Exchange Rates in the Open Economy

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.

[Optional] The Cost of Brazil’s Closed Economy
What is an Exchange Rate?

Exchange rates allow you to determine how much of one currency you can exchange for another.

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.

Exchange rates are determined in the world’s largest market, the foreign exchange market.

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 vs. Real Exchange Rates

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.

Real Exchange Rate

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.

[Optional] What is the difference between nominal and real interest rates?
Types of Exchange Rates
There are three main types of exchange rate systems:

1) Floating Exchange Rate
2) Fixed Exchange Rate
3) Managed Floating Exchange Rate

1) Floating Exchange Rate

A floating exchange rate, also known as a fluctuating or flexible exchange rate, is a type of regime wherein a currency’s value is allowed to fluctuate according to the foreign exchange market.

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.

Advantages of a Floating Exchange Rate

Many economists believe a floating exchange rate system is the best possible exchange rate regime because the rate automatically adjusts to economic circumstances.

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.

* Balance of Payments: A record of all transactions made between one particular country and all other countries during a specified time period.
2) Fixed Exchange Rate

A fixed, or pegged, exchange rate system, is a currency system in which governments try to maintain a currency value that is constant against a specific currency or good.

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.

To ensure that a currency will maintain its “pegged” value, the country’s central bank maintain reserves of foreign currencies and gold.

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.

[Optional] Fixed Exchange Rate: Definition, Pros, Cons
3) Managed Floating Exchange Rate

Managed Floating exchange rate refers to a system in which the exchange rate is determined by market forces and the central bank influences it through intervention in the foreign exchange market.

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.

Macroeconomic Effects of Currency Fluctation
Changes in the external value of a currency can have important effects on a number of macroeconomic outcomes and objectives.
Purchasing Power Parity

To examine the relationship between the nominal exchange rate and the real exchange rate, think about a simple case in which all countries produce the same goods, which are freely traded.

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.

According to the law of one price*, after accounting for the exchange rate, the prices of similar goods should be the same regardless of where they are purchased.

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.

* The Law of One Price is another way of stating the concept of purchasing power parity.
[Optional] Hamburger Economics: The Big Mac Index
How Exchange Rates are Determined

Like any other price in the economy, exchange rates are subject to the forces of supply and demand.

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.

1) Tastes & Preferences

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.

2) Interest Rates & Inflation

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.

Enlarged version:
3) Relative Income & Speculation

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.

Jim Rohn Sứ mệnh khởi nghiệp