A FIRST THEORY OF EXCHANGE RATE DETERMINATION: PURCHASING-POWER PARITY
The purpose of this chapter has been to develop some basic concepts that macro-economists use to study open economies. You should now understand how a nation’s trade balance is related to the international flow of capital and how national saving can differ from domestic investment in an open economy. You should understand that when a nation is running a trade surplus, it must be sending capital abroad, and that when it is running a trade deficit, it must be experiencing a capital inflow. You should also understand the meaning of the nominal and real exchange rates, as well as the implications and limitations of purchasing power parity as a theory of how exchange rates are determined.
The macroeconomic variables defamed here offer a starting point for analyzing an open economy’s interactions with the rest of the world. In the next chapter, we develop a model that can explain what determines these variables. We can then discuss how various events and policies affect a country’s trade balance and the rate at which nations make exchange order markets.