An open economy has important trade and financial links with other countries.

The foreign exchange (forex) market exchanges one national currency for another. The price at which the two currencies exchange is the exchange rate.

The international value of the domestic currency is the quantity of foreign currency per unit of the domestic currency. The domestic price of foreign exchange is the quantity of domestic currency per unit of the foreign currency.

A country’s effective exchange rate is an average of its exchange rate against all its trade partners, weighted by the relative size of trade with each country.

The effective exchange rate is a weighted average of individual bilateral exchange rates.

The pound appreciates when the $/£ exchange rate rises. The international value of sterling rises. The pound depreciates when the $/£ exchange rate falls. The international value of sterling falls.

An exchange rate regime describes how governments allow exchange rates to be determined.

In a fixed exchange rate regime, governments maintain the convertibility of their currency at a fixed exchange rate. A currency is convertible if the central bank will buy or sell as much of the currency as people wish to trade at the fixed exchange rate.

The foreign exchange reserves are foreign currency held by the domestic central bank.

The central bank intervenes in the forex market when it is forced to buy or sell pounds to support the fixed exchange rate.

In a fixed exchange rate regime, a devaluation (revaluation) is a fall (rise) in the exchange rate.

In a floating exchange rate regime, the exchange rate is allowed to find its equilibrium level without central bank invervention using the forex reserves.

The balance of payments records transactions between residents of one country and the rest of the world.

The current account of the balance of payments records international flows of goods, services and transfer payments.

The capital account of the balance of payments records the international purchases and sales of financial assets.

The financial account of the balance of payments records international purchases and sales of financial assets.

The balance of payments is the sum of current account, capital and financial account items.

The real exchange rate is the relative price of goods from different countries when measured in a common currency.

The purchasing power parity (PPP) exchange rate path is the path of the nominal exchange rate that maintains a constant real exchange rate.

Perfect capital mobility means that a vast quantity of funds flow from one currency to another if the expected return on assets differs across currencies.

Foreign direct investment (FDI) is the purchase of foreign firms or the establishment of foreign subsidiaries.

Speculation is the purchase of an asset for subsequent resale, in the belief that the total return – interest plus capital gain – exceeds the total return on other assets.

Interest parity means that expected exchange rate changes offset the interest differential between domestic and foreign currency assets.

A country is in internal balance when aggregate demand equals potential output.

A country in external balance has a zero current account balance.

Simultaneous internal and external balance is the long-run equilibrium of the economy.