Exchange Rates in the Open Economy
In this lesson, you’re expected to learn:
– what defines an open economy and exchange rates
– types of exchange rates
– how interest rates and purchasing power affect macroeconomic objectives
What is an Open Economy?
An open economy is one that engages in international exchange of goods, services, and investments.
The GDP of open economies includes exports (which add to GDP) and imports. Exports are goods and services sold to buyers outside the country, while imports are those purchased from foreigners.
The difference between exports and imports of goods and services is called net exports. This is also known as the Balance of Trade.
Nearly every economy in the world is an open economy to some extent.
Interdependence in the Global Economy
In the long run, operating in the global marketplace provides new constraints and opportunities for countries to improve their economic growth.
Perhaps the most important element concerns saving and investment, which are highly mobile and respond to incentives and the investment climate in different countries.
Whenever one currency is exchanged for another, foreign exchange has occurred and an exchange rate has been paid.
The exchange rate is nothing more than the current price of a currency in terms of another currency.
For example, the dollar’s exchange rate tells you how much a dollar is worth in a foreign currency, and vice versa. 1 US Dollar may buy you 0.9 Euro, 0.8 British Pound or 114 Japanese Yen.
Annual trade volume is close to one thousand trillion, with transactions occurring 24 hours a day.
The foreign exchange market is dominated by the Euro (€), Pound Sterling (£), and Japanese Yen (¥), with a vast majority of trades occurring in the US Dollar ($).
Nominal Exchange Rate
The nominal exchange rate indicates how much foreign currency can be obtained with one unit of the domestic currency.
For example, if the nominal exchange rate is 110 yen per dollar, one dollar can be exchanged for 110 yen.
The real exchange rate indicates how much of a foreign good can be obtained for one unit of a domestic good.
• Using the previous example, the nominal exchange rate is 110 yen per dollar.
• A hamburger costs 1100 yen in Japan and $2 in the U.S. – the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger.
• The real exchange rate = 220 / 1100 = 0.2 yen per dollar.
1) Floating Exchange Rate
2) Fixed Exchange Rate
3) Managed Floating Exchange Rate
A currency that uses a floating exchange rate is known as a floating currency. The dollar is an example of a floating currency.
Most exchange rates are determined by the forex market. For this reason, exchange rates vary on a moment-by-moment basis.
This variation depends on a lot of factors, including central bank interest rates, the country’s debt levels, and the strength of its economy.
This enables a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis. However, they also engender unpredictability as the result of their dynamism.
In a fixed exchange rate system, a country’s government decides the worth of its currency in terms of either a fixed weight of an asset, another currency, or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price.
They can sell these reserves in order to intervene in the foreign exchange market to make up excess demand or take up excess supply of the country’s currency.
Managed floating currencies are pegged to some value, which is either fixed or periodically adjusted.
This exchange rate system is a hybrid of fixed and floating regimes. It is also known as the “Dirty Floating” exchange rate system.
When similar goods have the same price in terms of the same currency, this is known as purchasing power parity, or PPP.
Purchasing power parity is the theory that currencies adjust according to changes in their purchasing power.
PPP holds in the long run but not in the short run.
– Countries actually produce different goods.
– Some goods are not traded internationally.
– There are transportation costs.
– There are also legal barriers to trade.
As exchange rates rise, people are more willing to buy, and vice versa. Appreciation occurs when an exchange rate increases, and depreciation occurs when exchange rates fall.
Changes in exchange rates can greatly affect businesses and entire economies. Economists and policymakers must therefore consider the implications of their actions on exchange rates.
Tastes, interest rates, inflation, relative income, and speculation affect exchange rates and thus economies.
As consumers’ tastes for imported goods change, so does the exchange rate between the countries involved. The results of this change in tastes is a depreciation of the home currency and appreciation of the foreign currency.
Over time, appreciation of a country’s currency may reduce the popularity of its products as they become relatively more expensive.
Changes in real interest rates also affect the foreign exchange market – they can cause sudden fluctuations in exchange rates. Savers are attracted to high interest rates, so when one country’s real interest rate rises relative to another country, savings flow toward the higher interest rate.
The presence of inflation in an economy provides an incentive for people to exchange their currency for one that is more stable. A good example of this is Zimbabwe where inflation reduced the value of its currency drastically.
As an economy’s income increases relative to another country, the exchange rate between the two changes.
Banks, companies, and individuals attempting to profit from foreign exchange will speculate in the market. For example, a speculator may suspect that European interest rates will rise faster than US interest rates, so he will purchase euros and hold them until they have appreciated enough to show a profit.