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ECON0016 (Macroeconomic Theory and Policy) Term 2 Summary - UCL Economics BSc Second Year
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  • Course
  • Macroeconomic Theory and Policy (ECON0016) (ECON0016)
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  • University College London (UCL)
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  • Macroeconomics

Summary of Term 2 (Open Economy) taught in ECON0016 (Year 2021/2022) Detailed notes from lecture notes, textbooks and other materials. Topics covered centre on the open economy model: 1) Macroeconomics for the Open Economy, 2) Supply-side, Demand-side and Real Exchange Rates, 3) Inflation-tar...

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  • April 14, 2024
  • 137
  • 2021/2022
  • Summary

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  • economics
  • macroeconomics
  • year 2
  • term 2
  • ucl

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UNIVERSITY COLLEGE LONDON

DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
Second Year – Term 2




MACROECONOMIC
THEORY AND POLICY
ECON0016
Rodrigo Antón García

rodrigo.garcia.20@ucl.ac.uk

London, 2022

,
, Contents

Topic 1 – Macroeconomics for the Open Economy. Carlin and Soskice Chapter 9.


o Topic 1.1 – Introducing the Open Economy. 1
o Topic 1.2 – Building the Flexible Exchange Rate 3-equation Model: The Forex
Market and the UIP Condition. 3
o Topic 1.3 – Developing and Using the UIP Diagram. 9


Topic 2 – Supply-side, Demand-side and Real Exchange Rates. Carlin and Soskice
Chapter 9.


o Topic 2.1 – Setting Up the Medium-Run Model. 13
o Topic 2.2 – The Supply-Side (ERU) and Demand-Side (AD) in the Model 16
o Topic 2.3 – Two Questions About the Medium-Run Model. 21


Topic 3 – Inflation-targeting in the Open Economy. Carlin and Soskice Chapter 9.


o Topic 3.1 – Introducing Optimal Monetary Policy. 25
o Topic 3.2 – Inside the Heads of the Central Banks and Forex Traders. 26
o Topic 3.3 – Optimal Response to a Permanent Negative AD Shock. 31


Topic 4 – Inflation-targeting, Exchange Rate Overshooting & Volatility. Carlin and
Soskice Chapter 9.


o Topic 4.1 – The Dynamic Model. 42
o Topic 4.2 – What Exactly is the RX curve? 43
o Topic 4.3 – A Model of Exchange Rate Overshooting and Applications. 46


Topic 5 – Demand side and Trade Balance in the Open Economy. Carlin and
Soskice Chapter 10.


o Topic 5.1 – Goods Market Equilibrium in the Open Economy. 54
o Topic 5.2 – Price-Setting, Real Exchange Rate and Terms of Trade. 57
o Topic 5.3 – How Does a Change in the Real Exchange Rate Affect the Trade
Balance? 61

,Topic 6 – The Real Exchange Rate, Inflation and the Supply-side: AD-BT-ERU.
Carlin and Soskice Chapter 10.


o Topic 6.1 – Introducing the Downward-Sloping ERU Curve. 67
o Topic 6.2 – The Downward-Sloping ERU Curve. 70
o Topic 6.3 – Applying the New Model; the Long-Run Equilibrium. 76
o Topic 6.4 – A Bird’s Eye View of the Macro Modelling. 83


Topic 7 – All About Oil: Macro Analysis of Oil Shocks and Natural Resource
Windfalls. Carlin and Soskice Chapter 11.


o Topic 7.1 – Oil Shocks in the World and in the Model. 88
o Topic 7.2 – Modelling an Oil Shock. 92
o Topic 7.3 – External Imbalances and Natural Resource Windfalls. 98


Topic 8 – External Imbalances. Carlin and Soskice Chapter 11.


o Topic 8.1 – Sector Financial Imbalances. 106
o Topic 8.2 – Global Imbalances and the Two-Bloc Model. 112
o Topic 8.3 – Global Imbalance, Inflation and Growth Strategies. 115


Topic 9 – Economics of Fixed Exchange Rates and a Common Currency Area.
Carlin and Soskice Chapter 12.


o Topic 9.1 – Choice of the Exchange Rate Regime. 117
o Topic 9.2 – Heterogeneity in the Eurozone: Why Join, Policy Assignment and
Performance. 120
o Topic 9.3 – Stabilization of Country Specific Shock Under Fixed Exchange Rates.
123


Topic 10 – The Eurozone Crisis; COVID-19 Crisis. Carlin and Soskice Chapter 12.


o Topic 10.1 – What Kind of Crisis was the Eurozone Crisis? 128
o Topic 10.2 – Governance Arrangements in the Eurozone. 129

,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García



ECON0016: MACROECONOMIC THEORY & POLICY SUMMARY – TERM 2

Topic 1 – Macroeconomics for the Open Economy. Carlin and Soskice Chapter 9.

o Topic 1.1 – Introducing the Open Economy.

To understand what is going on in globally interconnected economies and in the world
economy, we need to extend the macro model to include trade and financial openness.

- What did you learn in ECON0002?

CORE Unit 14 introduced the demand side in the open economy.
- Opening goods and services markets – exchange rates; trade surpluses &
deficits; relative prices in the transmission of monetary policy.
- Opening financial markets – market for bonds; foreign exchange market.

CORE Unit 15 introduced a global oil shock. We analyse in detail as both a demand and
a supply shock.

CORE 9, 15, 16, 17 introduced relationships of the WS/PS model to the modelling of the
supply side.

- What is new this term in ECON0016?

To last year’s work on the open economy, we add the supply side, a policy maker and
integrate in the 3-equation model, exchange rate regimes: flexible and fixed.

To last term’s work on the closed economy where you had a demand side, a supply side
and fiscal and monetary policy makers, we add open goods and financial markets as
well as interdependence among countries.

- Model Building.

The aim of the course is to build a model that allows us to understand macroeconomic
policy in countries in a globalized world economy. We need to extend the closed
economy model to include:
- Trade in goods and services.
- Trade in financial assets.
- Fact that the exchange rate regime determines policy instruments available.

Data will be used widely together with its correct modelling. For example, there are two
ways measure globalization and the extent of openness of an economy.

- Measure 1 – Exports and (plus) imports as a percent of GDP. Standard measure
of how open an economy is. This is a flow measure.
- Measure 2 – Gross external assets and (plus) liabilities a percent of GDP. Stock
measure. Used to measure financial openness. This is a stock measure.


1

,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García




Another example would be nominal and real exchange rates.

In this graph, an increase in the nominal exchange rate ! is a depreciation, a dollar buys
more pounds. Therefore, an increase in the graph’s y-axis represents appreciation.




Here the nominal exchange rate is fluctuating and influencing the real exchange rate.

One other example would be intra-eurozone real exchange rate indices in the eurozone.

The dashed line represents the place where the index for the real exchange rate begins
shows the nominal exchange rate for some members of the eurozone. There is no
change in the nominal exchange rate over this period because they are all using the euro.
Therefore, the graph presents the time series for changes in the real exchange rate.




Here the nominal exchange rate is not fluctuating and so the variation in the real
exchange rate is only due to differences in inflation.


2

,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García


o Topic 1.2 – Building the Flexible Exchange Rate 3-equation Model: The Forex
Market and the UIP Condition.

Here we introduce a new actor in the flexible exchange rate open economy: forex market
operators (foreign exchange market).

Elaborating the 3-equation model we covered in the first term we can observe that the
IS curve will have to be different in the open economy if we want to account for foreign
exchange markets.

" = $ + & + ' + () − +)

However, a more subtle change will be needed, that being figuring out the interaction
between the central bank and the foreign exchange market. For example, if the dollar
rose this will underscore the potential for the Fed to raise interest rates more than some
traders had expected.

- Open Economy Example: Inflationary Shock.

Let’s look at the example of an inflationary shock in the open economy in which foreign
exchange market is accounted for.

- We already know how the central bank reacts. But in the open economy, forex
will also play a role and interact with the central bank objectives.
- In fact, forex players will see that the interest rate is going to increase too, but
what is going to drive their behaviour is the change in the nominal rate.
- They are interested in the relation between the nominal interest rate on home
bonds and the exchange rate, and this will affect the actions that they take now as soon
as they get news of the shock: the new piece of modelling to be constructed in the model.




3

, Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García


• Defining the Nominal and Real Exchange Rates.

(Home’s) Nominal exchange rate ! can be defined either as the units of home currency
per units of foreign currency or the inverse of the same one.

In this course we will however use the first definition. This is an arbitrary choice, but we
ultimately have to jump one way. We will do so because 1 unit of foreign’s currency will
buy more units of home’s.

./. 23456 /7 ℎ/9! :2;;!3:"
!=
<3! 2345 /7 7/;!4=3 :2;;!3:"

Therefore, an increase in the nominal exchange rate is a nominal depreciation and a
decrease in the nominal exchange rate is a nominal appreciation.

! ↑ → @/9! :2;;!3:" ↓ ∶ C!D;!:4E54/3 → $/9D!5454F43!66 ↑ () ↑ & + ↓)
! ↓ → @/9! :2;;!3:" ↑ ∶ HDD;!:4E54/3 → $/9D!5454F43!66 ↓ () ↓ & + ↑)

We always think from the perspective of the home currency: if one unit of foreign
currency can buy more units of home currency then the foreign currency is stronger and
so the home currency has depreciated.

The nominal exchange rate shows the rate at which the currencies of two economies
can be exchanged for one another. To measure the rate at which domestic and foreign
goods and services can be exchanged for each other, we also need to take into account
the relative price level between the two economies: the real exchange rate.

(Home’s) Real exchange rate I can be defined as the price of foreign goods expressed
in home currency over the price of home goods.

J;4:! /7 7/;!4=3 =//K6 !LD;!66!K 43 ℎ/9! :2;;!3:" J∗ !
I= =
J;4:! /7 ℎ/9! =//K6 J

where J∗ is the foreign price level and J is the home price level.

The real exchange rate I is a measure of price competitiveness between two economies.
If I increases, this reflects the fall in price of home goods relative to the price of foreign
goods (when expressed in the same currency). This depreciation of the real exchange
rate would make home’s exports more attractive to foreigners an discourage the
consumption of imports by domestic consumers.

I ↑ → @/9! :2;;!3:" ↓ ∶ C!D;!:4E54/3 → $/9D!5454F43!66 ↑ () ↑ & + ↓)
I ↓ → @/9! :2;;!3:" ↑ ∶ HDD;!:4E54/3 → $/9D!5454F43!66 ↓ () ↓ & + ↑)

Note that we assume throughout our modelling of the open economy that a depreciation
of the real exchange rate (i.e., I) – an improvement in price competitiveness – will cause
an increase in net exports (i.e., the real value of exports – the real value of imports).



4

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