Principles of Economics 10.1 - Open Economies and Balance of Payments*

Question 1

What’s ‘international trade’?

Answer 1

International trade refers to the buying and selling of goods and
services across international boundaries, rather than domestically

Question 2

Explain the concept of exchange rates

Answer 2

• Countries have different currencies, so if you wish to buy goods from
  another country you need to convert your domestic currency into
  the relevant foreign currency.
• The rate at which you convert your domestic currency into foreign
  currency is the prevailing exchange rate. This is the price of one
  currency expressed in terms of another. *Some examples:
• 1 Euro is equivalent to 163 Japanese Yen.
• 1 British pound is equivalent to 1.26 US dollars.
• 1 Swiss franc is equivalent to 4.16 Emirati dirhams. These are nominal exchange rates*

Question 3

What’s a ‘nominal exchange rate’?

Answer 3

The price of a
domestic currency in terms of a foreign currency

Question 4

What’s the name for ‘the price of a
domestic currency in terms of a foreign currency’?

Answer 4

Nominal Exchange Rate

Question 5

What’s ‘real exchange rate’?

Answer 5

The cost of domestic goods in terms of foreign goods i.e. the rate at which a person can trade the goods
and services of one country for another.
For example:
* German cars per American cars.
* Australian wine per Chilean wine

Question 6

What’s the name for ‘the cost of domestic goods in terms of foreign goods’?

Answer 6

Real Exchange Rate

Question 7

In terms of notation, what do we denote for real exchange rates and nominal exchange rates?

Answer 7

We denote the nominal exchange rate by e and
the real exchange rate by ε

Question 8

For simplicity, how do we talk about exchange rates?

Answer 8

For simplicity we will talk about exchange rates in abstract terms:
* Nominal exchange rate: “the relative price of domestic currency in terms
of foreign currency”.
* Real: “the relative price of domestic goods in terms of foreign goods”.
In other words, we will proceed as though there is only a single ‘foreign
economy’ with some generic ‘foreign currency’.

Question 9

What is the relationship between nominal and real exchange rates?

Answer 9

The real exchange rate effectively allows for the relative price of goods in the two regions – it takes into account price levels.
Let P denote the overall price level in the domestic economy and P*
denote the price level in the foreign economy. The association
between the two types of exchange rate is:
ε = e x P / P*
* • As a made-up example, suppose:
- In the domestic economy CPI (consumer price index) is currently equal to 150.
- In the foreign economy, CPI is currently 200.
- The nominal exchange rate is currently 2.
- In this example, what is the real exchange rate?
• Answer: 2(150/200) = 1.5
• Domestic goods are relatively more expensive in this example,
because this value is greater than 1

Question 10

What does it mean when real exchange rate is more than 1?

Answer 10

If you have a real exchange rate of more than 1, this means that goods in the domestic economy is more expensive than in the foreign economy. Less than 1 means the opposite