Open Economy Macroeconomics
These are my notes on open economy macroeconomics.
The nominal exchange rate is the rate at which one country’s currency can be exchanged for the currency of another country.
In a flexible exchange rate system, the nominal exchange rate is determined by supply and demand in the foreign exchange market.
Fixed or managed exchange rates are controlled by the government.
The real exchange rate is the ratio of the prices of a basket of goods and services in two countries and thus influences net exports from one country to the other.
A decline in net exports reduces labor demand, lowers GDP, and causes unemployment.
The nominal exchange rate is the price of one country’s currency in units of another country’s currency.
If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate.
If the government fixes a value for the exchange rate and intervenes to maintain that value, then the country has a fixed exchange rate.
If the government intervenes actively to influence the exchange rate, then the country has a managed exchange rate.
The real exchange rate is defined as the ratio of the dollar price of a basket of goods and services in the US, divided by the dollar price of the same basket of goods and services in a foreign country.
The nominal exchange rate is the number of units of foreign currency per unit of domestic currency. The real exchange rate, in contrast, gives the ratio of the dollar price of a basket of goods and services purchased in the US to the dollar price of the same basket purchased in a foreign country.
The nominal exchange rate is determined by the supply and demand for a currency in the foreign exchange market. When a Chinese producer sells goods to a US firm and receives dollars, the Chinese firm converts the dollars to the Chinese currency in the foreign exchange market. This is equivalent to demanding yuan and supplying dollars in the foreign exchange market. In contrast, a Chinese firm that imports from the US would be doing the opposite in the foreign exchange market: supplying yuan and demanding dollars with which it will pay its US trading partners.
When a country has a flexible exchange rate, changes in the supply and demand for a currency lead to fluctuations in the nominal exchange rate. Many countries, however, manage or fix exchange rates and therefore peg their currencies to another currency, such as the dollar. Under managed or fixed exchange rates, fluctuations in the supply and demand for the currency do not necessarily lead to corresponding fluctuations in the exchange rate.
Though managed or fixed exchange rate systems might appear more stable at first, when the exchange rates they generate are out of line with market forces, these systems can lead to sudden changes in the exchange rate. In the process, they create huge profit opportunities, like the one exploited by the financier George Soros in 1992, when he bet that the British pound would be allowed to depreciate.
The real exchange rate is a key price for the economy in part because it determines net exports. A real exchange rate greater than 1 implies that US goods and services are more expensive than foreign goods and services. Thus, a real exchange rate above 1 discourages exports and encourages imports, reducing net exports.
A fall in net exports lowers GDP and shifts the labor demand curve to the left.
Domestic interest rates influence the real exchange rate. A fall in domestic interest rates reduces the appeal of domestic assets to investors, lowering both nominal and the real exchange rates. The resulting rise in net exports shifts the labor demand curve to the right and increases GDP.