U6: Open Economy

Unit 6: Open Economy- International Trade and Finance

Balance of Payments

The balance of payments is the difference between all international purchases and sales in a period of time. Balance of payments can be classified into the current account and the financial account:

Types of Accounts

Current Account

● Net exports/imports of goods (Balance of Trade)

● Net exports/imports of services

● Net income (investment income plus employee compensation)

● Net transfers

Capital Account

● Purchase and sale of fixed assets - example → real estate

Financial Account

● Net foreign direct investment

● Net portfolio investment

Reserves

● Changes in the official monetary reserves

Trade Deficits and Trade Surpluses

Trade Deficit

Imports are greater than exports → Buying more than Selling

Trade Surplus

Exports are greater than imports → Selling more than Buying

Exchange Rates

Appreciation

● The general increase in the price of an asset overtime.

○ Example: In 2018 the price of my house was $200k, in 2020 the price of my house rose to $400k. This would be an appreciation in price.

Depreciation

● The general decrease in the price of an asset overtime.

Regarding Currency

● Appreciation:

○ The value of a nation’s currency increases. (This means it is worth more compared to other nations.)

● Depreciation:

○ The value of a nation's currency decreases. (This means it is worth less compared to other nations.)

Foreign Exchange Market

● Represents the currency foreign exchange rates for countries

Equilibrium Exchange Rate: When countries trade currency, there is an exchange rate. At the equilibrium, the quantity of currency demanded is equal to the quantity of currency supplied.

Floating exchange rate: The price of a nation's currency is determined by the foreign exchange market (relation to other currencies).

There is a supply and a demand for the currency:

● In the foreign exchange market, there is a buyer and a seller of currency.

● Countries are trading currency and are based on levels of appreciation or depreciation. (They have different values.)

○ For example: The U.S. dollar is worth more than the Canadian dollar. (This would be because the U.S. dollar is stronger in the rate of exchange.)

Shifters of the Foreign Exchange Market

■ Change in preference

● This means a nation will want less of a certain currency.

● For example: Italy’s economy goes into a depression and the currency depreciates

● This would decrease the demand of the euro when trading currency with Italy.

■ Change in national inflation

■ Change in real interest rates

Real Interest Rate

The real interest rate is the interest rate that is adjusted for inflation by subtracting the rate of inflation.

How to Calculate

Real Interest Rate = Nominal Interest Rate - Rate of Inflation

■ Change in wages and income

○ Both Only Shift When:

■ If there is a change in inflation and income

In your graph, always label (as displayed above). It’s also helpful to know currency symbols of other nations!

Currency Market

Domestic Price:

● The cost of a good.

○ When trading, we think of the domestic price vs the price in other nations for the potential of training. 

Graph Example: