Chapter 15 Flashcards
What is the exchange rate?
It is the price of a currency stated in terms of a second currency
What are the two ways in which exchange rates are denoted?
Units of domestic currency / unit of foreign currency
Units of foreign currency / domestic currency
(We focus on the first version)
What is appreciation?
It is when a currency becomes more valuable, foreign currency costs less
What is depreciation?
It is when a currency becomes less valuable, foreign currency costs more
What are the most frequently used currencies in world trade and finances?
U.S. dollar;
EU euro;
Japanese yen;
British pound.
What are flexible exchange rate systems?
Exchange systems where the value changes day to day, even minute to minute
What is the fixed exchange rate system?
It is when the value of the currency is fixed to the dollar
What is trade and invetment?
It is when traders, investors, and travellers routinely transact in foreign currencies
What is interest rate arbitrage?
It is when financial arbitrageurs will take advantage of interest rate differentials between countries; they borrow money where interest rates are low and lend it where interest rates are high
What is specualtion?
It is when speculators buy and sell currency in anticipation of changes in the currency’s value; speculators sell overvalued currencies and buy undervalued ones.
What are retail customers?
They are firms and individuals who hold foreign currency to buy goods and services, to travel, to adjust their portfolios, and to speculate
What are commercial banks?
They are banks that hold currencies as part of their services for their customers
What are foreign exchange brokers?
They are the middlemen between banks and buyers and sellers of foreign exchange
What are central banks?
They are banks that hold foreign exchange as reserves to supply domestic banks that need it
What do businesses operating in multiple countries encounter?
They encounter exchange rate risk due to the possibility of currency fluctuations
What is the forward exchange rate?
It is the price of a currency that will be delivered in the future
What is the forward market?
It is the market for the buying and selling of currencies for future delivery
What is the spot market?
It is the market for the buying and selling of currencies in the present
What is hedging?
It is when investors and speculators use the forward market to protect against unanticipated currency fluctuations
What do investors and speculators engage in when they borrow in markets with low interest rates?
Interest rate arbitrage
What do investors and speculators engage in when they hedge against currency fluctuations?
They are engaging in covered interest arbitrage
What does an increase in supply do to the price? Decreases?
It lowers the price. It raises the price
What does an increase in demand do to the price? A decrease?
Raise the price, lower the price
What do price changes for foreign currency assume?
It assumes that there is a flexible exchange rate system
Why does the demand slope for foreign exchange slope down to the right?
Because, as foreign exchange is cheaper, more is demanded
Why does supply for foreign exchange slope up to the right?
Because, as foreign exchange is more expensive, foreigners are willing to supply more
Why are exchange rates difficult to predict?
They are difficult to predict because there are many factors that vary in the long run, medium run, and short run
What are the factors that vary in the long run, medium run, and short run for exchange rates?
Long run: Purchasing power parity.
Medium run: Business cycle.
Short run: Interest parity and speculation
What is purchasing power parity?
The exchange rate allows the same quantity of goods to be bought in either currency when converted from one to another.
What does the PPP exchange rate depend on?
It depends on goods arbitrage, which works slowly, if at all.
What is the medium run force?
It is the business cycle
What does faster growth mean for imports and foreign currency?
It means more imports and more demand for foreign currency
What happens to the home currency as the demand for foreign currency shifts to the right?
The home currency depreciates
What does faster growth abroad mean for home country exports and supply of foreign currency?
It means more home country exports and more supply of foreign currency
What happens to home country currency when the supply of foreign currency shifts to the right?
It means the home country currency appreciates
What is interest parity?
It is what holds that exchange rate movements should be sufficient to counteract any differences in interest rates between countries.
What is speculation?
It is the buying and selling of assets in anticipation of a change in value.
How can the interest parity condition be estimated?
It can be estimated from today’s interest rates and the exchange rate in the spot and forward markets.
What do interest rate arbitrageurs take advantage of?
They take advantage of interest rate differences in different countries.
They borrow in the low interest rate market and lend in the high interest rate market.
What does the real exchange rate show?
It shows whether a currency is depreciating or appreciating in its purchasing power over foreign goods and services.
Nominal appreciation or depreciation is not always the same as real.
Businesses and households that use foreign exchange are more concerned about the real value of their currency than the nominal.
What do flexible exchange rate systems let the home currency do?
It lets it change in value relative to other currencies
The exchange rate is a price, prices can change over time.
Flexible or floating rates have varying degrees of flexibility; some governments intervene occasionally, others very infrequently, to control the movement.
What are the two different format that the pegged exchange rates (flexible exchange rates) come in?
Hard pegs are not allowed to change in value at all.
Soft pegs are allowed to change within some limit, but not beyond that limit.
What is gold standard?
It is one type of fixed exchange rate: the value of currency is set to a quantity of gold
What are the rules of the gold standard?
Fix the currency to a given quantity of gold; e.g., $35 per ounce;
Keep a fixed ratio of domestic money to gold;
Be willing and able to convert domestic money to gold, and vice versa.
What are the characteristics of the gold standard?
The money supply is determined by the quantity of gold;
Countries cannot use monetary policy; the money supply is fixed to the quantity of gold.
Central banks or monetary authorities must be willing and able to supply gold when the demand increases.
What are the different forms that fixed exchange rates can come in?
Some countries adopt a foreign currency as their own.
Some peg to a foreign currency and keep it fixed.
Some peg to a basket of foreign currencies.
Some peg to a foreign currency and adjust it periodically. This is called a crawling peg.
Some peg to another currency, but let it float up or down by some percentage before they intervene.
What do fixed rates provide?
They provide:
Greater certainty about the future exchange rate;
A more certain environment for business planning.
What do fix rates not provide?
Protect against outside shocks, such as a sudden drop in commodity prices;
Let countries have an independent monetary policy; all monetary policy must support the currency, not the domestic economy.
What doe fixed rates require?
Caution in the creation of new money;
A high level of credibility; the rate must be perceived as stable and correct in value.
What do flexible rates provide?
Insulation from shocks that originate outside the economy, such as a sudden fall in commodity prices or a decline in foreign demand for domestic output;
The conditions for an independent monetary policy, which gives greater flexibility in addressing domestic concerns about economic growth, unemployment.
What is an optimal currency area?
It is a single currency area that denotes a region that adopts a single currency
What are the three conditions that must be met in order for a single currency to be better than multiple currencies?
Business cycles must be synchronized;
Labor and capital must be mobile between countries;
There must be policies for addressing regional differences in growth when the business cycles do not match.
What are the benefits of single currency?
Reduced transaction costs in currency conversions and accounting.
Data on increased trade and investment is mixed.
What is the largest potential cost of a single currency?
Countries sharing a currency give up their independent monetary policies.
