13 - C hapter 13 E xchange Rates, Business Cycles, and M...

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Chapter 13 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy Learning Objectives I. Goals of Chapter 13 A) Two primary aspects of interdependence between economies of different nations 1. International trade in goods and services 2. Worldwide integration of financial markets B) Interdependence means that nations are dependent on each other, so policy changes in one country may affect other countries II. Notes to Fourth Edition Users A) The IEB-IRP model from the first edition of the textbook appears following the answers to the analytical problems in this instructor’s manual B) The application “Why the Dollar Rose So High and Fell So Far in the 1980s” has been deleted C) The application on “European Monetary Unification” has been expanded to include a discussion of the introduction of euro currency and the change in the value of the euro relative to the dollar from 1999 to 2003 D) There is a new application on “Crisis in Argentina” in Section 13.5 Teaching Notes Exchange Rates (Sec. 13.1) A. Nominal exchange rates 1. The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency a. For example, if the nominal exchange rate is 110 yen per dollar, one dollar can be exchanged for 110 yen b. Transactions between currencies take place in the foreign exchange market c. Denote the nominal exchange rate (or simply, exchange rate) as e nom in units of the foreign currency per unit of domestic currency 2. Under a flexible-exchange-rate system or floating-exchange-rate system, exchange rates are determined by supply and demand and may change every day; this is the current system for major currencies 3. In the past, many currencies operated under a fixed-exchange-rate system, in which exchange rates were determined by governments
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264 Abel/Bernanke • Macroeconomics, Fifth Edition a. The exchange rates were fixed because the central banks in those countries offered to buy or sell the currencies at the fixed exchange rate b. Examples include the gold standard, which operated in the late 1800s and early 1900s, and the Bretton Woods system, which was in place from 1944 until the early 1970s c. Even today, though major currencies are in a flexible-exchange-rate system, some smaller countries fix their exchange rates B) Real exchange rates 1. The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good 2. If the nominal exchange rate is 110 yen per dollar, and it costs 1100 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger 3. The real exchange rate is the price of domestic goods relative to foreign goods, or e = e nom P/P For (13.1) 4. To simplify matters, we’ll assume that each country produces a unique good 5. In reality, countries produce many goods, so we must use price indexes to get P and For 6. If a country’s real exchange rate is rising, its goods are becoming more expensive relative to
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13 - C hapter 13 E xchange Rates, Business Cycles, and M...

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