Ch. 17: Exchange Rates and International Economic Policy Flashcards
What are the 2 types of exchange rate transactions?
- Spot transaction : Effects the immediate. 2 day exchange of bank deposits
- Spot transaction rate is the exchange rate used for spot transactions - Forward Transactions : Ensure the exchange of bank deposits are fixed future date
- Forward transaction rate is the exchange rate used for forward transactions
How do you calculate the appreciation / depreciation of a currency?
(New Rate - Old Rate) / Old Rate
How do you calculate the real exchange rate?
e = E x (P / P*)
e = real exchange rate
E = nominal exchange rate
P = U.S price levels
P* = Foreign price levels
What does it mean if the real exchange rate is greater than 1?
Lower than 1? Equal to 1?
If the real exchange rate is
> 1 = Domestic goods are cheaper than foreign goods
< 1 = Foreign goods are cheaper than domestic goods
= 1 –> Purchasing power of the two currencies are equal
How does the depreciation and appreciation of a currency impact its country’s products’ price levels?
If a country’s currency appreciates, then the country’s goods would become more expensive in a foreign country, and foreign products would become cheaper in the domestic country.
If a country’s currency depreciates, then the country’s products would become cheaper in a foreign country, and foreign products would become more expensive in the domestic country.
What is the Law of One Price?
The law of one price says that identical goods purchased in different countries should cost the same given that there are no barriers to trade and transportation costs are low.
If Japanese steel costs 10,000 yen per ton, and U.S steel costs $100 per ton, then for the Law Of One Price to hold, the exchange rate must equal to 100 yen per $1 (10,000 yen / $100), or $0.01 per 1 yen ($100 / 10,000 yen).
What is the theory of Purchasing Power Parity (PPP)?
The theory of purchasing power parity, basically determines how exchange rates are impacted in the long run. It is just application of the Law of One price to National price levels instead of individual price levels.
For example, of the Yen appreciates 10%, then for the PPP to hold, the U.S dollar would also have to appreciate 10%. And vice Versa.
How does expected relative returns on domestic assets impact the QD of domestic assets?
If the expected returns on domestic assets relative to foreign assets increase, then the quantity demanded for domestic assets also increase, shifting the demand curve to the right.
If the expected returns on domestic assets relative to foreign assets decrease, then the quantity demanded for domestic assets also decreases, shifting the demand curve to the left.
How does the domestic real interest rate (r ^ D) effect the QD of domestic assets?
If the domestic real interest increases, while holding the current exchange rate constant, the returns on domestic assets relative to foreign assets would increase, which would increase the QD for domestic assets and shifting the demand curve for domestic assets to the right.
If the domestic real interest rate decreases, holding the current exchange rate constant, the returns on domestic assets relative to foreign assets would decrease, decreasing the QD of domestic assets shifting the demand curve to the left.
What is the impact foreign real interest rate (r ^ F) on the QD of Domestic and foreign assets?
If the foreign real interest rate increases, holding the current exchange rate constant, then the relative expected returns on foreign assets would increase and the expected returns on domestic assets would decrease. The QD for domestic assets would decrease and the QD of foreign assets would increase.
How does a change in the expected future exchange rate ( E ^e t+1) of domestic assets impact the domestic currency?
If there is an increase in the expected future exchange rate for domestic assets, then the QD for domestic assets increases, which would appreciate the domestic currency
If there is a decrease in the expected future exchange rate of domestic assets, then the QD of domestic assets would decrease, which would depreciate the domestic currency.
How does exogenous appreciation/Depreciation of the exchange rate impact the economy?
Exogenous appreciation of the exchange rate would lead to contractionary measures in the economy. It would decrease aggregate output (Y) and inflation. Although, autonomous monetary policy could be put into place to counteract the contractionary shock caused by exogenous appreciation of the exchange rate.
Exogenous depreciation of the exchange rate could lead to expansionary measures in the economy. This means there could be a rise in aggregate output and inflation.
What are the effects on domestic currency when the central bank makes transactions on foreign exchange markets?
When the central bank buys domestic currency while selling off foreign assets, there will be a decrease in the banks’ international reserves, and the domestic currency will appreciate.
When the central bank sells domestic currency and also buys foreign assets, there will be an increase in the banks’ international reserves and will depreciate the domestic currency.
What does the central bank do when the domestic currency is undervalued / overvalued?
When the domestic currency is overvalued, then the central bank would buy domestic currency and sell foreign assets to keep the exchange rate fixed, leading to a decrease in international reserves.
When the domestic currency undervalued, the central will sell the domestic currency and buy foreign assets to keep the exchange rate fixed, leading to an increase in the international reserves.
What is a crawling PEG?
A crawling peg is considered to be a part of a fixed rate regime. It’s a range of exchange rates that allow a currency value to appreciate or depreciate at fixed rate in small amounts.
