Unit 6 Open Economy Macroeconomics: Exchange Rates, Net Exports, and Capital Flows

Foreign exchange market (FOREX)

The market where currencies are traded; people and firms exchange one country’s money for another to buy goods, services, or assets.

Exchange rate

The price of one currency in terms of another (e.g., “yen per dollar” or “euros per dollar”); the quote format determines how to interpret appreciation/depreciation.

Dollar appreciation

An increase in the value of the dollar relative to other currencies; in a “foreign currency per dollar” quote, appreciation shows as a higher exchange-rate number.

Dollar depreciation

A decrease in the value of the dollar relative to other currencies; in a “foreign currency per dollar” quote, depreciation shows as a lower exchange-rate number.

FOREX graph (market for dollars)

AP model with exchange rate on the vertical axis (foreign currency per dollar) and quantity of dollars exchanged on the horizontal axis.

Demand for dollars

Foreigners’ desire to obtain dollars to buy U.S. goods, services, and assets; an increase in this demand tends to appreciate the dollar.

Supply of dollars

Americans selling dollars to buy foreign goods, services, and assets; an increase in this supply tends to depreciate the dollar.

Equilibrium exchange rate

The exchange rate at which the quantity of dollars demanded equals the quantity of dollars supplied in the FOREX market.

Interest-rate differential (U.S. vs. foreign)

A comparison of interest rates across countries; if U.S. rates rise relative to foreign rates, U.S. assets become more attractive and demand for dollars increases.

Capital inflow

Foreign financial capital entering a country to buy domestic assets; in the U.S., this requires foreigners to buy dollars, raising demand for dollars.

Capital outflow

Domestic financial capital leaving a country to buy foreign assets; U.S. residents sell dollars to obtain foreign currency, increasing the supply of dollars.

Income (GDP) effect on FOREX

Higher U.S. income tends to raise imports (higher supply of dollars, dollar depreciates); higher foreign income tends to raise U.S. exports (higher demand for dollars, dollar appreciates).

Relative price levels (inflation differences)

If U.S. inflation is higher than abroad, U.S. exports fall and imports rise, decreasing demand for dollars and increasing supply of dollars, pushing the dollar to depreciate.

Tariff

A tax on imports; tends to reduce imports, decreasing the supply of dollars in FOREX and (in the AP model) tending to appreciate the dollar.

Quota

A limit on the quantity of imports; tends to reduce imports, decreasing the supply of dollars in FOREX and tending to appreciate the dollar.

Export subsidy

A government payment that encourages exports; tends to increase exports, raising foreign demand for dollars and tending to appreciate the dollar.

Exchange-rate expectations

Beliefs about future currency values; if investors expect the dollar to appreciate, demand for dollars rises today and the dollar appreciates today.

Net exports (NX)

Exports minus imports; measures how much domestic production is demanded abroad relative to foreign production demanded domestically. Formula: NX = X − M.

Aggregate expenditure identity with net exports

GDP in the aggregate expenditure model is Y = C + I + G + NX, so changes in NX shift aggregate demand in the short run.

Appreciation’s effect on trade

When the dollar appreciates, imports become cheaper to Americans and exports become more expensive to foreigners; imports rise, exports fall, and NX decreases (AP direction).

Depreciation’s effect on trade

When the dollar depreciates, imports become more expensive to Americans and exports become cheaper to foreigners; imports fall, exports rise, and NX increases (AP direction).

Real interest rate (r)

Inflation-adjusted interest rate; approximated by r = i − π^e, where i is the nominal rate and π^e is expected inflation.

Net capital outflow (NCO)

Domestic purchases of foreign assets minus foreign purchases of domestic assets; summarizes net financial capital leaving the country (can be negative for net inflow).

NCO and real interest rate relationship

In the AP model, higher domestic real interest rates reduce NCO (more capital inflow and fewer domestic purchases of foreign assets); lower real interest rates raise NCO.

Open-economy identities (linking saving, investment, and trade)

Key AP equalities: NCO = S − I and NCO = NX, linking financial flows to saving/investment and to net exports.