Unit 6 Overview: Open Economy-International Trade and Finance

You’ve made it to the last and final unit of AP Macroeconomics! 👊 Take a moment to embrace that feeling because we are heading on a trip around the world! 🌎 Sadly, I’m just kidding! There will be no physical trip around the world, but we are going to explore the world of International Trade and Finance, which is a close second! This look at the open economy can be challenging, but rest assured that a slow and steady approach will make you an expert in International Trade and Finance in no time 🕕

This unit begins with an overview of the Balance of Payments Accounts 📋, which at first glance may seem a bit daunting. However, you’ll quickly learn a few rules of thumb to help you keep the Current Account and the Capital Account straight. The Current Account includes net exports (our friend from GDP), net investments, and net transfers. Essentially trade, interest and dividends, and economic aid or grants. The Capital account includes investments, both financial and real (actual land and businesses).

Any time money flows into an economy you add to it, and when it flows out (you guessed it) you subtract it! With a little practice, you’ll be quick to assign transactions to the capital or current account. The coolest thing about these two accounts is that if you add them together—they will always equal 0! 

Next, let’s move on to exchange rates. These are the prices of currency in terms of other currencies. For example, how many Euros 💶 will a US Dollar 💵 cost? As exchange rates go up (known as appreciation), currency is more expensive and so are goods and services from that country.

As exchange rates go down (known as depreciation), currency gets cheaper, as do goods and services from that country. In today’s ever changing world, exchange rates adjust by the second and the trade of foreign currency has become an economic venture for many people 💹

The Foreign Exchange Market (also referred to as FOREX) exchanges all that currency. The basics of the FOREX market are much like the other markets you’ve already studied—an upward sloping supply curve that meets a downward sloping demand curve at a point that establishes the market equilibrium. The big difference is the way the axes are labeled and this is often the most confusing part of this topic, but it’s actually quite simple!

The easy part is the x-axis labeled with the quantity of one currency. The y-axis is the second currency over the currency found on the x-axis. And that’s it! Wasn’t too bad, was it? After we have the basics of the market graph down, we can explore the factors that will shift these curves and create changes in the FOREX market. 

Several years ago, a chain reaction began when Great Britain exited the European Union. Brexit, as it was called, affected economies all over the world! But, why did it do that? Why was this decision thousands of miles away lowering mortgage rates across the United States? As you probably already know, globalization is in full force in our modern world which means everything connects to everything else! Changes in one place can affect other places through the foreign exchange market.

These changes can be as simple as a rise in tourism somewhere and as complex as fiscal policies enacted by governments. Monetary policy can also influence the economy and therefore exchange rates. Not only do these things affect the foreign exchange market, but that in turn impacts other economic indicators - most notably GDP. 

Even though we learned about GDP a long time ago, you surely remember that the formula is C + G + I + Nx. And, of course, that Nx stands for net exports 🚢 That’s our connection back to this unit. All of this trade (both foreign exchange and goods/services) directly affects our GDP! The more we export, the higher our GDP. 

As mentioned earlier, monetary policy includes influencing the interest rate. When real interest rates differ from place to place, the flow of financial capital is affected. The higher the interest rate, the more financial capital will flow into that country 🔁 

Don’t be fooled by this unit’s placement at the end of the macroeconomics curriculum. It includes crucial concepts that will definitely 💯 be on your AP exam and, more importantly, will help you understand our world even better. These concepts also connect to comparative advantage from Unit 1. Making connections between these topics is the key 🔑 to cementing these in your economics mind!