Unit 6: Open Economy—International Trade and Finance

a. Define the current account (CA), the capital and financial account (CFA), and the balance of payments (BOP). b. Explain how changes in the components of the CA and CFA affect a country’s BOP. c. Calculate the CA, the CFA, and the BOP.

• The current account (CA) records net exports, net income from abroad, and net unilateral transfers.
• The CA is not always balanced; it may show a surplus or a deficit. A nation’s balance of trade (i.e., net exports) is part of the current account and may also show a surplus or a deficit.
• The capital and financial account (CFA) records financial capital transfers and purchases and sales of assets between countries.
• The CFA is not always balanced; it may show a surplus (financial capital inflow) or a deficit (financial capital outflow).
• The balance of payments (BOP) is an accounting system that records a country’s international transactions for a particular time period. It consists of the CA and the CFA.
• Any transaction that causes money to flow into a country is a credit to its BOP account, and any transaction that causes money to flow out is a debit. The sum of all credit entries should match the sum of all debit entries (CA+CFA=0).
• Enduring understanding MEA-4: Foreign trade accounting measures the flow of goods, services, and financial capital between countries.

a. Define the exchange rate, currency appreciation, and currency depreciation. b. Explain how currencies are valued relative to one another. c. Calculate the value of one currency relative to another.

• In the foreign exchange market, one currency is exchanged for another; the price of one currency in terms of the other is the exchange rate.
• If one currency becomes more valuable in terms of the other, it is said to appreciate. If one currency becomes less valuable in terms of the other, it is said to depreciate.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

a. Define the foreign exchange market, demand for currency, and supply of currency. b. Explain (using graphs as appropriate) the relationship between the exchange rate and the quantity of currency demanded (supplied).

• The demand for a currency in a foreign exchange market arises from the demand for the country’s goods, services, and financial assets and shows the inverse relationship between the exchange rate and the quantity demanded of a currency.
• The supply of a currency in a foreign exchange market arises from making payments in other currencies and shows the positive relationship between the exchange rate and the quantity supplied of a currency.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Define (using graphs as appropriate) the equilibrium exchange rate.

• In the foreign exchange market, equilibrium is achieved when the exchange rate is such that the quantities demanded and supplied of the currency are equal.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Explain (using graphs as appropriate) how exchange rates adjust to restore equilibrium in the foreign exchange market.

• Disequilibrium exchange rates create surpluses and shortages in the foreign exchange market. Market forces drive exchange rates toward equilibrium.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

a. Explain (using graphs as appropriate) the determinants of currency demand and supply. b. Explain (using graphs as appropriate) how changes in demand and supply in the foreign exchange market affect the equilibrium exchange rate.

• Factors that shift the demand for a currency (such as the demand for that country’s goods, services, or assets) and the supply of a currency (such as tariffs or quotas on the other country’s goods and services) change the equilibrium exchange rate.
• Fiscal policy can influence aggregate demand, real output, the price level, and exchange rates.
• Monetary policy can influence aggregate demand, real output, the price level, and interest rates, and thereby affect exchange rates.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Explain (using graphs as appropriate) how changes in the value of a currency can lead to changes in a country’s net exports and aggregate demand.

• Factors that cause a currency to appreciate cause that country’s exports to decrease and its imports to increase. As a result, net exports will decrease.
• Factors that cause a currency to depreciate cause that country’s exports to increase and its imports to decrease. As a result, net exports will increase. [See EK MOD-2.A.3 and EK MOD-2.H.1 for explanations of the effect of changes in net exports on aggregate demand and the resulting effects on output, employment, and the price level.]
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.

Explain (using graphs as appropriate) how differences in real interest rates across countries affect financial capital flows, foreign exchange markets, and loanable funds markets.

• In an open economy, differences in real interest rates across countries change the relative values of domestic and foreign assets. Financial capital will flow toward the country with the relatively higher interest rate. [See EK MKT-4.E.2 and EK MEA-4.A.6 for explanations of the impact on the loanable funds market and on net exports.]
• Central banks can influence the domestic interest rate in the short run, which in turn will affect net capital inflows.
• Enduring understanding MKT-5: The interaction of buyers and sellers exchanging the currency of one country for the currency of another determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries.