Chapter 16: Foreign Exchange Rates Flashcards
Dollarize
Non-US countries using the US Dollar as their currency due to it being an economically larger neighbor
Foreign Exchange Market
The market in which people or firms use one currency to purchase another currency
Largest market in the world economy, and approximate daily amount traded on it.
Foreign exchange markets
$5.3 trillion per day
4 groups that participate in the foreign exchange market
- Firms involved in international trade
- Tourists
- International investors buying ownership in foreign firms
- International investors making other financial investments
2 financial investment categories that cross international boundaries and require currency exchange
- FDI - Foreign direct investment
2. Portfolio Investment
Foreign Direct Investment (FDI)
Purchasing at least 10% of a firm in another country, or starting a new enterprise in another country
Portfolio Investment
Purely financial investment that does not involve management responsibility
Hedge
using a financial transaction to protect yourself against a risk from one of your investments (such as currency exchange risk)
Is Foreign Direct Investment (FDI) long-run or short-run investment?
Long Run
Is Portfolio Investment (FDI) long-run or short-run investment?
Short Run
Interbank Market
Banks provide foreign exchange as a service to customers, and then trade on the foreign exchange
Dealers
Banks and other firms that trade foreign exchange and provide it as a service to others
What makes the foreign exchange market so big?
Portfolio investment transactions
Appreciating Currency
Strengthening
The currency exchanges for more of other currencies
Depreciating Currency
Weakening
The currency exchanges for less of other currencies
For a US firm selling abroad, do they prefer a strong USD or weak USD?
Weak USD, because the firm will earn revenues in the foreign currency and then exchange it for USD
For a foreign firm selling in the US, do they prefer a strong USD or weak USD?
Strong USD, because the firm will earn revenues in USD and then exchange it for a greater amount of weaker foreign currencies
For a US tourist abroad, do they prefer a strong USD or weak USD?
Strong USD, because they will make purchases in the foreign currency, and have more foreign currency is the USD is strong
For a US financial investor that has already invested money in another country, do they prefer a strong USD or weak USD?
Weak USD, because they will be converting foreign currency earned to USD
How does a relatively high interest rate/rate of return affect a nation’s currency?
Makes it desirable, so demand goes for the nation’s currency goes up (so people can invest in that nation’s transactions), and the currency appreciates
How does a relatively high inflation rate affect a nation’s currency?
Buying power of the currency is eroding, discouraging its desirability. The exchange rate falls, currency depreciates.
Arbitrage
Buying/selling goods or currencies across international borders at a profit
PPP/Purchasing Power Parity Exchange Rate
Exchange rate that equalizes the prices of internationally traded goods across countries
What is the PPP Exchange Rate used for? (2)
- Comparing GDP size and other economic metrics between nations
- Know the PPP allows you to track and predict exchange rate relationships
Why are central banks concerned about the exchange rate?
- Exchange rate affects quantity of aggregate demand in an economy
- Frequent substantial fluctuations can disrupt international trade and cause problems in a nation’s banking system
How do exchange rates affect aggregate demand in a nation’s economy?
It has a powerful effect on incentives to import and export
How does a weak USD affect the motivation to export?
Encourages exports
4 Exchange Rate Policies
- Floating exchange rate
- Soft exchange rate pegs
- Hard exchange rate pegs
- Merging currencies
Floating Exchange Rate
Policy that allows the foreign exchange market to set exchange rates.
Example: USD.
Con: exchange rates can move a great deal in a short. time.
Soft Peg
Exchange rate policy where the government usually allows the rate to be set by the market, but in some cases will intervene
Hard Peg
Exchange rate policy where the government sets a fixed and unchanging value for the exchange rate
Merged Currency
Nations choose to share a common currency. Eliminates foreign exchange risk altogether. Gives up its own national control over monetary policy. Example: Euro.
