EC340FINAL Flashcards
Exchange rate
the price of one currency in terms of another
E(domestic/foreign)
E($/€) = American Terms
Fixed exchange rate (pegged, band)
does not fluctuate against some base currency over a period of time.
- Govt intervention in the market for foreign exchange is needed to maintain Fixed.
Floating exchange rate
fluctuating
- govt makes no attempt to peg the exchange rate against some currency
exchange rate crisis
a currency experiences a sudden and pronounced loss of value against another currency following a period in which the exchange rate had been fixed or relatively stable.
Exchange rate crisis may lead to gov’t declaring DEFAULT on loans.
what is a default
suspension on payments
currency crashes
common events - when a currency loses 30% of its value in U.S dollar terms over one year, having changed less than 20% each of the previous 2 years.
what does an increase in dollar - euro ($/€) exchange rate lead to?
an increase in wealth for americans who own eurozone assets and a decrease in wealth for europeans who own american assets
Gov’t expenditure
spending
current account
expenditure - national income
expen > income = deficit (borrowing)
expen
balance of payments accounts
imbalances are associated w/ all different kinds of international transactions and are recorded
- NOT possible for all countries to be running deficits at the same times
- Globally, deficits and surpluses balance
emerging and developing economies hold massive stock piles of what
foreign exchange reserves
how is the u.s in a current account deficit?
- expenditure exceeds income
- selling financial assets to foreigners to fund the difference
- the surplus country buys assets w/ excess income
wealth =
assets - liabilities
what others owe you) - (what you owe them
borrowing
lending
liabilities rise, reducing net worth
assets rise, increasing net worth
external wealth =
foreign assets - foreign liabilities
what is owed by the rest of the world) - (what you owe the rest of the world
Changes in external wealth result from
borrowing and lending / changes in foreign liabilities and foreign assets
- external wealth > 0 —> creditor
- external wealth debtor
common currency
shared policy responsibility: Eurozone
dollarization
country unilaterally adopts the currency of another country, and has no control over the currency
Appreciation Depreciation equation to determine this: E$/€,t = 1.06 E$/€,t+1 = 1.28
- Value has risen
- Value has fallen
: [(t+1) - (t)] /t
(1.28 - 1.06) / 1.06 = 21%
*Euro has appreciated by 21% against the dollar
Bilateral Exchange Rate
shows the price at which one currency is exchanged for another.
Multilateral exchange rate
Resulting in what?
- calculated by aggregating bilateral exchange rates by using trade weights to construct an average over each currency in the basket.
- The change in Effective Exchange Rate
40% of home trades with Country A
60% is with country B
Homes country appreciates 10% against country A, and depreciates 30% against country B.
What is the effective exchange rate?
(.1.4) + (-.3.6) = (.04-.18) = -14%
Trade weight
% that you trade with such countries
Appreciation in home country leads to a ________ in relative price of exports to foriegners and a _______ in relative price for imports
increase, decrease
managed float
somewhere between a fixed or float
crawling peg
steadily depreciating at a constant rate
Market for foreign exchange (forex or FX market)
not an organized exchange: trade is conducted “over the counter”
Spot contract “spot exchange rate”
~simplest forex contract is the immediate exchange of one currency for another between 2 parties
~most common type of trade
Derivatives
types: forwards, swaps, futures and options
contracts with pricing derived from the spot rate.
forwards
differs from spot contract in that the contract is made today, but the settlement date for the delivery of currencies is in the future, or “forward”
- time to delivery, maturity, varies. However the price is fixed TODAY and the contract holds no risks.
Forward premium vs discount
- is forward exchange price of currency exceeds the current spot price
- vise versa
swaps
A&B agree to trade at set price today and do reverse trade at a set price in the future.
combines forwards and spot contracts into one.
Options
- provides the buyer w/ the right to buy (call) or sell (put) a currency in exchange for another at a pre-specified exchange rate. (i.e “strike price”) at a future date.
- The buyer is under no obligation to trade and will not exercise the option if the spot price on the expiration date turns out to be more favorable.
capital control
Some governments engage in policies that restrict trading, movement of forex, or restrict cross-border financial transactions
In lieu of capital controls, the central bank must stand ready to buy or sell its own currency to maintain a fixed exchange rate
Market equilibrium
no-arbitrage condition = no opportunities to make a riskless profit
arbitrage
Arbitrage refers to a trading strategy that exploits price differences.
International arbitrage may lead to…
applied to a single good
applied to an entire basket of goods
- equalization of goods prices in different countries (expressed in a common currency).
- Applied to a single good, this idea is referred to as the law of one price.
- Applied to an entire basket of goods, it is called the theory of purchasing power parity.
Law of one Price (LOOP) assumptions
no transaction costs
no barriers to trade
identical goods in each location
no barriers to price adjustment
-Under above assumptions, we expect:
*prices must be equal in all locations for any good expressed in a common currency
*otherwise, there would be a profit opportunity from buying low and selling high
If LOOP holds for every good in CPI basket then
the prices of the entire baskets must be the same in each locations.
The purchasing power parity (PPP) theory states
that a basket of goods purchased in two countries should cost the same in a common currency.
*Absolute PPP:
(E $/€ * P eur) = P u.s
*both sides expressed in dollar amounts
The absolute PPP implies
that the exchange rate at which two currencies trade is equal to the relative price levels of the two countries:
*can be used to predict exchange rate movements
The PPP theory, whether in absolute or relative form, suggests
that price levels in different countries and exchange rates are tightly linked, either in levels or in rates of change.
real exchange rate
relative price of the baskets
Absolute PPP states that the real exchange rate is equal to
1.
If the real exchange rate qUS/EUR is below 1
- Foreign goods are relatively cheap.
- In this case, we say the euro is undervalued.
If the real exchange rate qUS/EUR is above 1,
- Foreign goods are relatively expensive.
- In this case, we say the euro is overvalued.
If the real exchange rate qUS/EUR rises
- more home goods needed in exchange for foreign goods
- intuitively called a real depreciation of the dollar.
If the real exchange rate qUS/EUR falls
- fewer home goods needed in exchange for foreign goods
- Intuitively called a real appreciation of the dollar.
what explains deviations from PPP
transaction costs
- transportation costs may add about 20% to the cost of goods moving internationally.
- Tariffs (and other policy barriers) may add another 10%, with variation across goods and across countries.
- Further costs arise due to the time taken to ship goods.
nontraded goods
- Some goods are inherently nontradable;
- Most goods fall somewhere in between freely tradable and purely nontradable.
what explains deviations from PPP conti
Imperfect competition and legal obstacles
- Many goods are differentiated products, often with brand names, copyrights, and legal protection.
- Firms can engage in price discrimination across countries, using legal protection to prevent arbitrage
- E.g., if you try to import large quantities of pharmaceuticals, and resell them, you may hear from the firm’s lawyers.
Price Stickiness
- One of the most common assumptions of macroeconomics is that prices are “sticky” prices in the short run.
- PPP assumes that arbitrage can force prices to adjust, but adjustment will be slowed down by price stickiness.
This adjusted index addresses
the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labor costs are lower
