An open economy has
important trade and financial
links with other countries.
The foreign exchange (forex)
market exchanges one national
currency for another. The price
at which the two currencies
exchange is the exchange
rate.
The international value of the
domestic currency is the
quantity of foreign currency per
unit of the domestic currency.
The domestic price of foreign
exchange is the quantity of
domestic currency per unit of
the foreign currency.
A country’s effective exchange
rate is an average of its
exchange rate against all its
trade partners, weighted by the
relative size of trade with each
country.
The effective exchange rate is a weighted average of
individual bilateral exchange rates.
The pound appreciates when
the $/£ exchange rate rises.
The international value of
sterling rises. The pound
depreciates when the $/£
exchange rate falls. The
international value of sterling
falls.
An exchange rate regime
describes how governments
allow exchange rates to be
determined.
In a fixed exchange rate
regime, governments maintain
the convertibility of their
currency at a fixed exchange
rate. A currency is convertible
if the central bank will buy or
sell as much of the currency as
people wish to trade at the
fixed exchange rate.
The foreign exchange
reserves are foreign currency
held by the domestic central
bank.
The central bank intervenes in
the forex market when it is
forced to buy or sell pounds to
support the fixed exchange
rate.
In a fixed exchange rate regime,
a devaluation (revaluation) is
a fall (rise) in the exchange rate.
In a floating exchange rate
regime, the exchange rate is
allowed to find its equilibrium
level without central bank
invervention using the forex
reserves.
The balance of payments
records transactions between
residents of one country and
the rest of the world.
The current account of the
balance of payments records
international flows of goods, services and transfer payments.
The capital account of the
balance of payments records
the international purchases and sales of
financial assets.
The financial account of the
balance of payments records
international purchases and
sales of financial assets.
The balance of payments is
the sum of current account,
capital and financial account
items.
The real exchange rate is the
relative price of goods from
different countries when
measured in a common
currency.
The purchasing power parity
(PPP) exchange rate path is the
path of the nominal exchange
rate that maintains a constant
real exchange rate.
Perfect capital mobility
means that a vast quantity of
funds flow from one currency to
another if the expected return
on assets differs across
currencies.
Foreign direct investment (FDI) is the purchase of
foreign firms or the establishment of foreign subsidiaries.
Speculation is the purchase of
an asset for subsequent resale,
in the belief that the total return
– interest plus capital gain –
exceeds the total return on
other assets.
Interest parity means that
expected exchange rate
changes offset the interest
differential between domestic
and foreign currency assets.
A country is in internal balance
when aggregate demand
equals potential output.
A country in external balance
has a zero current account
balance.
Simultaneous internal and
external balance is the long-run
equilibrium of the economy.
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