Introduction

So far, this book has treated the economy as a closed economy -- one with no economic links to the rest of the world -- purely to keep the analysis simple. In reality, almost every modern economy is open, connected to other economies through three channels: the output market (trading goods and services, so consumers and producers can choose between domestic and foreign goods), the financial market (buying and selling financial assets across borders), and the labour market (though immigration laws heavily restrict this one, unlike the movement of goods). This chapter focuses mainly on the first two.

Foreign trade affects a country's aggregate demand in two opposite ways: when residents buy foreign goods, that spending leaks out of the domestic circular flow of income, reducing domestic aggregate demand; when foreigners buy domestic exports, that spending is injected into the circular flow, raising it.

Cross-border transactions also raise a practical problem -- there is no single global currency, so a national currency is only accepted abroad if people trust that its purchasing power will stay reasonably stable. Historically, governments built this trust by promising free, fixed-price convertibility of their currency into another asset -- often gold, or another country's currency. What matters for that promise is both the ability to convert freely and the price at which the conversion happens, ideas this chapter returns to when it discusses the exchange rate in detail.