CHAPTER SUMMARY

1. The nominal exchange rate is the number of units of foreign currency that can be obtained for one unit of domestic currency. The real exchange rate is the num­ber of units of foreign goods that can be obtained for one unit of the domestic good.

2. There are two major types of exchange rate systems: flexible- or floating-exchange-rate systems, in which the value of the nominal exchange rate is determined by market forces; and fixed-exchange-rate systems, in which the value of the exchange rate is officially set by a government or group of governments. In a flexible­exchange-rate system, an exchange rate increase is called an appreciation, and an exchange rate decrease is called a depreciation.

3. The real exchange rate is important because it affects net exports, or exports minus imports. Other factors held constant, a decline in the real exchange rate makes domestic goods cheaper relative to foreign goods and thus tends to increase net exports in the long run. Because a drop in the real exchange rate raises the cost of imports, however, it may cause net exports to fall in the short run before physical flows of exports and imports have had time to adjust. The characteristic pattern of the response of net exports to a drop in the real exchange rate—falling net exports in the short run but rising net exports in the long run—is called the J curve.

4. In a flexible-exchange-rate system, the value of the (nominal) exchange rate is determined by supply and demand in the foreign exchange market. Foreigners demand the domestic currency to buy domestic goods and assets. Domestic residents supply the domestic currency to obtain the foreign currency needed to buy foreign goods and assets.

5.

6. The IS-LM model for an open economy is similar to that for the closed economy. The principal difference is that, in the open-economy IS-LM model, factors (other than output or the real interest rate) that increase a country's net exports cause the IS curve to shift up. Among the factors that increase net exports are a rise in foreign output, an increase in the foreign real inter­est rate, and a shift in world demand toward the domestic country's goods. Economic shocks or policy changes are transmitted from one country to another by changes in net exports that lead to IS curve shifts.

7. In an open economy with flexible exchange rates, a fiscal expansion increases domestic output, domestic prices, and the domestic real interest rate, as in a closed economy. The effect on the exchange rate is ambiguous. The increase in output raises the demand for imported goods, which weakens the exchange rate, but the higher real interest rate makes domestic assets more attractive, which strengthens the exchange rate. Because increased output raises the demand for imports, net exports fall. The fiscal expansion is trans­mitted to the foreign country by the increase in demand for the foreign country's exports.

8. In an open economy with flexible exchange rates, changes in the money supply are neutral in the basic classical model. Changes in the money supply also are neutral in the long run in the Keynesian model.

9. In a fixed-exchange-rate system, nominal exchange rates are officially determined. If the officially deter­mined exchange rate is greater than the fundamental value of the exchange rate as determined by supply and demand in the foreign exchange market, the exchange rate is said to be overvalued. The central bank can maintain the exchange rate at an overval­ued level for a time by using official reserves (such as gold or foreign-currency bank deposits) to buy its own currency in the foreign exchange market. A country that tries to maintain an overvalued exchange rate for too long will run out of reserves and be forced to devalue its currency. If financial investors expect a devaluation, they may sell large quantities of domestic assets (a speculative run). A speculative run increases the supply of the domestic currency in the foreign exchange market and increases the rate at which the central bank must pay out its reserves.

10. To raise the fundamental value of its exchange rate, the central bank can tighten monetary policy. There is only one value of the domestic money supply at which the fundamental value of the exchange rate equals its officially fixed rate. With fixed exchange rates, individual countries aren't free to use expan­sionary monetary policies to fight recessions because such policies result in an overvalued exchange rate. However, a group of countries in a fixed-exchange­rate system can use expansionary monetary policies effectively if they coordinate their policies.

11. The advantages of a fixed-exchange-rate system are that it may promote economic and financial integra­tion among countries and that it imposes discipline on the monetary policies of individual countries. A fixed-exchange-rate system won't work well if mem­ber countries have different macroeconomic policy goals or face different macroeconomic disturbances and thus are unable or unwilling to coordinate their monetary policies.

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