BOP Flashcards
Distinguish between indirect + direct quotation
Indirect = cost of domestic currency expressed in units of foreign
Direct = cost of foreign currency expressed in units of domestic
Appreciation
Currency becomes more valuable
Depreciation
Currency becomes less valuable
What’re the categories that affect the forex market?
Real flows (trade in goods + services, e.g. exports + imports)
Financial flows (trade on capital markets, e.g. FDI, foreign aid)
What’re the different types of ER?
Floating (determined by market force)
Fixed (set by central bank)
Managed (dirty) float (ER allowed to float freely within predetermined band but central bank intervenes to prevent from leaving)
Nominal (domestic currency expressed as foreign)
Real (the rate at which one country’s goods can be traded for another country’s goods)
Effective ER (Bilateral/multilateral) (price of one currency/price of a basket of currencies)
Spot (exchange takes place today)
Forward (exchange takes place in future (at ER agreed today))
Give the pro’s and cons of floating ER
Floating (P): can freely respond to changes in economy
Floating (C): can be very volatile (ER risk)
Give the pro’s and con’s of forward ERs
P: useful in eliminating ER risk
C: requires to pay a premium
What are the 2 main theories of ERs?
Purchasing Power Parity (PPP) > more LT
Uncovered Interest Parity (UIP) > ST
What is the ‘law of one price’?
The same good should cost the same in all countries when cost is expressed in a single currency
What are the problems of the ‘law of one price’?
A good available in one country might not be available in the other
Balance of Payments
A record of a country’s transactions with the rest of the world
What are the 2 main parts of the BoP and explain
Current account - records international flows of goods/services + income + transfer payments
Capital + financial accounts - records transactions involving a change in the ownership of assets
Describe Adam Smith’s theory of trade (absolute advantage)
1 region has an absolute advantage (AA) over another in prod. of good X when equal Q of resources can produce more of good X in 1st region than in 2nd (lower COP)
Total prod. can be increased if each country specialises in producing the product for which it has an absolute advantage (gains from specialisation > gains from trade)
Countries then import between goods they specialise in
Opportunity cost
How much of one good we have to give up to produce 1 more unit of the other good
Comparative advantage
Lower opportunity cost to produce a good in one country in comparison to producing the same good in another region
Terms of Trade (TOT) + how would this look on a diagram?
The ratio of the P of goods exported to those imported > determines the Q of imports that can be obtained per unit of exports
On diagram, it’s the slope of the International Trade Line
Formula for TOT?
Px/Pm * 100
Give the pro’s and con’s of the fixed ER
Pros: anchors (stabilises) expectations, eliminates ER risk (promotes trade, eases borrowing abroad)
Cons: may be misaligned with state of economy (not appropriate parity > equality)
