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Williamson_3e_IM_14

Williamson_3e_IM_14 - Chapter 14 Money in the Open Economy...

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Chapter 14 Money in the Open Economy Teaching Goals The previous chapter covered most of the important issues in open economy macroeconomics with respect to real variables in the economy. This chapter’s material covers interactions between real and nominal variables. The most important consequence of the addition of national moneys into the open economy is the need to fully understand exchange rates. A key building block to understanding the material in this chapter is to fully grasp the difference between a nominal exchange rate and a real exchange rate. Although students can easily memorize the equation that relates the two variables, they often become confused on this subject when discussing applications of the theory. The related topic of purchasing power parity is also difficult to fully grasp. The models in the chapter all rely on purchasing power parity, and yet evidence suggests that this relationship is not reliable when dealing with short-horizon developments. In this regard, it is useful to point out that deviations from purchasing power parity are typically due to real, as opposed to nominal factors. The models developed in this chapter are all classical in nature. Therefore, the nominal price level has no direct influence on individual welfare or the allocation of resources. A useful introduction to the material might therefore include a discussion of those factors, beyond the scope of the model at hand that give consequence to changes in nominal variables. Such factors include the possible confusion about relative prices, contracts that are written in nominal terms, and redistributions of wealth due to unanticipated inflation or deflation. While it would be unwieldy to construct a model with all of these features, hopefully the models of this chapter will provide some intuition about the possible problems created by foreign disturbances that affect the domestic price level. Classroom Discussion Topics Many times students are disappointed with economics because the discipline rarely offers strategies for reaping windfall gains. Ask the students if they ever thought of foreign-exchange speculation as a source of livelihood. Can the students work out the proper strategy if they are confident in their ability to predict future movements in nominal exchange rates? Is the possibility of windfall profits limited to the case of flexible exchange rates? Would it be useful to be able to predict devaluations? Remind the students that their ability to forecast must be better than market forecasts. Ask the students about the likely consequences of a widespread change in market expectations about exchange rate movements. Unfortunately, this point brings us back to the difficulties in making quick money from learning about economics.
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