Chapter 16: Foreign Exchange Rates

Question 1

Dollarize

Answer 1

Non-US countries using the US Dollar as their currency due to it being an economically larger neighbor

Question 2

Foreign Exchange Market

Answer 2

The market in which people or firms use one currency to purchase another currency

Question 3

Largest market in the world economy, and approximate daily amount traded on it.

Answer 3

Foreign exchange markets

$5.3 trillion per day

Question 4

4 groups that participate in the foreign exchange market

Answer 4

1. Firms involved in international trade
2. Tourists
3. International investors buying ownership in foreign firms
4. International investors making other financial investments

Question 5

2 financial investment categories that cross international boundaries and require currency exchange

Answer 5

1. FDI - Foreign direct investment

2. Portfolio Investment

Question 6

Foreign Direct Investment (FDI)

Answer 6

Purchasing at least 10% of a firm in another country, or starting a new enterprise in another country

Question 7

Portfolio Investment

Answer 7

Purely financial investment that does not involve management responsibility

Question 8

Hedge

Answer 8

using a financial transaction to protect yourself against a risk from one of your investments (such as currency exchange risk)

Question 9

Is Foreign Direct Investment (FDI) long-run or short-run investment?

Answer 9

Long Run

Question 10

Is Portfolio Investment (FDI) long-run or short-run investment?

Answer 10

Short Run

Question 11

Interbank Market

Answer 11

Banks provide foreign exchange as a service to customers, and then trade on the foreign exchange

Question 12

Dealers

Answer 12

Banks and other firms that trade foreign exchange and provide it as a service to others

Question 13

What makes the foreign exchange market so big?

Answer 13

Portfolio investment transactions

Question 14

Appreciating Currency

Answer 14

Strengthening

The currency exchanges for more of other currencies

Question 15

Depreciating Currency

Answer 15

Weakening

The currency exchanges for less of other currencies

Question 16

For a US firm selling abroad, do they prefer a strong USD or weak USD?

Answer 16

Weak USD, because the firm will earn revenues in the foreign currency and then exchange it for USD

Question 17

For a foreign firm selling in the US, do they prefer a strong USD or weak USD?

Answer 17

Strong USD, because the firm will earn revenues in USD and then exchange it for a greater amount of weaker foreign currencies

Question 18

For a US tourist abroad, do they prefer a strong USD or weak USD?

Answer 18

Strong USD, because they will make purchases in the foreign currency, and have more foreign currency is the USD is strong

Question 19

For a US financial investor that has already invested money in another country, do they prefer a strong USD or weak USD?

Answer 19

Weak USD, because they will be converting foreign currency earned to USD

Question 20

How does a relatively high interest rate/rate of return affect a nation’s currency?

Answer 20

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

Question 21

How does a relatively high inflation rate affect a nation’s currency?

Answer 21

Buying power of the currency is eroding, discouraging its desirability. The exchange rate falls, currency depreciates.

Question 22

Arbitrage

Answer 22

Buying/selling goods or currencies across international borders at a profit

Question 23

PPP/Purchasing Power Parity Exchange Rate

Answer 23

Exchange rate that equalizes the prices of internationally traded goods across countries

Question 24

What is the PPP Exchange Rate used for? (2)

Answer 24

1. Comparing GDP size and other economic metrics between nations
2. Know the PPP allows you to track and predict exchange rate relationships

Question 25

Why are central banks concerned about the exchange rate?

Answer 25

1. Exchange rate affects quantity of aggregate demand in an economy 2. Frequent substantial fluctuations can disrupt international trade and cause problems in a nation's banking system

Question 26

How do exchange rates affect aggregate demand in a nation's economy?

Answer 26

It has a powerful effect on incentives to import and export

Question 27

How does a weak USD affect the motivation to export?

Answer 27

Encourages exports

Question 28

4 Exchange Rate Policies

Answer 28

1. Floating exchange rate 2. Soft exchange rate pegs 3. Hard exchange rate pegs 4. Merging currencies

Question 29

Floating Exchange Rate

Answer 29

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.

Question 30

Soft Peg

Answer 30

Exchange rate policy where the government usually allows the rate to be set by the market, but in some cases will intervene

Question 31

Hard Peg

Answer 31

Exchange rate policy where the government sets a fixed and unchanging value for the exchange rate

Question 32

Merged Currency

Answer 32

Nations choose to share a common currency. Eliminates foreign exchange risk altogether. Gives up its own national control over monetary policy. Example: Euro.