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Exchange Rates and International Macroeconomics


Markets, Specialization, and Growth

  1. To hold a comparative advantage is to be better suited to the production of one good relative to another good compared with another person or country.

  2. When individuals specialize in the activities in which they have a comparative advantage and then trade with one another to fulfill their wants and needs, the total output will be greater than if each individual had produced everything they desired by themselves. This is how efficient production is achieved.

  3. As Adam Smith argued in The Wealth of Nations, markets and specialization have led to economic growth.


Balance of Payments

  1. The balance of payments provides a statement of all transactions between a country’s residents and residents of foreign countries. A balance of payments surplus (the quantity demanded of currency exceeds the quantity supplied) will put an upward pressure on the price of a nation’s currency. The balance of payments has two components:

    1. Current account: The part of the balance of payments listing all short-term payment flows, including net exports of goods and services, net investment income, and net transfers (foreign aid, gifts, or other payments not exchanged for goods and services).

    2. Capital account: The part of the balance of payments listing all long-term payment flows, including the sale of assets and securities between countries.

  2. Official transactions account: Official reserves are the government’s holdings of foreign currencies.

    1. Supporting a currency happens when a government buys its own currency to hold up the currency’s price.

    2. If a government sells its currency internationally, it is attempting to decrease the currency’s value.

  3. Balance of trade: The difference between the goods and services exported and imported in a country.


Exchange Rates

  1. The exchange rate between two currencies is the price of one currency in terms of the other currency.

  2. When comparing the currencies of two countries, the exchange rate is the equilibrium price of one currency in terms of the other. It is determined by the intersection of supply and demand for that currency.

  3. A number of forces are at work in determining exchange rates, including:

    1. Changes in a country’s price level,

    2. Changes in a country’s income,

    3. Changes in a country’s interest rates.

  4. Fixed exchange rate regimes: A government can attempt to maintain a fixed exchange rate by maintaining predetermined values of its currency in terms of other currencies.

  5. Flexible exchange rate regimes: Most governments today leave exchange rates to fluctuate according to the market effects of supply and demand for the currency.

  6. Advantages and disadvantages of high exchange rates

    1. Advantage: If foreign currency is cheaper, the price of imports is less, and lower import prices help keep domestic inflation low due to the competitive pressures of foreigners.

    2. Disadvantage: High exchange rates encourage imports and discourage exports (causing a trade deficit).

    3. Economists disagree on the best policy toward exchange rates.