The Open Economy and Exchange Rates
The Open Economy
& Exchange Rates.
Trade, capital and currencies connect domestic decisions to the world economy. Distinguish nominal from real exchange rates and trace how prices, finance and competitiveness shape external adjustment.
Observe
State the quotation first.
An exchange-rate movement is ambiguous
until its units are defined.
If the rate is foreign currency per euro, a rise means euro appreciation. If it is euros per unit of foreign currency, a rise means euro depreciation. Good analysis always names the numerator and denominator.
Say “the euro appreciates against the dollar” rather than saying only “the exchange rate rises.”
Think
Move from currency to competitiveness.
The nominal rate is only
one part of the real rate.
Competitiveness also depends on domestic and foreign prices. With e defined as foreign currency per unit of domestic currency, a rise in q = eP/P* represents real appreciation: domestic goods become relatively more expensive.
Currency price
How many foreign-currency units exchange for one domestic unit.
Relative goods price
Nominal exchange adjusted for domestic and foreign price levels.
Saving and investment
CA ≈ S − I: net lending abroad when domestic saving exceeds investment.
Analyse
Calculate real appreciation.
Build an open-economy
competitiveness index.
Set the nominal exchange rate and domestic and foreign price indices. The base values are all 100 or 1.00, so the resulting real-rate index is easy to interpret.
Foreign-exchange laboratory
INTERACTIVE REAL EXCHANGE RATE
Open-economy indicators
The domestic economy has experienced real appreciation relative to the base, weakening price competitiveness.
Apply
Trace adjustment and constraints.
Depreciation changes prices quickly;
trade volumes adjust slowly.
A depreciation raises import prices and can increase inflation before export quantities rise or import demand falls. The current account may initially worsen—the J-curve—before improving if trade volumes respond sufficiently.
Market adjustment
The currency moves with trade, capital, expectations and policy conditions.
Official commitment
Authorities defend a parity using reserves, rates and policy adjustment.
Shared currency
Members cannot use national nominal depreciation and adjust through prices, productivity and demand.
Interest differential
Higher expected returns may attract funds and appreciate the currency, conditional on risk expectations.
Expectations can dominate current trade flows.
Unequal exposure
Exporting, tourism and import-intensive regions respond differently to currency and trade shocks.
National averages conceal spatial effects.
Decide
Interpret the quotation.
What happens when foreign currency per euro
rises from 1.10 to 1.20?
Assume the quotation is explicitly dollars per euro.
MACROECONOMICS · MODULE 13 COMPLETE
You can now analyse
an open economy.
Exchange rates connect domestic prices, global finance and trade. Clear quotations, real-rate adjustment and balance-of-payments consistency are essential for sound policy reasoning.
