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).


Before discussing macroeconomic models we must define what we mean by money. Money has a long and interesting history and an understanding of how we came to use money is useful for any macroeconomist. Unfortunately, there is not enough space to describe how money was “invented” and how it evolved over time. There are, however, many excellent descriptions on the Internet.

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.

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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