Week 14 · Chapter

Chapter 14 — Open-Economy Macro: Exchange Rates & the Balance of Payments

Principles of Macroeconomics Free sample edition

The module's primary reading · ~35–45 minutes · Objective 8 (analyze the short-run and long-run Phillips curve and the quantity equation of money, and apply open-economy tools — comparative advantage and the gains from trade, the trade balance, exchange rates, and the balance of payments — and weigh the Keynesian and classical / monetarist views of stabilization policy evenhandedly), with Objective 5 (use the aggregate-demand and aggregate-supply model to analyze short-run fluctuations and the business cycle — name which curve shifts, in which direction, and what happens to the price level and real output — and measure recessionary and inflationary gaps) · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

This week is about the price of money itself. Before you can buy something made in another country, someone has to swap dollars for that country's currency. The swap happens at an exchange rate (the price of one currency in another). When that price moves, everything that crosses a border gets cheaper or dearer, so a "strong dollar" helps some people and squeezes others. You will also meet the balance of payments (a country's record of everything it buys from and sells to the rest of the world), and learn why its two halves always add to zero.

Why you already care about this

Picture three illustrative people this week, with made-up numbers. A student is heading abroad for a semester and changes 300 dollars at an airport counter. A small furniture maker in a river town quotes a price to a buyer overseas for 12 dining chairs. A repair shop owner is pricing a machine made in Japan, quoted at 1,200,000 yen. Not one of them sets the exchange rate. All three live with it.

The student wants each dollar to buy as much foreign money as possible. The furniture maker hopes the opposite, because a dollar that buys a lot abroad makes her chairs look expensive to foreign buyers. The shop owner, like the student, gains when the dollar buys more. Same price, three different hopes.

News reports say "the dollar strengthened" or "the dollar slid" as if everyone knows what that means. This chapter turns those phrases into a chain you can compute and a record you can read.

By the end of this chapter you will be able to:

read an exchange rate written as "1 dollar = 120 yen" and convert a price from one currency to the other;
tell an appreciation from a depreciation, and compute the percentage change in the rate;
trace the export link and the import link of the price chain, and say what happens to net exports;
run the chain backwards for a depreciation, flipping every arrow;
say which way a change in net exports shifts aggregate demand, and what happens to the price level and real output;
sort everyday transactions into demand for dollars and supply of dollars, and name the drivers of the rate;
compute the current account and the financial account and show that they sum to zero;
lay out both views on a strong dollar and a current-account deficit, labelling positive and normative claims.

Carry this line with you: a stronger dollar is not stronger exports — it is cheaper imports.

Where we are

Already covered: Week 2, Measuring Output, gave you net exports NX = X − IM inside GDP = C + I + G + NX. Week 5, Aggregate Demand & Aggregate Supply, taught you to tell a movement along a curve from a shift of it, and named the exchange-rate effect as one reason aggregate demand slopes down. Weeks 10 and 11 showed how the central bank moves interest rates. Week 13, International Trade & Comparative Advantage, explained why countries trade and how to read the trade balance.
This week: you put a price on the trade itself. You learn how an exchange rate moves the prices of exports and imports, who trades dollars and why, and how a country's books with the rest of the world balance.
How they connect: last week's exports and imports now carry a price tag in two currencies. A change in that price moves net exports, and net exports are a part of aggregate demand, so the Week 5 diagram comes back.
Where we're going next: Week 15, Macroeconomic Schools & Policy Debates, closes the course by setting the Keynesian and classical / monetarist views side by side on the policy questions you have met all term.

Three earlier ideas carry this chapter. From Week 2, exports X are goods made here and sold abroad, imports IM are goods made abroad and bought here, and net exports are X − IM. From Week 5, a change in anything other than the price level shifts aggregate demand, and an aggregate demand shift moves the price level P and real output Y together. From Week 13, a trade deficit means imports exceeded exports; it is a description, not a loss.

1. Read an exchange rate: the price of one currency in another

Start at the airport counter. You hand over dollars and get euros back. The counter is selling euros and buying dollars, and the posted rate is the price of the deal.

An exchange rate is the price of one currency expressed in another; this course writes it as the amount of foreign currency one dollar buys, so 1 dollar = 120 yen means a dollar buys 120 yen.

This course always quotes the rate from your dollar's side: how much foreign money one dollar buys. You will see the letter e for that number. In the course's main example, e is yen per dollar, and it starts at 100. So "1 dollar = 100 yen" says one dollar buys 100 yen.

Two moves follow from that one number. To turn a dollar price into foreign currency, multiply by e. To turn a foreign price into dollars, divide by e.

Worked example — the student's 300 dollars. These numbers are illustrative, made up for this example, not a real quote. The counter posts 1 dollar = 0.90 euros.

Dollars into euros. 300 × 0.90 = 270 euros.
A euro price into dollars. A museum pass costs 45 euros, so 45 ÷ 0.90 = 50 dollars.

In words: at this rate the student's 300 dollars buy 270 euros, and a 45-euro pass costs her 50 dollars. She decides the pass is worth it.

Misconception check. Students often multiply when they should divide, because both moves use the same rate. That is tempting when you are working fast. The fix is to watch the units. The rate is euros per dollar, so dollars × (euros per dollar) gives euros, and euros ÷ (euros per dollar) gives dollars. If your answer comes out in a unit that makes no sense, you used the wrong move.

In practice (your tools). In Google Sheets, type a rate in A2, such as 0.90. Type a dollar amount in B2 and enter =B2*A2 in C2 to get the foreign amount. Type a foreign price in D2 and enter =D2/A2 in E2 to get its dollar price. Change A2 and watch both answers move.

Memory hook: dollars times the rate; foreign money divided by it.

2. Tell appreciation from depreciation

When the rate changes, you need a word for which way it went. The words come from your dollar's point of view.

Here is the course's illustrative exchange-rate chain, Dataset O, constructed for this course and not real data. The dollar goes from 100 yen to 120 yen.

An appreciation is a rise in a currency's value against another currency: after an appreciation of the dollar, one dollar buys more foreign currency than before, which makes the country's exports pricier abroad and its imports cheaper at home.
A depreciation is a fall in a currency's value against another currency: after a depreciation of the dollar, one dollar buys less foreign currency than before, which makes the country's exports cheaper abroad and its imports pricier at home.

Worked example — the size of the move. Dataset O, illustrative.

Before and after. e goes from 100 to 120 yen per dollar.
Extra yen per dollar. 120 − 100 = 20 more yen.
Percentage change. (120 − 100) ÷ 100 × 100 = 20 ÷ 100 × 100 = 20%.

In words: the dollar appreciated by 20%. A traveler with dollars now gets 20 more yen for each one.

The same move has a mirror. Each yen now buys fewer dollars than before, so the yen depreciated against the dollar. One rate, two currencies, two names, depending on whose side you stand on.

Misconception check. Students often say "the dollar went from 100 to 120 yen, so it got weaker." That is tempting, because a bigger number sometimes means a higher price, and a higher price can sound like a worse deal. But this number is how much a dollar buys. A dollar that buys 120 yen instead of 100 is worth more. A rise in yen per dollar is an appreciation of the dollar.

Memory hook: more yen per dollar is a stronger dollar, not a weaker one.

3. Follow the export link: pricier abroad

Now you follow one product across the border. A U.S. factory sells a car for 25,000 dollars. The factory keeps that price the whole time. A buyer in Japan, though, pays in yen, so the buyer's price depends on e.

Worked example — the car abroad. Dataset O, illustrative.

Before. 25,000 dollars × 100 = 2,500,000 yen.
After. 25,000 dollars × 120 = 3,000,000 yen.
The change. 3,000,000 − 2,500,000 = 500,000 yen more.

In words: the car's dollar price never moved, yet it costs a buyer in Japan 500,000 yen more. That is 3,000,000 versus 2,500,000 yen, a 1.2-fold price for the same car. Some buyers in Japan choose another car, so U.S. exports tend to fall.

Think back to the furniture maker. Her 12 chairs carry a dollar price she has not changed. After the dollar appreciates, her overseas buyer sees a higher price in his own money and may order from a closer maker. Her costs did not rise; only the exchange rate moved.

Misconception check. Students often think an appreciation is good news for exporters, because "strong" sounds like a win for everyone. But a stronger dollar makes every U.S. export cost more in foreign money. The furniture maker and the car factory both lose sales abroad. An appreciation helps buyers of imports, not sellers of exports.

Memory hook: strong dollar, pricey exports; cheap imports.

4. Follow the import link: cheaper at home, and net exports fall

Now you cross the border the other way. A factory in Japan sells a machine for 1,200,000 yen. A repair shop here pays in dollars, so the shop divides the yen price by e.

Worked example — the machine at home. Dataset O, illustrative.

Before. 1,200,000 yen ÷ 100 = 12,000 dollars.
After. 1,200,000 yen ÷ 120 = 10,000 dollars.
The change. 12,000 − 10,000 = 2,000 dollars less.

In words: the same machine now costs the shop 2,000 dollars less. The shop owner decides to buy the imported machine, and so do other buyers, so imports tend to rise.

Put the two links together, and you get the whole chain. Exports tend to fall and imports tend to rise. Net exports are X − IM, so a smaller X and a larger IM both pull NX down.

Worked example — the direction of net exports. Use the two links you computed above.

Exports. The car is pricier abroad, so X tends to fall.
Imports. The machine is cheaper at home, so IM tends to rise.
Net exports. NX = X − IM, so NX falls.

In words: after the dollar appreciates, net exports fall. Notice the word "tend," and keep it in your own answers. The chain tells you the direction; how far exports and imports move depends on how buyers respond.

Caveat: this chain holds other things equal. If foreign incomes boom in the same year, foreign buyers might buy more U.S. cars anyway. The exchange rate pushes; other forces can push back.

Misconception check. Students often follow one link and stop: "the dollar appreciated, so imports rose." That is half the chain. Net exports have two parts, and an appreciation moves both of them in the direction that lowers NX. Say both links, then say NX.

Memory hook: exports down, imports up; net exports down.

5. Run the chain backwards: depreciation flips every arrow

What if the dollar slides back? Suppose it goes from 120 yen to 100 yen. Each dollar now buys fewer yen, so the dollar has depreciated. Every arrow in the chain flips.

Worked example — the depreciation. Dataset O, run in reverse, illustrative.

The rate. e goes from 120 back to 100 yen per dollar, a depreciation.
The car abroad. 25,000 × 120 = 3,000,000 yen before; 25,000 × 100 = 2,500,000 yen after. Cheaper abroad, so exports tend to rise.
The machine at home. 1,200,000 ÷ 120 = 10,000 dollars before; 1,200,000 ÷ 100 = 12,000 dollars after. Pricier at home, so imports tend to fall.
Net exports. X tends to rise and IM tends to fall, so NX rises.

In words: a depreciation makes U.S. exports cheaper abroad and imports pricier at home, so net exports rise. The furniture maker smiles; the repair shop owner frowns.

The exchange-rate price chain in both directions (Dataset O, illustrative; prices in dollars and yen)
Link	Appreciation: 100 to 120 yen per dollar	Depreciation: 120 to 100 yen per dollar
The car abroad	2,500,000 to 3,000,000 yen	3,000,000 to 2,500,000 yen
Exports	Tend to fall	Tend to rise
The machine at home	12,000 to 10,000 dollars	10,000 to 12,000 dollars
Imports	Tend to rise	Tend to fall
Net exports	Fall	Rise

Read each row across, and you will see that every entry flips, not only the last one.

Misconception check. Students often flip the rate and the last step but leave a middle link alone, writing "the dollar depreciated, so imports got cheaper." That is tempting, because "cheaper imports" was the headline of the last section. But after a depreciation, a dollar buys fewer yen, so the yen price of the machine costs more dollars. Check each row on its own.

Memory hook: flip the rate; flip every arrow, not only one.

6. Carry the chain onto the AD–AS diagram

Now you bring back the diagram from Week 5. Real output Y runs along the horizontal axis. The price level P runs up the vertical axis. Aggregate demand slopes down, and short-run aggregate supply slopes up.

Net exports are one of the four parts of aggregate demand, along with consumption, investment, and government purchases. So when the exchange rate moves net exports, it changes spending at every price level. That shifts the whole aggregate demand curve.

Worked example — reading an appreciation on the diagram. Follow the shift in words; no new numbers are needed.

What changed. The dollar appreciated, so NX fell.
Name the curve. Aggregate demand.
Name the direction. Left, because spending on U.S. output fell at every price level.
Read P and Y. The economy walks down the short-run aggregate supply curve, so the price level and real output both fall.

In words: all else equal, an appreciation shifts aggregate demand left, so the price level and real output both fall. A depreciation does the reverse: aggregate demand shifts right, and both rise.

Honesty note: in a real economy the exchange rate rarely moves alone. The same force that moved the dollar, such as a change in interest rates, may also move investment. The diagram isolates one push at a time.

Misconception check. Students often draw an exchange-rate change as a movement along aggregate demand, because Week 5's exchange-rate effect also involved exports and imports. But that effect started with a change in the price level P, which moves you along the curve. Here P did not start the story; the currency market did. A change in anything other than P shifts the whole curve.

Memory hook: a rate change shifts AD; a price-level change slides along it.

7. Meet the foreign-exchange market

Who decides that a dollar buys 120 yen and not 100? Nobody decides it alone. The rate is a price, and like most prices it comes out of a market.

The foreign-exchange market is the market where currencies are traded for one another; buyers of a country's exports and assets demand its currency, and the country's buyers of imports and foreign assets supply it.

Think of it as two crowds, and ask which one you are in. One crowd wants dollars. A buyer in Japan who orders a U.S. car needs dollars to pay the factory. A family from abroad on vacation here needs dollars for hotels and meals. A saver abroad who buys a U.S. government bond, a share of a U.S. company, or a building here needs dollars too. All of them demand dollars.

The other crowd has dollars and wants foreign money. The repair shop that imports the machine must turn dollars into yen. The student heading abroad turns dollars into euros. A U.S. saver who buys shares in a foreign company needs that country's currency. All of them supply dollars.

Worked example — sorting four transactions. No numbers, only the direction.

A coffee roaster here imports green beans. It pays in foreign currency, so it supplies dollars.
A tour group from abroad visits a national park here. It needs dollars to pay, so it demands dollars.
A pension fund abroad buys U.S. bonds. It needs dollars to buy them, so it demands dollars.
A U.S. family pays rent for a semester abroad. It needs foreign currency, so it supplies dollars.

In words: anyone who wants to buy something priced in dollars demands dollars, and anyone here who wants to buy something priced in another currency supplies dollars.

A floating exchange rate is an exchange rate that is set in the foreign-exchange market by the demand for and supply of a currency, with no government holding it at a chosen level.
A fixed exchange rate is an exchange rate that a government or central bank commits to hold at a chosen level by buying or selling currency whenever market pressure pushes the rate away from it.

This course models the dollar with a floating rate. Under a floating rate, the rate settles where the demand for dollars meets the supply. If more people want dollars than are offered at 100 yen, the price of a dollar rises toward 120. A fixed rate works differently: the government or central bank stands ready to trade its currency at the chosen rate, and it must keep enough foreign currency on hand to do so.

Misconception check. Students often assume a government "sets" a floating rate by decree, the way a store sets a price tag. That is tempting, because news reports talk about the dollar as if someone moved it on purpose. But under a floating rate, the price comes out of a huge number of trades by buyers and sellers. Policy can push on the demand or the supply, through interest rates for example, but nobody writes the rate down.

Memory hook: buying here demands dollars; buying abroad supplies them.

8. Name the drivers of the dollar

If the rate comes from demand and supply, then anything that shifts either crowd moves the rate you pay. Economists name three drivers. Each one is a comparison between countries, which is why the word "relative" keeps appearing.

Relative interest rates. Savers go where their money earns more.

Worked example — a saver chooses a bond. These numbers are illustrative, made up for this example, not real rates. A saver in Japan can earn 2% a year on a bond at home or 5% a year on a U.S. bond of the same risk.

Compare. 5 − 2 = 3, so the U.S. bond's yearly rate is higher by three percentage points.
Decide. The saver buys the U.S. bond.
The currency step. To buy it, the saver needs dollars, so the demand for dollars rises.
The rate. More demand for dollars pushes e up, so the dollar tends to appreciate.

In words: higher U.S. interest rates attract foreign savers, who demand more dollars, so the dollar tends to appreciate. Connect that to Week 11. A contractionary move by the central bank raises U.S. interest rates, so it can also lift the dollar and lower net exports, which pushes aggregate demand the same way the rest of the chain does.

Relative inflation. If prices here rise faster than prices abroad, U.S. goods get dearer next to foreign goods. Foreign buyers want fewer U.S. goods, so they want fewer dollars, and U.S. buyers turn toward imports, so they supply more dollars. Faster U.S. inflation makes the dollar tend to depreciate.

Relative growth. When the U.S. economy grows faster than its trading partners, U.S. households earn more and buy more of everything, imports included. That supplies more dollars. Faster growth can also draw foreign investment toward U.S. firms, which demands more dollars. The two pulls run in opposite directions. Which one wins is a question for evidence, not a rule.

Limitation: these drivers say which way the rate tends to move, all else equal. Real currency markets also react to news and to what traders expect, and this course does not try to forecast any real rate.

Misconception check. Students often decide that higher interest rates here make the dollar weaker, because higher rates "cost more." That is tempting, because a higher rate is bad news for a borrower. But in the currency market the crowd that matters is savers. A higher return here pulls their money in, and to bring it in they must buy dollars.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of something you or your family bought that was made abroad. If the dollar depreciated, would you still buy it, switch to a product made here, or go without? What else would shape the choice?
(b) Think of a business or job near you that sells to customers in other countries, or that serves visitors from abroad. Which driver of the dollar would that business watch most closely, and why?

Memory hook: higher rates pull dollars in; faster inflation pushes them out.

9. Read the balance of payments: two accounts that mirror each other

Every dollar that leaves the country to buy an import ends up in someone's hands abroad. What do they do with it? They spend it on U.S. goods, or they use it to buy U.S. assets. The balance of payments is the record that tracks both.

The balance of payments is the record of all of a country's transactions with the rest of the world over a period, organized into the current account and the financial account.
The current account is the part of the balance of payments that records trade in goods and services together with international income and transfer flows; at the principles level it is mostly net exports.
The financial account is the part of the balance of payments that records purchases and sales of assets such as bonds, shares, and buildings across borders; a positive balance means a net inflow of foreign investment.

Start with something you know: a household budget. An illustrative household earns 50,000 dollars this year and spends 53,000 dollars (made-up numbers, not real data).

Worked example — a household's two accounts. Follow the household's year in three lines.

Its "current account." 50,000 − 53,000 = −3,000 dollars.
How it paid. It sold 3,000 dollars of shares, so its "financial account" is +3,000 dollars.
The sum. −3,000 + 3,000 = 0.

In words: the household spent 3,000 dollars more than it earned, and it covered the gap by selling assets. The money did not vanish; it was paid for, the same way the student at the airport counter paid for her euros.

A country works the same way, as you will see. Use the course's illustrative account from Week 2, Dataset A, constructed for this course and not real data, in billions of dollars.

Worked example — the country's balance of payments. Dataset A, illustrative.

Current account. CA = X − IM = 100 − 150 = −50, a current-account deficit of 50 billion dollars.
Financial account. FA = +50, a net inflow of 50 billion dollars of foreign investment.
The identity. CA + FA = −50 + 50 = 0.

In words: the country bought 50 billion dollars more from abroad than it sold, and foreign savers used those 50 billion dollars to buy U.S. assets. The current-account deficit is matched dollar for dollar by financial-account inflows.

A current-account deficit is a negative current-account balance, which arises when a country spends more abroad on goods, services, income, and transfers than it earns from abroad; at the principles level it is matched by an equal financial-account surplus.
An accounting identity is an equation that holds by the way the books are kept, whatever the economy does; it records what happened and passes no judgment on it. CA + FA = 0 is one.

Honesty note: in this illustrative account the current account equals net exports, because the account has no income or transfer flows. In real data those flows exist, so the current account and the trade balance differ a little. The identity still holds.

Misconception check. Students often read a current-account deficit as money that disappears from the country, like water down a drain. That is tempting, because "deficit" sounds like a loss. But every dollar spent on imports ends up with someone abroad, and it comes back as a purchase of U.S. bonds, shares, or buildings. The 50 billion dollars of deficit returns as 50 billion dollars of financial-account inflows.

Memory hook: out on the current account; back on the financial account.

10. Weigh the strong dollar and the deficit: two views at full strength

So is a strong dollar with a current-account deficit good or bad? Here the course stops computing and starts weighing. Both sides accept the price chain and the identity you learned in this chapter. They disagree about what the numbers mean and about whose interests count most.

The first view: a strong dollar and a lasting deficit are a problem. A strong dollar makes U.S. exports pricier abroad, so exporters like the furniture maker lose sales. Workers in industries that compete with imports lose ground too, because imports get cheaper. And a deficit that lasts year after year means foreign savers own a growing share of U.S. assets. The returns on those assets, such as interest and profits, are paid abroad in future years, so more future income flows out.

The second view: a strong dollar and a deficit can be a sign of strength. A strong dollar raises what households' dollars can buy abroad, so the student and the repair shop owner gain. It also cheapens imported parts that U.S. producers use. And the financial-account inflows pay for investment here: foreign savers buy U.S. bonds and shares because they want to invest here, and that money can fund new factories, offices, and homes.

Now you separate the two kinds of claims, as the course asks you to every week.

Positive and normative claims in the debate over a strong dollar and a current-account deficit
Claim	Kind	Which view leans on it
An appreciation makes exports pricier abroad and imports cheaper at home.	Positive, agreed by both	Both
The current account and the financial account sum to zero.	Positive, an accounting identity	Both
A lasting deficit raises the income paid abroad in future years.	Positive, disputed size	First view
Foreign inflows mostly fund productive investment here.	Positive, disputed evidence	Second view
Protecting jobs in exporting industries should come first.	Normative	First view
Cheaper goods for households should come first.	Normative	Second view

Notice that the first two rows are not up for debate. The disagreement lives in how big the effects are, which is a question for evidence, and in whose gains or losses to weigh most, which is a question of values. This course gives you both views and leaves the verdict to the evidence and your own values.

Misconception check. Students often decide that a deficit is a scorecard, so a country with a deficit is "losing" to its trading partners. That is tempting, because sports and business both keep score. But the identity says the deficit is matched by inflows, and whether those inflows are a strength or a worry depends on how big the effects are and on what you value. A strong answer names the agreed ground first, then states each view's best case, then labels which parts are positive and which are normative.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Write the strongest one-sentence case that a strong dollar is a problem, then the strongest one-sentence case that it is a strength, and label the normative part of each.
(b) Name one piece of evidence that would move you toward one view, and say whether that evidence is positive or normative.

Memory hook: same identity; different readings, different values.

Key terms

exchange rate — The price of one currency expressed in another; this course writes it as the amount of foreign currency one dollar buys, so 1 dollar = 120 yen means a dollar buys 120 yen. (first used: 1. Read an exchange rate: the price of one currency in another)
appreciation — A rise in a currency's value against another currency: after an appreciation of the dollar, one dollar buys more foreign currency than before, which makes the country's exports pricier abroad and its imports cheaper at home. (first used: 2. Tell appreciation from depreciation)
depreciation — A fall in a currency's value against another currency: after a depreciation of the dollar, one dollar buys less foreign currency than before, which makes the country's exports cheaper abroad and its imports pricier at home. (first used: 2. Tell appreciation from depreciation)
foreign-exchange market — The market where currencies are traded for one another; buyers of a country's exports and assets demand its currency, and the country's buyers of imports and foreign assets supply it. (first used: 7. Meet the foreign-exchange market)
floating exchange rate — An exchange rate that is set in the foreign-exchange market by the demand for and supply of a currency, with no government holding it at a chosen level. (first used: 7. Meet the foreign-exchange market)
fixed exchange rate — An exchange rate that a government or central bank commits to hold at a chosen level by buying or selling currency whenever market pressure pushes the rate away from it. (first used: 7. Meet the foreign-exchange market)
balance of payments — The record of all of a country's transactions with the rest of the world over a period, organized into the current account and the financial account. (first used: 9. Read the balance of payments: two accounts that mirror each other)
current account — The part of the balance of payments that records trade in goods and services together with international income and transfer flows; at the principles level it is mostly net exports. (first used: 9. Read the balance of payments: two accounts that mirror each other)
financial account — The part of the balance of payments that records purchases and sales of assets such as bonds, shares, and buildings across borders; a positive balance means a net inflow of foreign investment. (first used: 9. Read the balance of payments: two accounts that mirror each other)
current-account deficit — A negative current-account balance, which arises when a country spends more abroad on goods, services, income, and transfers than it earns from abroad; at the principles level it is matched by an equal financial-account surplus. (first used: 9. Read the balance of payments: two accounts that mirror each other)
accounting identity — An equation that holds by the way the books are kept, whatever the economy does; it records what happened and passes no judgment on it. (first used: 9. Read the balance of payments: two accounts that mirror each other)

Summary

An exchange rate is the price of one currency in another, quoted here as the foreign money one dollar buys.
To turn dollars into foreign money, multiply by the rate; to turn foreign money into dollars, divide.
More foreign money per dollar is an appreciation; less is a depreciation.
An appreciation makes exports pricier abroad and imports cheaper at home, so net exports fall.
A depreciation flips every arrow, so net exports rise.
An exchange-rate change shifts aggregate demand, moving the price level and real output together.
Buyers of U.S. goods and assets demand dollars; U.S. buyers of foreign goods and assets supply them.
Relative interest rates, relative inflation, and relative growth drive a floating rate.
The current account and the financial account sum to zero; a deficit is matched by inflows.
Whether a strong dollar is a problem is partly evidence and partly values.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

In an illustrative example (not a real quote), the dollar goes from 1 dollar = 20 pesos to 1 dollar = 16 pesos. Is that an appreciation or a depreciation of the dollar? Find the percentage change in pesos per dollar, and find the peso price of a U.S. backpack priced at 50 dollars before and after.
In an illustrative example (not a real quote), a guitar made abroad is priced at 900 euros. The dollar goes from 1 dollar = 0.75 euros to 1 dollar = 0.80 euros. Find the guitar's dollar price before and after, name the move, and say what tends to happen to imports.
Sort each transaction as demanding dollars or supplying dollars: (a) a bakery here imports chocolate from abroad; (b) a family from abroad books a ski trip here; (c) an insurance company abroad buys shares in a U.S. firm; (d) a U.S. retiree buys an apartment abroad.
In an illustrative island economy (not real data), exports are 80 and imports are 110, in billions of dollars, and there are no income or transfer flows. Find the current account and the financial account. A classmate says the deficit means 30 billion dollars "left the country for good." Explain what is wrong.

Answers (worked reasoning — read after attempting)

A dollar now buys 16 pesos instead of 20, which is fewer pesos, so the dollar depreciated. The percentage change is (16 − 20) ÷ 20 × 100 = −4 ÷ 20 × 100 = −20%. The backpack costs 50 × 20 = 1,000 pesos before and 50 × 16 = 800 pesos after. It is cheaper abroad, so U.S. exports of backpacks tend to rise. Reading "16 is smaller, so it got cheaper, so the dollar strengthened" mixes up the price of the backpack with the price of the dollar.
Before: 900 ÷ 0.75 = 1,200 dollars. After: 900 ÷ 0.80 = 1,125 dollars, which is 1,200 − 1,125 = 75 dollars less. A dollar buys more euros, so the dollar appreciated, and the import got cheaper at home, so imports tend to rise. Multiplying 900 by the rate would give euros times euros per dollar, a unit that makes no sense, which is the sign you needed to divide.
(a) Supplies dollars: the bakery turns dollars into foreign currency to pay for the chocolate. (b) Demands dollars: the family needs dollars to pay for the trip. (c) Demands dollars: the shares are priced in dollars. (d) Supplies dollars: the retiree turns dollars into foreign currency to buy the apartment.
The current account is CA = 80 − 110 = −30 billion dollars. The identity CA + FA = 0 means FA = +30 billion dollars, a net inflow of foreign investment. The classmate is wrong because the 30 billion dollars spent on imports beyond export earnings came back: people abroad used those dollars to buy the island's bonds, shares, or buildings. The deficit is matched by inflows; it is recorded, not lost.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the Keynesian model and the classical model meet side by side on the policy questions this course has raised.

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