Chapter 17: The Foreign Exchange Market Flashcards
exchange rate
the price of one currency in terms of another currency
what does the exchange rate affect?
inflation and output
foreign exchange market
where trading of currencies and bank deposits denominated in particular currencies takes place
- organized as a over-the-counter market
foreign exchange market
where trading of currencies and bank deposits denominated in particular currencies takes place
- organized as an over-the-counter market
What are the two kinds of exchange rate transactions
spot transactions and forward transactions
spot transactions
the immediate two day exchange of bank deposits
forward transactions
the exchange of bank deposits at some specific future date
spot exchange rate
the exchange rate for spot transactions
forward exchange rate
the exchange rate for forward transactions
appreciation
when a currency increases in value
depreciation
when a currency decreases in value
why are exchange rate important?
affect relative prices of domestic and foreign goods
relationship between the value of currency and import/export prices
- if currency appreciates, the price of imports decreases and the price of exports increases
- if currency depreciates, the price of imports increases and the price of exports decreases
deposits denominated in dollars
when a bank is buying dollars in the foreign exchange market
two parts of analyzing exchange rates
- how exchange rates are determined in the L.R
- use L.R determinants of exchange rates to help us understand how they are determined in the S.R
Theory of Purchasing Power Parity (PPP)
the exchange rate between two countries’ currencies in terms of goods and services
- ensures that the prices are consistent across two countries
real exchange rate
the rate at which domestic goods can be exchanged for foreign goods
relationship between price level and the value of currency
- if a country’s price level rises, then the other country’s currency appreciates
- if a country’s price level rises, then their country’s currency depreciates
Pros and cons of PPP
Pro: good prediction of long run exchange rates
Con: bad prediction of short run exchange rates, can be a big discrepancy between the actual exchange rate and the PPP exchange rate
Why the PPP cannot fully explain exchange rates
- does not take into account nontradable goods and services
- similar goods are not identical
- there are barriers to trade (tariffs and quotas)
nontradable goods and services
things that cannot be traded across borders (housing, land, haircuts, golf lessons)
tariffs
taxes on imported goods
quotas
restrictions on the quantity of goods and that can imported
overvalued
when a country’s goods and services are expensive relative to other countries’
undervalued
when a country’s goods and services are cheap relative to other countries’
four major factors that affect the exchange rate
- relative price levels
- trade barriers
- preferences for domestic vs foreign goods
- productivity
relationship between factors that affect the exchange rate and the value of currency
- if factor increases demand of domestic goods, domestic currency will appreciate
- if factor decreases demand of domestic goods, domestic currency will depreciate
price levels and currency
- a rise in price level causes currency to depreciate
- a fall in price level causes currency to appreciate
trade barriers and currency
increasing trade barriers causes a country’s currency to appreciate
preferences and currency
- increased demand for a country’s exports causes currency to appreciate
- increased demand for imports causes the domestic currency to currency to depreciate
productivity and currency
as a country becomes more productive, its currency appreciates
what does a shift in demand curve mean
- right shift => currency appreciation
- left shift => currency depreciation
causes of shifts in demand
- domestic interest rates (increase leads to right shift)
- foreign interest rates (increase leads to left shift)
- expected future exchange rate (increase leads to right shift)
effects of changes in interest rates on the exchange rate
- domestic real interest rates rise => domestic currency appreciates
- domestic interest rates rise due to expected increase in inflation => domestic currency depreciates
gold and value of currency
- when value of currency falls, price of gold increases
- both serve as a store of value
why is the price of gold high?
- low opportunity cost (interest rates) of holding gold
- expected depreciation of dollar
- QE => price of $ decreases - unusual levels of uncertainty
- COVID - fears that central bank may inflate their way out of debt crisis
- debt/P
Factors that caused dollar to appreciate
- better US economic growth vs ROS
- foreign firms buying profitable US firms
- the Fed is expected to raise interest rates faster than ECB or BOJ
- rising interest rate differentials are providing opportunities for carry trade investors
Advantages of $ appreciation for US
- lower interest rates
- rising asset prices
- falling import prices and US tourists abroad benefit from increased purchasing power of the dollar
- falling inflation
Disadvantages of $ appreciation for US
- US firms overseas profits are worth less in dollar terms
- US exports are less price competitive vs foreign goods and services
- Falling exports will reduce AD and reduce economic growth
Advantages of $ appreciation for ROW
- Euro Zone and Japan will see faster inflation and economic growth
disadvantages of $ appreciation for ROW
- capital will outflow from emerging market economies
- bad for foreign governments and firms who have liabilities denominated in dollars and revenues denominated in local currency
Why the $ exchange rate fell in 2002-2008
- subprime credit mess => subprime currency
- Fed lowering money market interest rate
- weaker US investment prospects
- trade deficits
- US budget deficit
- inflation concerns
what causes trade deficits?
- insufficient savings
- budget deficits
twin deficits
exports decrease as imports increase
currency wars
when countries devalue their currency
pros and cons of devaluing currency
pro: exports will be more attractive to foreign countries
cons: imports will cost more, politicization of exchange rates, downward spiral of competitive devaluation
Why doesn’t Greece devalue to restore their economy?
they don’t solely control value of euro
How can Greece restore competitiveness?
- domestic deflation (falling wages and prices) => shift right the AS curve
- increased productivity => shift right AS curve
real exchange rate equation
real exchange rate = nominal exchange rate * PL_US/PL_ROW
Equation for the profits on goods when the loan is in dollars
profits = PQ (revenue) - wL (labor costs) - iDexchange rate (interest on debt in dollars)
