ECON1002 · Introductory Macroeconomics
Exchange Rates, the Balance of Payments & Open-Economy Macro
The open-economy chapter links the dollar, prices and the external accounts. The real exchange rate rer = eP/Pᶠ measures competitiveness, and purchasing power parity predicts %Δe = %ΔPᶠ − %ΔP, so higher domestic inflation means depreciation. The FX market shows how monetary policy moves the dollar, fixed regimes face overvaluation and speculative attacks, and the policy trilemma says you can have at most two of {fixed exchange rate, free capital flows, independent monetary policy}. The external accounts satisfy CAB + KAB = 0 and the identity NS − I = NX.
It is examined as rer/PPP calculations, an FX diagram of an interest-rate change, and an open-economy identity (twin deficits) computation.
What this chapter covers
- 011. Nominal exchange rate e (foreign per domestic); appreciation (e↑) vs depreciation (e↓)
- 022. Real exchange rate rer = eP/Pᶠ and competitiveness (real depreciation ⇒ X↑, M↓)
- 033. PPP & the Law of One Price: %Δe = %ΔPᶠ − %ΔP (higher domestic inflation ⇒ depreciation)
- 044. The FX market: supply of A$ up-sloping, demand down-sloping; tightening MP ⇒ appreciation
- 055. Fixed vs floating; overvalued fixed ER drains reserves; speculative attack; defend by tightening MP
- 066. The policy trilemma: at most 2 of {fixed ER, free capital flows, independent MP}
- 077. Balance of payments: CAB + KAB = 0 (floating); current vs capital account structure
- 088. Open-economy identities: NS + KI = I and NS − I = NX; twin deficits
Real exchange rate, PPP depreciation and the open-economy identity
- 1 mark(a) rer = eP/Pᶠ = (2 × 12)/30 = 24/30 = 0.8.
- 1 mark(b) PPP: %Δe = %ΔPᶠ − %ΔP = 3% − 7% = −4%, so the domestic currency depreciates about 4% (higher domestic inflation ⇒ weaker currency).
- 1 mark(c) In changes, (ΔSₚᵣᵢᵥ + Δ(T−G)) − ΔI = ΔX − ΔM ⇒ (8 + 12) − ΔI = 5 − 9.
- 1 markSolve: 20 − ΔI = −4 ⇒ ΔI = 24. Investment rose by $24bn.
Key terms
- Nominal vs real exchange rate
- The nominal exchange rate e is units of foreign currency per domestic dollar; the real exchange rate rer = eP/Pᶠ adjusts for relative price levels and measures international competitiveness. A real depreciation (rer falls) makes domestic goods cheaper abroad — exports up, imports down.
- Purchasing power parity (PPP)
- The long-run tendency for the real exchange rate to settle so that goods cost the same across countries (Law of One Price). It implies %Δe = %ΔPᶠ − %ΔP, so a country with higher inflation sees its currency depreciate. PPP holds in the long run, not in the short run.
- FX market & monetary policy
- The exchange rate is set by the supply of and demand for the currency. Tightening domestic monetary policy (a higher interest rate) attracts capital inflows, raising demand for the dollar (and reducing supply), so the currency appreciates; loosening does the reverse.
- Overvalued fixed exchange rate & speculative attack
- Under a fixed (pegged) regime, if the official rate is above the fundamental value there is excess supply of the currency, and the central bank must buy its own currency with foreign reserves. A speculative attack — mass selling — drains reserves and can force a devaluation; defending requires tightening monetary policy.
- Policy trilemma
- A country can have at most two of: a fixed exchange rate, free international capital flows, and an independent monetary policy. Choosing any two rules out the third — e.g. a fixed rate with open capital markets forfeits monetary independence.
- Balance-of-payments identity
- Under a floating rate, the current account balance and the capital (financial) account balance sum to zero: CAB + KAB = 0, so a current-account deficit is matched by a capital-account surplus (net capital inflow). Under a fixed rate the difference shows up as a change in official reserves.
Exchange Rates, the Balance of Payments & Open-Economy Macro FAQ
How is the open-economy material examined in ECON1002?
Three calculation types plus a diagram. You compute the real exchange rate from rer = eP/Pᶠ, apply PPP to find the predicted nominal-exchange-rate change, and solve an open-economy identity (NS − I = NX, or the twin-deficits relation) for a missing change. The diagram question uses the FX market to show how an interest-rate change moves the dollar, or how a fixed regime is defended.
Why does higher domestic inflation cause the currency to depreciate?
Through PPP. If domestic prices rise faster than foreign prices, domestic goods become relatively expensive, so to keep the real exchange rate constant the nominal rate must adjust: %Δe = %ΔPᶠ − %ΔP. With e measured as foreign-per-domestic, faster home inflation makes %Δe negative — the currency depreciates. Intuitively, a currency that buys less at home should buy less abroad too.
How does monetary policy move the exchange rate?
By changing the return on holding the currency. Tightening domestic monetary policy raises the interest rate, attracting foreign capital: demand for the dollar rises (and supply falls) in the FX market, so the currency appreciates. Loosening lowers the rate and depreciates the currency. This is also how a country defends an overvalued fixed rate — it tightens policy to raise the currency's fundamental value.
What are the twin deficits and what does NS − I = NX mean?
Start from the identity NS − I = NX, with national saving split as NS = Sₚᵣᵢᵥ + (T − G). It says that if a country invests more than it saves, it runs a trade (and current-account) deficit, financed by capital inflow. The 'twin deficits' idea links a budget deficit (T − G negative) to a current-account deficit: a larger budget deficit lowers national saving, which — holding investment and private saving fixed — widens the external deficit.
Exam move
This is the densest chapter, so split it into a calculation set and a diagram set. Calculations: drill rer = eP/Pᶠ, the PPP rule %Δe = %ΔPᶠ − %ΔP (watch the e-convention — foreign-per-domestic means home inflation depreciates the currency), and the open-economy identities NS − I = NX and the twin-deficits relation, solving for any one missing change while keeping signs consistent (a smaller deficit means T − G rises). Diagrams: rehearse the FX market for a tightening (appreciation) and the fixed-rate defence (reserves, speculative attack, tighten MP). Memorise the trilemma as 'pick two of three' with one example, and keep the balance-of-payments identities (CAB + KAB = 0 floating; reserves change under a peg) on a single mental card. Because the final focuses on Weeks 8-13, give this chapter heavy revision time.
