Open Economy Macroeconomics

About this unit

An open economy trades goods, services and financial assets with other countries. This unit introduces the record of these transactions, the balance of payments, and the price at which one currency exchanges for another, the foreign exchange rate. It explains current and capital accounts, surpluses and deficits, and how exchange rates are set under fixed, flexible and managed floating systems.

Key ideas

• The balance of payments (BoP) records all economic transactions of residents with the rest of the world in a year.
• The current account covers trade in goods, services, income and transfers; the capital account covers assets and liabilities.
• Autonomous transactions determine whether BoP is in surplus or deficit; accommodating transactions settle the gap.
• The exchange rate is the price of one currency in terms of another.
• Under a flexible rate, demand and supply of foreign exchange set the rate; under a fixed rate the government sets it.
• Depreciation and devaluation make a currency cheaper; appreciation and revaluation make it dearer.

How to prepare

Learn the items in each account and practise classifying transactions. Draw the demand and supply diagram for foreign exchange and learn why each curve slopes as it does. Expect classification questions and simple balance of trade calculations.