MOD.

1: BASIC CONCEPTS
1 OPEN ECONOMY
Thinking about an open economy, we have to think about the economy of a country trading
with other foreign economies.

2 BALANCE OF PAYMENTS
The balance of payments is an accounting device that is used to record all the transactions of
goods and financial flows with the rest of the world. In particular, there are two components
that we are going to analyze in deep:

- Current account (CA): It is a record of all the transactions of goods and services.
- Capital account (KA): It is a record of all financial transactions.

The key principle we have to bare in mind is that whenever we record an entry in the current
account, we have to record an entry in the capital account. DOUBLE-ENTRY BOOK-KEEPING

In other words, whenever we have a transaction of a country with a foreign country (Spain
sells a car to China), at the same time there is a financial transaction from the foreign country
to ours (China pays the car to Spain).

Trade flows (goods and services) and capital flows (financial) are related to each other.

2.1
EXAMPLE VIDEO
IMPLICATIONS OF BALANCE OF PAYMENTS
A country with:
- Current account DEFICIT is reducing its foreign assets (increasing its debt) with the rest of
the world. (Imports > Exports)
- Current account SURPLUS is increasing its foreign assets (reducing its debt) with the rest
of the world. (Exports > Imports)
If we have large trade imbalances, our country might be subject to instability. Debt with
foreigners keep increasing.

3 EXCHANGE RATES
The exchange rate allows us to have a common unit of measure.

3.1.1 NOMINAL EXCHANGE RATE (E)

It is the price of domestic currency in terms of foreign currency. It indicates what is the value
of one unit of the domestic currency in terms of the foreign currency.

If E increases, Nominal Exchange Rate appreciates. Our currency is becoming more expensive.
If E decreases, Nominal Exchange Rate depreciates. Our currency is becoming cheaper.

3.1.2 REAL EXCHANGE RATE (ε)

It is the price of domestic goods in terms of foreign goods.

P×E
ε= ¿
P
where:
- P is the price of domestic goods in domestic currency.
¿
- P is the price of foreign goods in foreign currency.
- E is the nominal exchange rate.
- P × E is the price of domestic goods expressed in foreign currency.

If ε increases, real exchange rate appreciates.

If ε decreases, real exchange rate depreciates.

Example:

P= 10 P*=15 E=1.2

Ε=10*1.2/15=0.8; This means that we need 0.8 foreign cars to buy one domestic car. Domestic
cars are cheaper than foreign car, we need less than one foreign car to buy one domestic car.
Domestic cars are 20% cheaper than foreign cars.