1-3 Exchange Rates Flashcards
Give examples of exchange rate regimes
- Hard pegs (no separate legal tender)
- Soft pegs (can be against basket eg Botswana, stabilised arrangement, or w horizontal bands, crawling, crawl-like)
- Floating regimes (free floating w limited moderation or floating w more intervention)
- Residual - other management
The trilemma says that three policy goals can’t be accomplished at the same time. These are …
- Fixed exchange rate
- International capital mobility
- Monetary policy autonomy
What is money?
A store of value
A unit of account
A medium of exchange
The forward exchange rate is …
the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor.
What determines the exchange rate between currencies?
This has proven to be a very difficult question to answer.
Approaches include:
- Balance of payments
- International parity conditions
- Monetary approach
- Asset market approach
- Technical analysis
- Efficient market approach
Equilibrium in the Forex Market
Tba
Riskless interest arbitrage leads to the CIP condition which is …
Covered Interest Parity
i.e. the direct dollar return or dollar deposits must equal the dollar return on euro deposits, where forward contracts are used to cover risk - The forward rate is determined by home and foreign interest rates and the spot exchange rate
What are do the quoting conventions around currency mean i.e.: Direct, indirect Bid, ask/offer, dealers spread Spot, forward, cross
Direct: # of unit of home to 1 unit foreign
Indirect: # of units of foreign to 1 unit of home dealer will sell at ask/offer and buy at bid: difference is the spread (size based on depth and stability)
Spot is rate quoted for today
Forward is rare quoted for future
Cross is implied from the spot rate on two against a third currency
What formula is this and what is it’s significance?
•Purchasing Power Parity (PPP) states that all identical goods sold in different markets should sell for the same price when quoted in a common currency.
S = Exchange Rate
P1 and P2 = the price levels of the standard consumption basket (the price level) in the country of the quoted and base currencies respectively.
This is Law of One Price in aggregate
The Fisher effect …
… makes clear the link between inflation and interest rates
… tells us that the nominal interest rate I must fall because it is a decreasing function of i; the general model of money demand then tells us L(I) must fall because it is a decreasing function of I. Predicts the change in the opportunity cost of money is equal to the nominal interest rate and change in inflation rate.
People should reduce their money holdings in times of inflation.
What are the factors causing shift in foreign exchange demand and supply curves?
- Levels of domestics income 2. Changes in foreign income levels 3. Interest rate differentials 4. Expectations 5. Exogenous factors e.g. military commitment that will cause spending to rise
What are the elements of equilibrium in FX?
The supply curve, SS, for the domestic currency and its demand curve, DD, intersect at R0, the equilibrium exchange rate/
The demand and supply of the domestic currency, D, (and the foreign currency, F) at the equilibrium rate, is the quantity, Q0.
What do demand and supply of a currency depend on?
Demand: - value of exports - inflows of remittances, pensions, funds - govt and private Supply: - value of exports - Outflows of remittances, pensions, govt and private funds
The Asset Approach and the Monetary Approach are together …
A more complete theory of exchange rates that could long-run and short-run approaches
Risky interest arbitrage leads to the UIP which is …
Uncovered Interest Parity - when spot contracts are used and exchange risk is not covered, the dollar return on dollar deposits must equal the expected dollar return on euro deposits - UIP explains how the spot rate is determined by home and foreign interest rates and expected future spot rate
What formula is this and what is it’s significance?
Relative PPP states that the rate of change in prices between two countries over a period of time determines the rate of change of the exchange rate over that periodso that purchasing power remains unchanged
where eis the expected rate of change in the exchange rate (E(S t)/ S 0 - 1)
The International Fisher Effect (IFE) formula for the expected spot rate also yields …
Uncovered Interest Rate Parity (UIRP)
This parity is also derived from an arbitrage condition that the expected costfrom borrowing in the domestic currency should be equivalent to borrowing locally and investing in the foreign currency uncovered
Relative PPP
States that the rate of change in prices between two countries over a period of time determines the rate of change of the exchange rate over that periodso that purchasing power remains unchanged.
What’s the relationship between Absolute and Relative PPP?
Relative PPP is an economic theory which predicts a relationship between the inflation rates of two countries over a specified period and the movement in the exchange rate between their two currencies over the same period. It is a dynamic version of the absolute purchasing power parity theory.
If absolute PPP holds, then relative PPP must also hold; BUT, if relative PPP holds, absolute PPP does not have to hold.
What’s the ‘real’ exchange rate? i.e. (qt)
And what do deviaitions from PPP imply about competitiveness?
The real exchange rate (qt) measures deviations from PPP.
•If PPP holds, q_t = 1.
Deviations from PPP have implications for the competitiveness of a country in international trade.
- If qt < 1, competitiveness of the country of the quoted currency improves.
- If qt > 1, competitiveness of the country of the quoted currency worsens.
Covered interest rate parity (CIRP) says that the forward rate is equal to the spot rate adjusted for the interest rate differential between the two countries. It should hold if what two factors are present?
- Markets are efficient
- There are no government controls to prevent arbitrage.
