6. Exchange Rates, International Trade, and Capital Flows
j. explain the effects of exchange rates on countries' international trade and capital flows.
What are the two approaches to analyze the impact of the exchange rate on trade and capital flows?
- The elasticities approach - emphasizes price changes as a determinant of a country's balance of payments and exchange rate.
- The absorption approach - assumes that prices remain constant and emphasizes changes in real domestic income
Why is the exchange rate an important price in an economy?
When a country's currency depreciates, domestic goods become relatively cheaper and foreign goods relatively more expensive in the global market. Hence, we would expect exports to rise and imports to decline.