C.5 The Global Financial System and Exchange Rates Flashcards
Open economy
An economy in which households, firms, and govt’s borrow, lend, and trade internationally
Balance of payments
A record of a country’s trade with other countries in goods, services, and assets
Current account
The part of the balance of payments that records a country’s net exports, net factor payments, and net transfers
Financial account
The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country
Net exports
Imports - exports
Net factor payments
Investment and employment income received - paid
Transfers
transfer payments by Canadian residents to international residents - transfer payments to Canadian residents from international residents
A current account surplus indicates that…
A country is consuming less than its current income, so it must be lending to the rest of the world or buying assets from the rest of the word
Foreign direct investment
Investment into productions or firms by foreigners, either by setting up or expanding firms or by purchasing companies
Foreign portfolio investment
The purchase of financial assets, such as stocks or bonds, by foreigners
Financial account equation
Increase in foreign holdings of Canadian assets - Increase in Canadian holdings of foreign assets
Statistical discrepancy
The amount that differs between the sum of the current and financial accounts
Capital account
Records minor transactions like
1) migrants’ transfers
2) sales and purchases of non-produced, non-financial assets, which include copyright, patents, trademarks, or rights to natural resources
Nominal exchange rate
The price of one country’s current in terms of another country’s currency
Spot exchange rate
The current price of one country’s currency for another currency, for immediate exchange
Current depreciation
A decrease in the market value of one country’s currency relative to another country’s currency, when the exchange rate is flexible
Forward exchange rate
The exchange rate used to exchange currencies in the future
Multilateral exchange rate
An index in which the value of the currency is measured against the average of the country’s main trading partners
Real exchange rate
The rate at which the goods and services in one country can be exchanged for goods and services in another country
Real exchange rate eq’n
e = E*(P/P*) where, e = Real real exchange rate E = Nominal exchange rate P = Domestic price level P* = Foreign price level
Real means in terms of…
… goods and services
Exchange rate system
An arrangement among countries about how exchange rates should be determined
Fixed exchange rate system
A system in which exchange rates are set at levels determined and maintained by government or central bank
Managed floating exchange rate system
A system in which private buyers and sellers in the foreign exchange market determine the value of currencies most of the time, with occasional central bank intervention
Sources of demand for Canadian dollars
- Foreign demand for Cad’n goods and services
- Foreign demand for Cad’n physical assets
- Foreign demand for Cad’n paper assets
How the nominal exchange rate affect the three sources of demand
- Foreign demand for Cad’n goods and services depends negatively on real exchange rate
- Foreign demand for Cad’n physical assets or claims on physical assets or claims on physical assets depends negatively on the real exchange rate
- Foreign demand for Cad’n paper assets depends negatively on the nominal exchange rate
% return on foreign bonds eq’n
[(E^e_+1)(1 + i*) - E]/E where, E^e_+1 = expected nominal exchange rate one year from now E = nominal exchange rate i* = interest rate
Arbitrage
Taking advantage of price differences across markets by buying a product in one market and reselling int another markets at a higher price
What is the basic rule for the demand & supply curves of the Cad’n dollar
Anything that makes Cad’n goods, services, or assets more attractive relative to foreign ones shifts the demand curve to the right and the supply curve to the left
A lower nominal Cad’n exchange rate relative to another foreign price makes Cad’n products more…
Appealing
Interest rate spread
Difference between Cad’n and foreign interest rates
A higher Cad’n interest rate (or a lower foreign interest rate) makes Cad’n procuts more….
Appealing
A shift in demand for Cad’n goods and services with shift the demand curve ____ and the supply curve ____
- right
2. left
If the nominal exchange rate exceeds the equilibrium exchange rate E*, then there is _____ supply and the Cad’n dollar _____
- excess
2. depreciates
If traders expect the Cad’n interest rate to rise, this increases the _____ for the Cad’n dollar which causes an immediate ______ of the Cad’n dollar
- demand
2. appreciation
Currency revaluation
An increase in the market value of one country’s currency relative to another country’s currency when the exchange is fixed
Currency devaluation
A decrease in the market value of one country’s currency relative to another country’s currency when the exchange rate is fixed
How does the central bank control the exchange rate with a fixed exchange rate?
By buying and selling the country’s currency on the foreign exchange market, using or acquiring foreign currency reserves
A pressure to appreciate in a fixed exchange rate means that there was excess ______ for the currency. The central bank will prevent appreciation by increasing the _____ which _______ the exchange rate
- demand
- supply
- stabilizes
The down side of an increase in the amount of currency leads to higher _______ and higher ______
- money supply
2. inflation
Currency overvaluation
Overvaluation is a situation in which, at the current exchange rate, the real exchange rate is higher than one
If a currency is overvalued then the _____ ___ is higher than the currency they’re fixed to
higher
Three reasons a currency might be devalued
- Political instability
- Overvaluation
- Investor sentiment that the currency was likely to be devalued
Law of one price
The notion that identical products should sell for the same price everywhere, including in different countries, as long as they are freely tradeable
Advantage of fixed exchange rate system
Easier for businesses to plan and to borrow in other currencies
Disadvantages of fixed exchange rate system
Difficult to maintain
Eliminates possibility of depreciation during a recession
Advantages of floating exchange rate system
No need for gov’t intervention
Allows exchange rate to reflect demand and supply in the market
Disadvantage of floating exchange rate system
Can make business planning difficult
Disadvantages of managed float exchange rate system
Central bank interventions are likely to be ineffective with a widely traded currency
Interventions are effective against short-run pressures but not against fundamental trends
Advantage of managed float exchange rate system
Allows greater exchange rate stability than in a floating system
Purchasing Power Parity (PPP)
The theory that, in the long run, nominal exchange rates adjust to equalize the purchasing power of different currencies
PPP states that, in the long run, the nominal exchange rate should adjust to…
adjust to purchasing power of different currencies so the real interest rate equals 1
if PPP holds, the % change in the nominal exchange rate is equal to the difference between the ____ and _____ inflation rates
domestic and foreign
Three reasons PPP does not hold
- not all goods and services are traded internationally
- Countries impose barriers to trade like tariffs and quotas
- Arbitrage is hampered by transportation costs
Interest parity condition
The proposition that differences in interest rates on similar bonds in different countries reflect investors’ expectations of future changes in exchange rates
Interest parity condition equation
i = i* - (E^e_+1 - E)/E where, i = domestic interest rate i* = foreign interest rate E^e_+1 = the expected nominal interest rate one year from now
Differences in in interest rates on bonds depend on
1.
2.
- investors typically see even similar bonds having important differences in liquidity and and default risk
- the transaction costs of purchasing foreign financial assets are higher than for domestic assets
Saving = S = ?
S = S_Households + S_Gov’t + S_Foreign
S_Households is (def’n and eq’n)
Def’n: Funds households have left from their incomes (including transfer payments received from the gov’t)
Eq’n: (Y + TR - T) - C
S_gov’t is
Def’n: The difference between the gov’t’s tax receipts and its spending on goods and services and on transfer payments to households
Eq’n: T - (G + TR)
S_foreign
Def’n: Saving from the foreign sector is (-1)*net exports
Eq’n: -NX
Basic national income eq’n
Y = C + I + G - NX
where,
Y = national income
C = consumption expenditure
I = investment expenditure on capital goods
G = gov’t purchases of goods and services
NX = net exports
The supply of loanable funds is determined by
- The willingness of households to save
- The extend of gov’t saving
- the extent of foreign saving that is invested in Cad’n financial markets
The demand of loanable funds is determined by
The willingness of firms to borrow money to engage in new investment projects (e.g. new factories or carrying out reasearch or new houses)
A change in a variable that affects the willingness to demand or supply funds will ______ the curves
shift
When the gov’t runs a budget deficit, the _____ of loanable funds ….
Supply
Shifts to the left
Crowding out
The reduction in private investment that results from an increase in gov’t purchases
A small open economy’s domestic real interest rate equals
the world interest rate
In a small open economy where L^s>L^d, the domestic desired ______ exceeds domestic desired ______
- lending
2. borrowing
