Learning Objectives
13.1 Describe real and nominal exchange rates, how they are related, and how they change over time.
13.2 Usea supply-and-demand framework to explain how exchange rates are determined.
13.3 Use the relationship between exchange rates and international trade to develop an openeconomy IS-LM model.
13.4 Discuss the international effects of domestic macroeconomic policies.
13.5 Evaluate the strengths and weaknesses of different types of exchange rate systems.
In Chapters 9-12 we focused on a closed economy, or one that doesn't interact with other economies. For some purposes, ignoring the foreign sector simplifies the analysis. But the reality is that today, more than ever, we live in a highly interdependent world economic system.
There are two primary aspects of the interdependence of the world's economies. The first is international trade in goods and services, which has increased steadily in volume since World War II. Today, firms produce goods and services with an eye on foreign and domestic markets, and they obtain many raw materials from distant sources. Expanded international trade has increased productivity by allowing economies to specialize in producing the goods and services best suited to their natural and human resources. However, expanded trade also implies that national economies are more dependent on what happens in other countries. For example, because Japan sells so much of its output to the United States, a U.S. recession or macroeconomic policy change may affect the Japanese economy as well. In the fourth quarter of 2008, during the financial crisis, U.S. GDP declined 8% (at an annual rate), causing a sharp decline in imports from Japan, which contributed to a 12% decline (at an annual rate) in Japan's GDP.
The second is the worldwide integration of financial markets, which allows borrowers to obtain funds and savers to look for their best lending opportunities almost anywhere in the world, not just in their own countries.
By allowing saving to flow to the highest-return uses regardless of where savers and investors happen to live, the integration of world financial markets increases worldwide productivity, as does the development of an integrated world trading system. But financial market linkages, like trade linkages, increase the sensitivity of individual economies to developments abroad. For example, because of closely connected financial markets, macroeconomic policies that change the real interest rate in one country may affect real interest rates and economic activity in other countries. When U.S. real interest rates declined sharply and turned negative during the financial crisis in 2008, real interest rates in many other countries declined similarly as well.In this chapter, we build on earlier analyses of the open economy (Chapter 5) and cyclical fluctuations (Chapters 8-11) to examine the macroeconomic implications of trading and financial links among countries. We are particularly concerned in this chapter with how economic openness affects fiscal and monetary policies and how macroeconomic policy changes affect the economies of a country's trading partners. We begin our discussion by introducing two new variables that play central roles in the international economy: the nominal exchange rate and the real exchange rate.
13.1