Unit 3: Exchange Rates and Open-Economy Macroeconomics
The previous units were concerned primarily with the problem of making the best use of the world's scarce productive resources at a single point in time. In this unit, we shift our focus and ask: How can economic policy ensure that factors of production are fully employed? And what determines how an economy's capacity to produce goods and services changes over time? We will learn how the interactions between national economies influence the worldwide pattern of macroeconomic activity. We will also discuss the role of trade in growth and welfare in an open economy, the causes and consequences of factor mobility, as well as the role of multinationals.
Completing this unit should take you approximately 10 hours.
Upon successful completion of this unit, you will be able to:
- define Gross Domestic Product (GDP) and discuss its usefulness as a measure of economic well-being;
- list the components of GDP and the relative importance of each in GDP;
- define the current account, the trade balance, and the capital account balances;
- explain the relationship between national investment and national saving;
- distinguish between GDP and Gross National Product (GNP);
- list the components of the capital account;
- describe the relationship between the current account and the capital account balances;
- identify how a country's government budget balance and its current account balance are related;
- list the principal participants in foreign exchange markets;
- define arbitrage;
- define an exchange rate, and distinguish between the spot and forward exchange rates;
- list the components of the rates of return on domestic and on foreign deposits;
- explain how a currency appreciation or depreciation affects rates of return;
- define covered and uncovered interest rate parity, and to distinguish them from each other;
- define purchasing power parity and the conditions under which it holds;
- explain the relationship between the consumer price index and the purchasing power parity exchange rate;
- discuss the reasons why the purchasing power parity condition generally does not hold between two countries;
- define the real interest rate and to list its determinants;
- determinants of aggregate demand;
- explain the AA and DD curves and to list the changes that might make each shift;
- define the value effect and the volume effect;
- explain how the current account adjustment to currency appreciation or depreciation varies over time (the J-curve);
- use the IS/LM model to explain the effects of changes in monetary and fiscal policy;
- identify and describe the various fixed exchange rate systems;
- listing and explain the mechanisms central banks use to fix exchange rates;
- describe the effectiveness of fiscal and monetary policies under a fixed rate system; and
- identify the features of a financial crisis.
3.1: National Income Accounting and the Balance of Payments
In this subunit, we will discuss the concept of the current account balance, use the current account balance to extend national income accounting to open economies, and apply national income accounting to the interaction between saving, investment, and net exports. We will also describe the balance of payments accounts, learning the relationship between that balance and the current account balance. Then, we will relate the current account to changes in a country's net foreign wealth.
3.2: Exchange Rates and the Foreign Exchange Market: An Asset Approach
In this subunit, we will relate exchange rate changes to changes in the relative prices of countries' exports, describe the structure and functions of the foreign exchange market, use exchange rates to calculate and compare returns on assets denominated in different currencies, apply the interest parity condition to find equilibrium exchange rates, and identify the effects that interest rates and expectation shifts have on exchange rates.
Read these slides and take notes.
3.3: Money, Interest Rates, and Exchange Rates
In this subunit, we will discuss the national money markets in which interest rates are determined, learn how monetary policy and interest rates feed into the foreign exchange market, and distinguish between the economy's long-run position and its short-run position (in which money prices and wages are sticky). We will also explain how price levels and exchange rates respond to monetary factors in the long run. Then, we will outline the relationship between the short-run and long-run effects of monetary policy and explain the concept of short-run exchange rate overshooting.
3.4: Price Levels and the Exchange Rate in the Long Run
In this subunit, we will explain the purchasing power parity theory of exchange rates and the theory's relationship to international goods-market integration. We will also describe how monetary factors (such as ongoing price level inflation) affect exchange rates in the long run, discuss the concept of the real exchange rate, and demonstrate factors that affect real exchange rates and relative currency prices in the long run. Then, we will explain the relationship between international real interest rate differences and expected changes in real exchange rates.
3.5: Output and the Exchange Rate in the Short Run
This subunit will explain the role of the real exchange rate in determining the aggregate demand for a country's output. We will also learn how an open economy's short-run equilibrium can be analyzed as the intersection of an asset market equilibrium schedule (AA) and an output market equilibrium schedule (DD). Then, we will explore how monetary and fiscal policies affect the exchange rate and national output in the short run, describe and interpret the long-run effects of permanent macroeconomic changes, and explain the relationship among macroeconomic policies, the current account balance, and the exchange rate.
3.6: Fixed Exchange Rates and Foreign Exchange Rates
This subunit will demonstrate how a central bank must manage monetary policy so as to fix its currency's value in the foreign exchange market. We will also analyze the relationship between the central bank's foreign exchange reserves, its purchases and sales in the foreign exchange market, and the money supply. Then, we will explain how monetary, fiscal, and sterilized intervention policies affect the economy under a fixed exchange rate, discuss causes and effects of balance of payments crises, and describe how alternative multilateral systems for pegging exchange rates work.