KW_Macro_Ch_19_Sec_02_The_Role_of_the_Exchange_Rate

KW_Macro_Ch_19_Sec_02_The_Role_of_the_Exchange_Rate -...

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>> Open-Economy Macroeconomics Section 2: The Role of the Exchange Rate chapter 19 We’ve just seen how differences in the supply of loanable funds from savings and the demand for loanable funds for investment spending lead to international capital flows. We’ve also learned that a country’s balance of payments on current account plus its balance of payments on financial account add to zero: a country that receives net capital inflows must run a matching current account deficit, and a country that generates net capital outflows must run a matching current account surplus. The behavior of the financial account—reflecting inflows or outflows of capital—is best described by equilibrium in the international loanable funds market. At the same time, the balance of payments on goods and services, the main component of the cur- rent account, is determined by decisions in the international markets for goods and services. So given that the financial account reflects the movement of capital and the current account reflects the movement of goods and services, what ensures that the balance of payments really does balance? That is, what ensures that the two accounts actually offset one another?
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2 CHAPTER 19 SECTION 2: THE ROLE OF THE EXCHANGE RATE The answer lies in the role of the exchange rate, which is determined in the foreign exchange market . Understanding Exchange Rates In general, goods, services, and assets produced in a country must be paid for in that country’s currency. American products must be paid for in dollars; European products must be paid for in euros; Japanese products must be paid for in yen. Occasionally, sellers will accept payment in foreign currency, but they will then exchange that cur- rency for domestic money. International transactions, then, require a market—the foreign exchange market in which currencies can be exchanged for each other. This market determines exchange rates, the prices at which currencies trade. (The foreign exchange market is, in fact, not located in any one geographic location. Rather, it is a global electronic market that traders around the world use to buy and sell currencies.) Table 19-3 shows exchange rates among the world’s three most important currencies as of 4:25 P . M ., EST, on August 22, 2005. Each entry shows the price of the “row” curren- cy in terms of the “column” currency . For example, at that time US$1 exchanged for 0.8178, so it took 0.8178 to buy US$1. Similarly, it took US$1.2228 to buy one 1. These two numbers reflect the same rate of exchange between the euro and the U.S. dol- lar: 1/1.2228 = 0.8178. There are two ways to write any given exchange rate. In this case, there were 0.8178 to US$1 and US$1.2228 to 1. Which is the correct way to write it? The answer is that there is no fixed rule. In most countries people tend to express the exchange rate as the price of a dollar in domestic currency. However, this rule isn’t universal, and the U.S.
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