy may fall into a deflation
trap. Let’s consider a negative demand shock that drives inflation to −2%.
The minimum real interest rate that is possible to achieve is 2%. If such a
real interest rate is associated with output below equilibrium, the negative
output gap in the following period will induce a deflationary spiral.
(b) A closed economy is more likely to fall into a deflation trap. Indeed,
in open economy, the real exchange rate will take on some of the burden
of adjustment, and the central bank normally needs to cut interest rate
less aggressively to achieve the same output gap. This implies that in an
open economy, a central bank has more room to act in order to avoid a
deflation trap.
(c) If a negative demand shock hits an economy that is already close to
the zero lower bound, then it is likely that a small open economy will also
fall into a deflation trap.
8. Compare the decision making process taken by the central bank (and
forex market in the open economy) in a closed and open economy after a
permanent positive supply shock. Create a table similar to Table 9.2. How
does the real interest rate in the new medium-run equilibrium compare in
the two cases?
ANSWER:

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 9
Table left as an activity for students.

In the closed economy there is a new lower stabilising rate of interest.
The new medium run equilibrium is at a higher level of output, which
is associated with a lower interest rate via the IS curve. The interest
rate must be equal to the world interest rate in the open economy, so the
interest rate is unchanged in the new medium run equilibrium.
9. Explain what is meant by this statement: "The behaviour of the nominal
exchange rate in the model is a residual".
ANSWER:
Let’s consider the case of an inflation shock. The behaviour of domestic
inflation is determined entirely by the Phillips curve and monetary rule
mechanisms. Since the model pins down how the real exchange rate (in
conjunction with the central bank’s monetary policy rule) must respond
to the inflation shock, the behaviour of the nominal exchange∗
rate is a
residual. Indeed, the real exchange rate is defined as: Q = PP e . Since we
know that P ∗ is exogenous to the small open economy because it is set
in the rest of the world, and P and Q are pinned down by the inflation
shock and the best response policy response, it follows that the nominal
exchange rate e is just the residual.
10. This question uses material from Sections 9.5.2 and 9.5.4 of the Appendix.
For a benchmark case, draw the P C − MR and the IS − RX diagrams
after an inflation shock. Now increase the interest-sensitivity of aggregate
demand (i.e. a) and redraw the graphs. What has happened to r0 and
q0 ? Explain your results.
ANSWER:
The two diagrams are shown below in Fig. 9.6.
The graphs show that a higher a makes both the IS curve and the RX
curve flatter. What does this mean for the optimal interest and exchange
rate responses to the demand shock? It makes them smaller. Hence the
optimal response with a higher a is a lower r0 and a less depreciated q0.
This is because more of the optimal output gap is now accounted for by
the interest rate component. i.e. the output gap stays the same, but
the contribution from −a (r0 − r∗ ) in the output gap equation increases:
y1 − ye = −a (r0 − r∗ ) + b (q − q0 ).
9.2 Problems and questions for discussion

1. "Following an announcement from the Riksbank (the Swedish central
bank) of an interest rate increase, an immediate depreciation of the Krona
was observed". How can you explain this outcome? In your answer explain
the economics of the UIP condition. Summarize your findings highlight-
ing the role played by expectations and communication by the central

Low a – negative High a – negative

r demand shock r demand shock
IS ( A, q0 )
IS ( A, q0 )
B
IS ( A, q ) IS ( A, q )
r0 C B
r1 r0 C
A,Z r1 A,Z
r* r*
RX RX
y1 y2 ye y y1 y2 ye y
A′
π π
A′ PC (inflation shock) PC (inflation shock)
PC (π t ) PC (π t )
π1 B
PC (π t +1 )
π1 B
PC (π t +1 )
π2 C π2 C
PC (π * ) PC (π * )
πT =π* πT =π*
A,Z A,Z
MR MR
ye y y
Figure 9.6: Changing the interest sensitivity of expenditure in a small open

economy
bank. You are advised to take the following steps and in each case to
draw a U IP diagram:
(a) Show the ‘normal case’ in which the central bank announcement is
followed by an immediate appreciation of the Krona.
(b) Suppose the rise in the interest rate had been widely expected in
financial markets. Show in the U IP diagram that there would be no
immediate change in the exchange rate when the Riksbank made its
announcement.
(c) Finally, show how an immediate depreciation in the Krona can be
explained.
ANSWER:
Behaviour in forex markets is heavily influenced by expectations. Agents
move to take advantage of arbitrage opportunities immediately. This ques-
tion brings out this forward-looking behaviour by assuming in part (a) that
the interest rate change is completely unanticipated, i.e. a surprise. In
part (b), we assume the opposite, i.e. that agents expected exactly the
interest rate increase that the Rijksbank implemented. As a result, the
exchange rate does not alter when the announcement is made. In part
(c), we have a mixture of anticipated and unanticipated changes because
the agents were expecting a larger rise in the interest rate than actually

(a) Immediate appreciation (b) No appreciation (c) Immediate depreciation
i UIP i i
UIP
UIP
C C C
i1 i1 i1
A,B A A
i* i* i*
B B
UIP’
UIP’
e1 e0 log e e0 = e1 e2E log e e0 e1 e2E log e

e1E = e2E depreciation e1E
depreciation
e1E depreciation
depreciation ↑ depreciation ↑ depreciation ↑

e e e
e0
e1 e0 e1 e1
e0
t =1 t=2 time t =1 t=2 time t =1 t=2 time
Figure 9.7: Interest rate rise by the Riksbank - three scenarios
occurred. Only the unanticipated component produces a change in the

exchange rate.
(a) The UIP condition dictates that interaction between the nominal ex-
change rate and the interest rate. The equation is:
eE
t+1 − et
i − i∗ = ,
t et
interest gain (loss)
expected depreciation (appreciation)
For the duration of this question, we will assume that the Riksbank an-
nouncement of an increased interest rate occurs at time t = 1 and that it
is expected to last for one period. The UIP diagrams and the path of the
exchange rate for the three parts of the question are shown in Fig. 9.7
In the first case, the announcement is unexpected and it is expected to
exceed i∗ for one period. The gain from holding Swedish bonds over this
time needs to be offset by a depreciation of the Krona. This means the
exchange rate must immediately appreciate, so that it can depreciate over
the following year. This is the standard result of the UIP model. In the
diagram, the economy remains unchanged (A and B coincide) until the
announcement occurs in t = 1. The economy then goes to C and returns
to A over the course of the next year.

(b) If the change is widely anticipated by financial markets then at time

t = 0 this will be reflected in their expections for the exchange rate in
a year’s time. If we call this expected exchange rate eE 1 , the financial
markets expect this to be a more appreciated exchange rate and the cur-
rent exchange rate e0 jumps to equal eE ∗
1 . This is consistent with i = i on
′
U IP . We can think about the dynamics of the exchange rate via the UIP
condition shown above. We know that it will equal i∗ for the next year.
This means that e0 immediately appreciates to eE 1 for the UIP condition
to hold. Hence at time t = 1 when the interest rate increase is actually
announced there is no change needed to the exchange rate. It is already in
a position where it can depreciate over the next year to offset the positive
interest differential between home and foreign bonds (on UIP ). In this
case, the economy is observed going from A to B to C and then back to
A over the year whilst i > i∗ .
(c) In the third case, the financial markets have anticipated the rate rise,
but they have overestimated the size of it. This leads the exchange rate to
appreciate too far at time t = 0. When the smaller than expected rate rise
is announced at t = 1 the exchange rate jumps to a depreciated level at
e1 . The level it jumps to is such that the expected depreciation over the
next year will exactly offset the higher interest rate. Here the economy
goes from A to B to C and then back to A over the year whilst i > i∗
2. The Bank of England keeps a directory of the minutes from the monthly
meetings of their Monetary Policy Committee online:
(http://www.bankofengland.co.uk/monetarypolicy/pages/decisions.aspx)
(a) Pick a period following a shock such as after September 11th 2001 or
following the 2008-09 financial crisis and see how the Bank of England
comments on the interaction between the interest rates they set and
the UK pound exchange rate. Are interest rate differentials thought
to be causing movements in the exchange rate? If not, then does the
movement of exchange rates invalidate the U IP condition?
(b) Find some news articles from the same period that talk about the
reactions of the foreign exchange market (useful sources for market
news include the Financial Times, Reuters and Bloomberg). Did the
forex market anticipate changes in interest rates before they hap-
pened? If so, were their predictions proved correct?
ANSWER:
(a) The student should select an appropriate period of economic tran-
sition. The student should be able to select excerpts from the Bank of
England minutes that talk about the BoE’s view on changes in the ex-
change rate and whether interest rate differentials are causing them. The
student should then think about these comments in relation to the UIP
condition. If their findings do not match the theoretical predictions of

ϭ͘ /ŶŝƚŝĂůĂƉƉƌĞĐŝĂƚŝŽŶ
r IS ( A, q )
IS ( A′, q′) Ϯ͘ ZĞĂůĞǆĐŚĂŶŐĞƌĂƚĞŽǀĞƌƐŚŽŽƚŝŶŐ
ϯ͘ ƋƵŝůŝďƌŝƵŵĂƉƉƌĞĐŝĂƚŝŽŶ
r0 C
A, Z B
r*
IS ( A′, q0 ) IS ( A′, q )
RX
y Depreciation
y0 ye y1
π q ERU
PC(π 0 ) PC(π )
*
AD
π0 B
π1 C
AD′ ϭ Ϯ ϯ
π =π *
T A, Z q A
B
q′
C Z
q0
MR y1 ye y0 y
y1 ye y0 y
Figure 9.8: A positive demand shock in a small open economy
the UIP condition, then students should think about whether their find-
ings invalidate the UIP condition. If the exchange rate is not behaving as
the interest rate differentials would predict could this simply be driven by
changes in the expected exchange rate?
(b) Left to students.
3. Assume you are in a small open economy with flexible exchange rates.
The economy experiences a permanent positive demand shock.
(a) Draw the P C − M R, the IS − RX and the ERU − AD graphs to help
you explain the path back to medium run equilibrium.
(b) Draw a graph of the real exchange rate over time and give a brief
explanation of its path.
(c) How does the medium run equilibrium vary from that in the closed
economy?
ANSWER:
Fig. 9.8 shows the adjustment of the economy to the shock.
(a) The positive demand shock shifts the IS curve rightwards. This in-
creases output to y0, which is above its equilibrium level and this pushes
up inflation to π0 . In the next period, because of backwards looking infla-
tion expectations the Phillips curve shifts upwards to P C(π0 ). The central
bank use the MR curve to find the output gap that will minimise their loss

depreciation ↑
q
q′
qo
t =1 t=2 time
Figure 9.9: The path of the exchange rate after positive demand shock in small
open economy
function, which is when output is equal to y1 . To achieve this output gap

the central bank needs to set the interest rate at r0 , which is greater than
the world interest rate r∗ . This depresses interest sensitive expenditure
and pushes down inflation. The economy then continues to adjust down
the M R curve until output is back at equilibrium and inflation is back to
its initial level. In the new equilibrium the level of autonomous demand
(A) will be higher and there will be an appreciated exchange rate.
(b) The foreign exchange market is assumed to be acting with rational
expectations. This causes the real exchange rate to jump to an appreciated
rate, as the forex market knows that the central bank will set home’s
interest rate above the world interest rate to squeeze inflation out of the
system. We can tell from the AD − ERU diagram that the exchange
rate is appreciated in the new equilibrium. However it overshoots (i.e.
appreciates by more than the eventual equilibrium exchange rate) so that
the real exchange rate can depreciate during the period where r exceeds
r∗ . This is necessary for the UIP condition to hold. The interest rate
gain from holding home’s bonds needs to be offset by the expected loss on
holding home’s currency. The movement of the exchange rate is shown in
Fig. 9.8.
(c) In the closed economy, the same shock would result in a permanently
higher stabilising rate of interest. In the open economy, in medium run
equilibrium, r must equal r∗ . This means that the real exchange rate has
to be more appreciated in the new equilibrium for output to be equal to
equilibrium output and for inflation to be constant. In the closed economy,
the demand shock is dealt with by a higher interest rate supressing interest
sensitive demand. In the open economy, an appreciated exchange rate
reduces net exports, which reduces output back to equilibrium.
4. This question uses the Macroeconomic Simulator available from the Carlin
and Soskice website to model supply-side reform in the open economy.
Start by opening the simulator and choosing the open economy (flexible
exchange rate) version. Then reset all shocks by clicking the appropriate

button on the left hand side of the main page. Use the simulator and the
content of this chapter to work through the following questions:
(a) Decide on a supply-side reform and describe briefly how it is modelled

– i.e. does it affect the W S or P S? What effect does this have on
the ERU curve?
(b) Apply a permanent 2% positive supply shock. (Note that a positive
supply shock is one that reduces equilibrium unemployment; raises
equilibrium employment.)
(c) Use the impulse response functions from the simulator or from your
sketches to help explain the path of the economy following the above
shock.
(d) Draw the IS − RX and P C − M R diagrams for this scenario. Draw
the AD − ERU diagram for this scenario. [Hint: the path of the key
variables (output, inflation, real interest rate, real exchange rate)
will have to match the impulse response functions from the simula-
tor. Remember that whenever the central bank sets the interest rate
different from r∗ to get the economy on to the M R curve, the econ-
omy will be off the AD curve. Once the economy is back at a MRE,
then r = r∗ and the economy is, once again, on the AD curve.]
(e) Briefly discuss one aspect of this way of modelling the adjustment
of the economy to a supply-side reform that seems to you to be
unrealistic. Express your concern in terms of the assumptions of
the model.
ANSWERS:
(a) The equation for theERU curve is:
y = ye (z W , z P ) (ERU curve)
where z W is the set of supply-side factors that shift the W S curve such
as unionization, labour market regulations, and unemployment benefits.
z P is the set of factors that shift the P S curve such as the tax rate, the
level of technology (i.e. labour productivity) and the degree of product
market competition. Students should suggest a factor (such as those listed
above) that could plausibly shift either the W S or P S curve and correctly
identify the direction of the resulting shift of the ERU curve. In the case
of a positive supply shock, we can model this as a shift rightwards of the
wage-setting (W S) curve or an upwards shift in the price-setting curve,
which both shift the ERU permanently to the right.
(b) Left for students.
(c) The impulse response functions for this answer are shown in Figs. 9.10
and 9.11. For this answer, we assume the positive supply-side shock is a

reduction in unemployment benefits that shifts the WS curve outwards.

The immediate effect in period 5 is a fall in inflation. After the shock,
workers are too weak to secure the wage increases that would keep their
real wages unchanged. Firms therefore put their prices up by less and
inflation in the economy falls. A supply shock shifts both the Phillips
curve and the M R curve, because the new equilibrium is at a higher level of
output than the initial equilibrium. The central bank chooses the output
gap to get the economy onto the new MR curve. It requires a period
where output is above the new equilibrium level to get inflation back to
target, due to the assumption of backwards-looking inflation expectations.
To stimulate this level of output the central bank must cut interest rates
below the world level, as shown by the initial drop in the impulse response
function for interest rates. The cutting of the interest rate stimulates
demand, which increases GDP. As highlighted by the impulse response
function, GDP jumps and then gradually falls back to the new equilibrium,
which is at a higher level of GDP than the initial equilibrium. The interest
rate is gradually increased along the RX curve to the new equilibrium,
where it once again equals the world interest rate. We know that there
must be a depreciated exchange rate at the new equilibrium, as home’s
interest rate must equal the world interest rate and aggregate demand is
higher. The supply shock has not affected autonomous consumption or
investment and government spending has not increased so the additional
demand must arise from an increase in net exports. However, on the path
to equilibrium there is a period where the home interest rate is below the
world interest rate. From the real UIP condition:
E
rt − r∗ = qt+1 − qt (Real UIP condition)
In the 3-equation model and hence the simulator, the economy takes longer
than one period to adjust back to equilibrium. This means there is an
interest rate differential for multiple periods. We can use the cumulative
form of the UIP condition to reflect this. It highlights the facts that the
initial jump in q in period zero takes account of the whole path of interest
rate deviations:
∞

(rt − r∗ ) = q̄ − q0 (Cumulative real UIP condition)
t=0
We know that this must mean that the exchange rate is appreciating. The
path of the exchange rate therefore shows some overshooting on the path
to the new depreciated equilibrium exchange rate, to allow for this period
of appreciation.
(d) See Fig. 9.12.
(e) The students could pick up on a number of things here. Some examples
of aspects in the adjustment process that they could find unrealistic are:

/ŶƚĞƌĞƐƚƌĂƚĞƐ
/ŶĨůĂƚŝŽŶ ;ĚĂƐŚĞĚŝƐƌĞĂůͿ
'W 'WŐƌŽǁƚŚ
Figure 9.10: Impulse response functions of macroeconomic variables after a

positive supply shock in an open economy with flexible exchange rates
(1) The negative inflationary shock only lasts one period. (2) The CB
and foreign exchange market have accurately predicted this is a supply-
side shock and guide the economy to a new medium-run equilibrium at
higher output. (3) The model has no uncertainty and the adjustment of
the economy is rapid (the economy is stabilised in three or four periods)
and involves jumps in inflation, interest rates and GDP. Possibly the jump
in GDP is the least realistic. They may also mention that CBs tend to
smooth the interest rate, making only small changes each month.
5. This question uses material from Sections 9.5.2 and 9.5.4 of the Appendix.
The parameters that underlie the economy are a = b = α = β = 1,
which implies that λ= 0.5. The economy is initially in equilibrium and
experiences a positive inflation shock. Use the steps set out in Section
9.5.2 to graphically derive the RX curve. [Hint: You will need pick the
initial equilibrium r∗ and use a grid to ensure accurate measurements].
What is the new r0 ?
ANSWER:
Left for students. The answer will vary depending on the initial equilib-
rium and the size of the shock chosen by the students.

Figure 9.11: Impulse response functions of exchange rates after a positive supply
shock in an open economy with flexible exchange rates
r
IS ( A, q ) IS ( A, q0 )
A
r* Z C
r0
RX
IS ( A, q )
ye ye′ y1 y Depreciation
π q ERU ERU ′ AD
PC(π = π T , ye )
A Z PC(π = π T , ye′ ) q0
Z C
q′
π =π *
T
PC(π = π1 , ye′ )
C
π1 B
q
A
MR′
MR
ye ye′ y1 y ye ye′ y
Figure 9.12: A positive supply shock in the open economy 3-equation model

The 3-Equation Model in The Open Economy - Answers: 9.1 Checklist Questions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

The 3-Equation Model in The Open Economy - Answers: 9.1 Checklist Questions

Uploaded by

Copyright:

Available Formats

Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System

The 3-equation Model in

9.1 Checklist questions

© Wendy Carlin and David Soskice 2015. All rights reserved.

2CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

log e0 = log eE loge1 log e

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.1. CHECKLIST QUESTIONS 3

log e0E log e1E log e

A change in the expected exchange rate in a year’s time

Figure 9.2: A change in expected exchange rate

© Wendy Carlin and David Soskice 2015. All rights reserved.

4CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

IS (q0 ) IS (q1 ) IS (q2 )

Figure 9.3: Deriving the AD curve

indexed by expected inflation, which equals world inflation, shifts to go

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.1. CHECKLIST QUESTIONS 5

© Wendy Carlin and David Soskice 2015. All rights reserved.

6CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

Zh͛ Zh Zh

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.1. CHECKLIST QUESTIONS 7

Figure 9.5: Exchange rate overshooting

6. Is the following statement true or false? Explain your answer. “Central

© Wendy Carlin and David Soskice 2015. All rights reserved.

8CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 9

Table left as an activity for students.

9.2 Problems and questions for discussion

© Wendy Carlin and David Soskice 2015. All rights reserved.

10CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

Low a – negative High a – negative

Figure 9.6: Changing the interest sensitivity of expenditure in a small open

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 11

(a) Immediate appreciation (b) No appreciation (c) Immediate depreciation

e1 e0 log e e0 = e1 e2E log e e0 e1 e2E log e

depreciation ↑ depreciation ↑ depreciation ↑

t =1 t=2 time t =1 t=2 time t =1 t=2 time

Figure 9.7: Interest rate rise by the Riksbank - three scenarios

occurred. Only the unanticipated component produces a change in the

© Wendy Carlin and David Soskice 2015. All rights reserved.

12CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

(b) If the change is widely anticipated by financial markets then at time

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 13

Figure 9.8: A positive demand shock in a small open economy

© Wendy Carlin and David Soskice 2015. All rights reserved.

14CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

function, which is when output is equal to y1 . To achieve this output gap

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 15

(a) Decide on a supply-side reform and describe briefly how it is modelled

(a) The equation for theERU curve is:

© Wendy Carlin and David Soskice 2015. All rights reserved.

16CHAPTER 9. THE 3-EQUATION MODEL IN THE OPEN ECONOMY – ANSWERS

reduction in unemployment benefits that shifts the WS curve outwards.

© Wendy Carlin and David Soskice 2015. All rights reserved.

9.2. PROBLEMS AND QUESTIONS FOR DISCUSSION 17

Figure 9.10: Impulse response functions of macroeconomic variables after a

© Wendy Carlin and David Soskice 2015. All rights reserved.

Zh͛ Zh Zh