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25 The Open Economy, Part 1

25 The Open Economy, Part 1 - Agenda Exchange Rates...

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1 25-1 Exchange Rates, Business Cycles, and Macroeconomic Policy in the Open Economy, Part 1 25-2 Agenda Exchange Rates How Exchange Rates Are Determined ¾ A Supply-and-Demand Analysis 25-3 Exchange Rates Nominal exchange rates: ¾ 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. 25-4 Exchange Rates Nominal exchange rates: ¾ Transactions between currencies take place in the foreign exchange market . ¾ Denote the nominal exchange rate (or simply, exchange rate) as e nom in units of the foreign currency per unit of domestic currency.
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2 25-5 Exchange Rates Nominal exchange rates: ¾ 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 25-6 Exchange Rates Nominal exchange rates: ¾ In the past, many currencies operated under a fixed-exchange-rate system, in which exchange rates were determined by governments. The exchange rates were fixed because the central banks in those countries offered to buy or sell the currencies at the fixed exchange rate. Though major currencies are in a flexible-exchange-rate system, some smaller countries fix their exchange rates. 25-7 Exchange Rates Real exchange rates: ¾ The real exchange rate indicates how much of a foreign good can be obtained for one unit of a domestic good. Suppose 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 is 0.2 yen per dollar. 25-8 Exchange Rates Real exchange rates: ¾ The real exchange rate is the price of domestic goods relative to foreign goods, or e = e nom P/P For
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3 25-9 Exchange Rates Real exchange rates: ¾ Although countries produce many goods, and price indexes should be used to get P and P For , to simplify matters, assume that each country produces a unique good. ¾ If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country. 25-10 Exchange Rates Appreciation and depreciation: ¾ In a flexible-exchange-rate system: • When e nom falls, the domestic currency has become weaker and has undergone a nominal depreciation . • When e nom rises, the domestic currency has become stronger and has undergone a nominal appreciation . 25-11 Exchange Rates Appreciation and depreciation: ¾ In a flexible-exchange-rate system: • When e falls, the domestic currency has become weaker and has undergone a real depreciation .
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