Exchange Rates Flashcards
actors in the foreign exchange market
foreign exchange market
market in which currencies are exchanged for other currencies
floating exchange rate
market forces alone without any government or central bank intervention determine its value
fixed exchange rate
exchange rate is set and maintained at some level by the government
managed exchange rate
no announced level or band but either the exchange rate is allowed to float within some implicit upper and lower bound or authorities intervene whenever they consider the direction or speed of adjustment is the currency is undesirable
appreciation
price of currency increases within a floating system
depreciation
price of currency decreases within a floating system
devaluation
official price of currency decreases within a fixed system
revaluation
official price of a currency increases within a fixed system
causes of change in exchange rate
- change in foreign demand for country’s exports (growing exports - excess currency demand - currency appreciates)
- change in domestic demand for imports (import demand increases - excess currency supply - currency depreciates)
- changes in relative growth rates (high growth rate - incomes increase - import demand increases - currency depreciates)
- changes in relative inflation rates (accelerating inflation - rising prices - export demand decreases - currency depreciates)
factors affecting cross-border capital flows
- changes in relative interest rates (IR decrease - domestic bonds less attractive to foreign investors)
- expectations of future growth (economy growth expected - potential business opportunities)
- currency speculation
when will an exchange rate appreciate?
- foreign demand for exports decreases
- domestic demand for imports decreases
- domestic interest rates increase
- expected growth
- speculators anticipate appreciation
when will an exchange rate depreciate?
- foreign demand for exports decreases
- domestic demand for imports decreases
- domestic inflation increases
- domestic interest rates decrease
- speculators anticipate depreciation
what happens if there is pressure for currency to devalue in a fixed system?
- central bank starts buying currency using foreign exchange reserves
- central bank increases interest rates to attract foreign capital inflows
- official borrowing of foreign exchange
- government restricts imports and access to foreign exchange
what happens if there is pressure for the currency to appreciate in a fixed system?
- central bank sells domestic currency to buy foreign currency
- central bank decreases interest rates to create an outflow of foreign capital
why might a country keep the currency overvalued?
- import substitution strategy
- exports more expensive abroad
- combat inflation
why might a country keep the currency undervalued?
- cheaper exports for competitive advantage
- export-led growth
- creates friction between trading partners
- inflationary pressure
advantages of floating exchange rates
- can use monetary policy to achieve domestic goals
- trade imbalances automatically corrected
- exchange rate adjustments are smooth and continuous
- less speculation
- less need for central bank to keep foreign exchange reserves
disadvantages of floating exchange rates
- increased uncertainty hurts trade
- government tends to adopt inflationary policies for short-term gains
advantages of fixed exchange rates
- less uncertainty increases trade volume
- policy discipline as inflationary growth not an option
- curbs high inflation
disadvantages of fixed exchange rates
- cannot use monetary policy
- gov deprived of exchange rate policy
- restricts use of expansionary fiscal policy because deficit may affect money supply or interest rates
- exchange rate adjustments are abrupt and disruptive
- trade deficits not automatically corrected requiring use of contractionary fiscal policy
- central bank may maintain large foreign exchange reserves
purchasing power parity
rate that will equate the cost of purchasing the same basket of goods in two countries
balance of payments
record of all transactions of a country with the rest of the world over a period
current account
- goods and services (imports and exports)
- primary income (differences between primary income received abroad and payable abroad, includes profits)
- secondary income (donations)
current account balance
sum of net exports of goods and services, net income and net current transfers over a period
capital account
- receivable and payable capital transfers
- acquisition and disposal of patents, copyrights, etc.
financial account
FDI
porfolio and other investments
reserve assets
is current account deficit a problem?
- pressure for currency to depreciate
- temporary deficits imply improvement in standards of living because nation is consuming more than producing
- persistent deficits imply chronic inflation, uncompetitive product markets and rigid labor markets
implications of persistent current account deficit
- surplus is required in capital and financial accounts
- sale of domestic assets to foreigners (low price, loss of sovereignty)
- borrowing from abroad (future repayments and interest)
- national income diverted away from domestic development
- living standards decrease
policies to correct persistent current account deficit
- expenditure-reducing: contractionary fiscal and monetary policies
- expenditure-switching: devaluation, trade protection, imports more expensive
- supply-side policies: decreasing domestic monopoly power, increasing labor market flexibility
why is current account surplus a problem?
- economy consuming inside production possibilities
- living standards lower than need be
- very reliant on foreign demand for growth
- inefficiently employing resources if surplus due to trade barriers
- currency appreciates
marshall-lerner condition
devaluation will improve trade deficit if PEDX + PEDM > 1
terms of trade
- ratio of average price of exports over the average price of imports
- volume of imports attainable by a unit of exports
improvement in terms of trade
- terms of trade increase
- country can attain greater volume of imports with the same exports
worsening in terms of trade
- terms of trade decrease
- country can attain smaller volume of imports with same exports
causes of improvement in terms of trade
- world demand for country’s exports increases
- country’s supply of exports decreases
- appreciation of currency
- average domestic prices increasing faster than abroad
- imposition of trade barriers
what are the consequences of an improvement in terms of trade?
- if due to increase in world demand, export revenues increase
- if due to decrease in world supply, depends on PED (price inelastic: export revenues increase)
- price elastic: export revenues decrease
- if due to appreciation, trade surplus decreases
- if due to tariff, trade balance improves
