Macroeconomics

The exchange rate is defined as the price of one unit of currency in terms of another currency. If one euro costs 1.5 USD then 1 USD costs 1/1.5 = 0.667 euro. If the exchange rate is stated in terms of the euro (for example, 1.5 USD/euro) then the euro is called the base currency or the unit currency.

Prices and price level

Price level

Prices are of great importance in macroeconomics as indeed they are in microeconomics. However, in microeconomics we are more interested in prices of individual goods and services and such prices are rarely important for the economy as a whole although there are exceptions (for example, the price of oil).

When you borrow money, you usually have to pay a fee for the loan. This fee is often called interest, particularly if the fee is proportional to the amount you borrow. The interest rate is commonly expressed as a percentage of the size of the loan per unit of time, typically per year.

If the interest rate is 10% per year, you must, for example, pay 1,000 per year if you borrow 10,000. The interest rate may be fixed or floating. If it is fixed, you will pay the same percentage for the entire duration of the loan. With a floating interest rate, the interest rate will change regularly depending on market conditions.

The open economy

So far, our model for exchange rate determination has been very simple. We have assumed that domestic interest rates are unaffected by foreign interest rates. We begin this chapter by looking more carefully at this assumption (the classical model of exchange rate determination). Then, a more realistic model of exchange rate determination is considered.

Finally, we will discuss the Mundell- Fleming model (MF-model).

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