Open economy
macroeconomics examines
how the economy is affected by
links with other countries
through trade, the exchange
rate and capital flows.
Capital controls are
regulations preventing private
sector flows of financial capital.
Unsterilized intervention uses
the forex reserves to offset
payments imbalances, consequently changing the
domestic money supply.
Sterilization is an open market
operation between domestic
money and domestic bonds, to
offset the change in domestic
money supply that a balance of
payments surplus or deficit
otherwise induces.
Sterilized intervention does
not work when there is perfect
capital mobility, because
offsetting capital flows are
immediately induced.
Perfect capital mobility
undermines monetary
sovereignty. If interest rates
are set to maintain the pegged
exchange rate, they cannot be
set independently to influence
the domestic economy.
A Tobin tax is a small tax on
capital flow transactions.
The par value is the exchange
rate that the government
agrees to defend.
A devaluation (revaluation)
reduces (increases) the par
value of the pegged exchange
rate.
With floating exchange rates,
monetary sovereignty is
restored even under perfect
capital mobility. The central
bank sets the interest rate and
accepts the exchange rate
determined by market forces.
The purchasing power parity
(PPP) path of the nominal
exchange rate is the path that
offsets differential inflation rates
across countries, maintaining a
constant real exchange rate.
Floating exchange rates are
volatile because they are asset
prices that reflect beliefs about
the entire future. Such beliefs
can change a lot.
When new information
becomes available, asset
prices jump to the level that
now properly reflects the new
information.
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