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AEM 2300 Trade & Finance > Final Exam Lectures (+Cengage Brain questions) > Flashcards

Final Exam Lectures (+Cengage Brain questions) Flashcards

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1
Q

In a free market, which factors contribute to changes in short-run exchange rates?

A
  • real interest rate differentials,
  • news about market fundamentals,
  • speculative opinion about future exchange rates.
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2
Q

In the long run, what are four key factors that contribute to changes in exchange rates?

A
  1. relative productivity levels,
  2. relative price levels,
  3. preferences for domestic goods and foreign goods
  4. barriers to trade.
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3
Q

What are the economic benefits of immigration?

A
  • For immigrating worker and their family: private economic benefits such as income, educational, and job opportunities, as well as public benefits through taxes paid.
  • Filling available labor demands (both low and high skill) in destination country
    • Source of cheap labor to host country’s firms. Low-cost labor, means lower costs to the firm and could lead to the firm charging lower prices.
  • Payments(or remittances) to source country
  • Help solve demographic challenges in the destination country. Ex: social security benefits and the worker/beneficiary ratio. 1960 -5:1, 2005 -3:3, 2040 -2:1
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4
Q

What are some of the costs of immigration?

A
  • Brain drain in source country; important in new economy based on technology, innovation, and knowledge generation
  • Public sector and social sector costs in destination country: health services, welfare programs, and public education. (short-term effects)
  • Wage effects on low-skill labor force in the destination country as firms get to avoid raising wages to attract and retain workers
  • Wage effects contribute to increasing income inequality by mitigating income levels of low income workers
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5
Q

What are some characteristics of Multi-National Enterprises or Mult-National Corporations?

A
  • Operation in many host countries
  • High ratio of foreign sales to total sales
  • Cross-national borders
  • Diverse manufacturing, mining, extraction, and business services operations
  • R&D activities
  • Directed from a distant company planning center
  • Multinational stock ownership
  • Multinational company management
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6
Q

Types of integration (Multinational companies)

A
  1. Vertical Integration
    * Parent MNE establishes foreign subsidiaries or produce raw & intermediate input for the finished product
  2. Horizontal Integration
    * Parent company sets up a subsidiary to produce an identical product in the host country or simply acquires another company.
  3. Conglomerate Integration
    * Diversify into nonrelated markets
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7
Q

For multinational corporations what are some sources of competitive advantage?

A

There are many:

  • Vertical integration and supply chains
  • Horizontal integration
  • Economies of scale in production: outsourcing of labor functions, financing, R&D, market information.
  • Knowledge and market flexibility in responding to changing market conditions
  • Lower risk due to diversification across different markets
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8
Q

What are some issues multinational corporations (or MNE) face?

A
  • Local labor market effect: employment losses –>ability to minimize bargaining power, expatriate workers means lower gains for local workers, and buying local business vs creating new ones means lower employment gains for local population.
  • Abuses of transfer prices: internal pricing within MNE typically to avoid/reduce taxes.
  • Technology transfer
  • For source country: tax compromises or loss of revenue for treasury and outsourcing means loss of employment.
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9
Q

The importance of the monetary aspects of trade

A
  • International financial market transactions dwarf trade in goods and services
  • Global finance is an important source of global integration
  • Exchange rates strongly influence merchandise trade - exchange rates “common denominator” in trade
  • Role of central bank and other governmental policies in affecting interest rates, exchange rates, and economic growth
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10
Q

What are five types of capital?

A
  1. Natural capital
  2. Physical capital
  3. Financial capital
  4. Human capital
  5. Social capital

**Capital assets - the engine of economic growth**

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11
Q

Financial capital markets. What is its purpose?

A

Financial capital markets serve to - pool domestic savings, attract foreign capital, intermediate between lenders and borrowers, and provide financing to entrepreneurs, all in order to promote economic growth

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12
Q

How is an international portfolio investment distinctive in comparison to a foreign direct investment?

A

It is an investment to diversify investor’s portfolio, not involving direct management control.

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13
Q

What is a foreign direct investment?

A

Flow of funding (lending and/or purchase) to establish or acquire influence and/or partial control of a foreign firm or to expand or reinvest in said firm

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14
Q

What account is the FDI ( Foreign Direct Investment) part of?

A

Capital and Financial account

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15
Q

What is a capital and financial account?

A
  • Records financial transactions which affect the balance of assets between countries: corporate stocks and bonds, government securities, real estate, and commercial deposits. (e.g. U.S. foreign investments [capital outflow (-)] and foreign investments in the U.S. assets [capital inflow(+)])
  • Includes private sector and central bank transactions
  • Other financial transactions include: debt forgiveness, transfer of migrants financial assets, sales & purchases of patents, copyrights, trademarks, and leases
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16
Q

What is a current account?

A

Measures net balance of exports and imports of goods and services. The current account balance is composed of: goods (merchandise balance or “balance of trade”), services (services balance), income (investment income), and transfers (unilateral transfers).

**A current account balance is a more comprehensive measure than “balance of trade”**

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17
Q

What are motivations of international capital flow?

A
  1. Maximize expected rate of return on capital
  2. Diversify risk within international portfolio (explains two-way investment flows)
  3. Market expansion and diversification
  4. Minimize costs of production
  5. Horizontal or vertical integration
  6. Secure access to raw materials
  7. Secure access to promising markets
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18
Q

What are capital controls?

A

Government-imposed barriers on capital outflows (domestic savers or investors investing abroad) or capital inflows (foreign savers or investors investing domestically)

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19
Q

Why may government want to impose capital controls?

A
  1. Regulate foreign exchange and influence its balance of payments position and domestic currency value
  2. Encourage or discourage specific transactions (using parallel exchange rate system)
  3. Enable domestic monetary or fiscal policy to be more flexible and powerful by limiting scope of exchange rate policy
  4. Limit financial market stability by regulating inflows/outflows
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20
Q

Benefits for Foreign Direct Investments (FDI) for host country

A
  • Increased tax production, exports, and employment
  • Generate tax revenues
  • Achieve scale economies and production efficiency
  • Human capital development, increased managerial and technical skills
  • Technology transfer
  • Increased competition with domestic industry may lower market power and thus reduce prices
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21
Q

Problems with Foreign Direct Investment (FDI) in host country

A
  • Instability in the exchange rate and balance of payments
  • Adverse impact on terms of trade
  • Crowding out of domestic investment and shifting of sizable funds away from alternative investments
  • Loss of country over domestic policy
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22
Q

Balance of Payments (BOP)

A
  • Statistical account of the transactions between the residents of one country and the rest of the world for one year or a fraction thereof
  • BOP accounts based on system of double-entry bookkeeping with a credit (inflow) and debit (outflow) entered for each transaction
  • Total credits always = total debits
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23
Q

HISTORY/HANDLING OF: Balance of Payments (BOP)

A

Post WW2 to 1973

  • Under Bretton Woods system there was an emphasis on BOP surplus/deficit indicator of pressure to devalue or revalue currency

Since 1970s

  • Less stress on BOP due to acceptance of monetarist principal that BOP surplus/deficit is temporary; focus on XC rates as long-run equilibrating mechanism
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24
Q

Balance of Payments: What is a credit?

A

Inflow of payments: Any payment to a resident or anything that creates a claim to payment to a resident

  • exports of goods and services
  • income (dividends, interest, etc.) earned on foreign investments
  • unilateral transfers to residents
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25
Q

Balance of Payments: What is debit?

A

Outflow of payments: Any payment by a resident or anything that creates a claim by a resident

  • imports of goods and services
  • interest and dividends paid to foreign bond or stockholders
  • capital outflows
  • unilateral transfers abroad
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26
Q

What is a Settlement Account

A

Records net changes in central bank assets and official reserves: foreign exchange holdings, gold, inventories, loans to IMF, foreign holdings of domestic currency, etc…

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27
Q

Why are there imbalances in the balance of payments?

A

Short-Run:

  • Domestic income or income in ROW(rest of the world), may increase or decrease via economic growth or recession
  • Prices of imports and exports change
  • Demand for currency changes
  • Customer tastes and preferences
  • Natural and man-made disasters (9/11, Japanese tsunami, financial crisis, etc..)
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28
Q

Sources of imbalance of the balance of payments in the long run.

A

Long-Run:

  1. Inflation changes
  2. Rate of economic growth - especially relative rates
  3. Interest rates
  4. Resource discovery and depletion
  5. Technology affecting competitiveness
  6. Policy: preferential trading agreements: trade liberalization or fiscal and monetary policy
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29
Q

What is the foreign exchange rate?

A

The price of foreign currency denominated in terms of domestic currency. In other words, the foreign exchange rate is a price like any other price.

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30
Q

What are functions of money?

A
  • Medium of exchange
  • Unit of account
  • Store of value
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31
Q

What are some observations concerning exchange rates?

A
  1. Demand and supply of foreign exchange are two sides of the same phenomenon
  2. Foreign exchange rate represents equilibrium price as in any other market (“equilibrium exchange rate”)
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32
Q

Though exchange rates are like prices how are they different?

A
  1. Can be defined in terms of many other currencies (N-1 unique exchange rates)
    • If there are N countries(currencies), there are N-1 exchange rates
    • Exchange rates are relative prices
  2. Exchange rates are constantly and instantaneously changing
  3. Extensive government intervention in foreign markets
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33
Q

Spot market

A

Sale or purchase of foreign currency for immediate delivery

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34
Q

Arbitrage

A

simultaneous purchase and sale of currency in different markets, taking advantage of different exchange rates in those markets – profits made on the difference

35
Q

Arbitrage in currency markets similar to the ________ principal governing the spatial trade in goods.

A

“Law of One Price”

36
Q

What is the “Law of One Price?”

A

Identical goods sold in multiple markets should sell for the same price (excluding transportation and transaction costs) in currency markets when converted to the same currency.

37
Q

Does the “Law of One Price” actually hold?

A

Usually not, due to:

  • differentiated products
  • poor or costly information
  • market imperfections especially in developing countries
38
Q

Under what conditions does the “Law of One Price” most likely to hold?

A

Homogeneous goods, characterized by good information and few market imperfections -

  • commodities
  • currencies

Law of One Price underlies or rooted in “purchasing power parity”

39
Q

Forward Market

A

buying or selling for future delivery

40
Q

Forward transaction

A

An agreement (contract) to buy or sell a specified amount of a foreign currency at a future date at an agreed price (forward price)

41
Q

Future Markets

A

Obligation to buy or sell a specific quantity of a foreign currency at a specified future time at a specific price

42
Q

Options Market

A

Right, but not the obligation, to buy or sell a specific quantity of foreign currency at a specific future time at a specific price:

  • call option: option to buy
  • put option: option to sell
43
Q

Why use forward currency markets?

A

Can be used to hedge (limit) exchange rate risk

44
Q

Uncovered interest arbitrage

A

Making foreign financial investments without obtaining “cover” for exchange rate risk

45
Q

Covered interest arbitrage

A

offsets exchange rate risk by making foreign financial investments with a simultaneous transaction in the forward foreign exchange market

46
Q

Fixed exchange rates (regime)

A

currency pegged to one major currency or market basket of currencies

47
Q

Ajustable peg (regime)

A

domestic currency pegged to one or more foreign currencies, with periodic adjustments to achieve devaluation/revaluation

48
Q

Managed (“dirty”) float regime

A

exchange rate fluctuations are based primarily on market forces, but central banks intervene to limit rate movements when necessary

49
Q

Free (“clean”) float regime

A

exchange rates clear at currency market equilibria, with in-payments and out-payments equated

50
Q

History of alternative exchange rates regimes

A
  • 1970’s -1990’s away from fixed rates to flexible, managed floating rates as countries adopted more market-oriented policies
  • 1975, countries with pegged rates accounted for 70% of developing country global trade
  • By 1996, only 20%.
51
Q

Define Fixed exchange rates

A

Nominal exchange rate is fixed; country’s central bank buys and sells foreign exchange to maintain domestic currency at “par” value, or within a narrow band.

52
Q

Define (adjustable) pegged exchange rates

A
  • Similar to fixed exchange rates, except that pegged currency values are allowed to change over time.
  • Currency value fixed against a major currency ($, Euro) with adjustments (ad hoc or scheduled) reflecting changes in domestic and international economies.
  • Changes may be preannounced and scheduled (“crawling pegs”), or announced spontaneously with no prior notice (“shock therapy”)
53
Q

Why was the Adjustable Pegs system (under the Bretton Woods system) created? What institution was a result of this system?

A
  • System designed to stabilize post-WWII international monetary system, avoid chaos that followed WWI, and provide orderly procedures for exchange rate changes
  • Created International Monetary Fund to supervise the international monetary and exchange rate system and to extend credit (loans and short-term reserves) to member countries to help overcome BOP deficits.
54
Q

Requirements of the Adjustable pegs system under Bretton Woods

A
  • Official currency values established (fixed) against the dollar (the official reserve currency), with periodic adjustments
  • Central banks obligated to intervene to maintain exchange rates at “par” values within a 1% (+/-) currency band.
  • Countries with persistent BOP surpluses or deficits required to devalue or revalue their currencies to a new par value with an “adjustable peg”
55
Q

Bretton Woods system exerted stability on post-WWII inter-national financial system, but ultimately ended (1973) due to?

A
  • Inability of exchange rates to simultaneously balance the BOP and reflect comparative advantage.
  • Frequency of speculation and currency market distortions
  • U.S. policies at end of Bretton Woods era encouraged transmission of excess demand and inflation abroad
  • “Crisis of confidence” in dollar in early 1970’s; convertibility to gold suspended in 1971, dollar began a “managed float” in 1973
56
Q

What do management exchange rate systems include?

A
  • Parallel exchange rate systems
  • Surrender of foreign currency
  • Capital and exchange restrictions
  • Adjustable pegs
  • Crawling pegs
57
Q

What are reasons for exchange rate management?

A
  • Maintain BOP equilibrium, fine-tune macroeconomic policy
  • Maintain overvalued exchange rates
  • Protect “infant industries’
  • Prevent capital flight
  • Allocate scarce foreign exchange.
58
Q

What are some problems with exchange management and controls?

A
  • Currency over/under valuation distorts comparative advantage
  • May encourage black markets for foreign currencies.
  • Distortions of capital flows –rapid currency appreciation, capital flight
59
Q

What is a major limitation of freely floating rates?

A

Increased likelihood of exchange rate volatility

60
Q

Managed float or “dirty float”: how it works and its history

A
  • Large increase in countries using managed float since late ‘80’s
  • Based on floating exchange rates, but central banks buy or sell reserves to manage the value of their currency: buy domestic currency to raise value, sell domestic currency to lower value
  • Central banks try to moderate exchange rate movement without keeping rates rigidly fixed.
  • Requires policy coordination among central banks.
61
Q

What is a key result of a managed float regime?

A

Managed float enables monetary policy to be effective in stimulating the macroeconomy:

62
Q

Purchasing power parity exchange rate approach

A
  • Suggests that exchange rates adjust to equalize the relative purchasing power of currencies; thus exchange rates are determined by relative price levels across countries.
  • Other factors also determine exchange rate movements; factor supplies, technology, market structure changes, commodity price shocks, monetary policy changes, etc.
  • Principle of PPP sets long-term guidelines to exchange rate changes, but does not predict short-run movements well.
63
Q

What are basic tools of fundamental analysis?

A
  • Interest rate parity
  • Relative inflation & prices in countries (Purchasing Power Parity)
  • Current account balance, trade balance, etc.
  • Asset markets, & behavior of capital & financial account
64
Q

Fundamental analysis of Foreign Exchange Rates?

A
  • Bases estimates of future exchange rate values on econometric analysis of “fundamental” market forces —macroeconomic outcomes, key economic indicators, asset values, etc. (rate of interest, economic growth, projected growth, budget surplus/deficit, BOP surplus/deficit, unemployment rate, manufacturing productivity, housing sector activity)
  • Fundamental analysis good for long-run analysis, but doesn’t give short-term currency pricing recommendations
65
Q

Technical Analysis of Foreign Exchange Rates

A
  • Predicts future price trends based on historical patterns of exchange rate prices, cycles and volatility; primarily for analyzing short-run changes
  • In a “perfect” market, market knowledge and expectations are already incorporated –the “market discounts everything”: rate of interest (relative to other economies), economic growth and projected growth, budget and current account surplus/deficits, etc..
  • useful to traders to understand and predict short-term behavior of currency prices, stock prices, etc
66
Q

What is the main principal of Technical Analysis?

A

“Efficient market hypothesis” –all market fundamentals (including expectations) are already reflected in market exchange rates

67
Q

What are some implications of the “efficient market hypothesis”?

A
  • Future changes in stock values should be largely unpredictable, e.g., follow a “random walk.”
  • “Past performance does not guarantee future performance”
68
Q

Does the “efficient market hypothesis” hold?

A

Yes, in general, but some patterns are common:

  • Excessive volatility in response to new information, lagged response to dividend announcements, etc.
  • “January effect”
  • Mean reversion
69
Q

What tools does the technical analysis of foreign exchange rates use?

A
  1. charts - line, bar, candlestick
  2. “support” and “resistance” levels indicating the historic upside (indication to buy) and downside (indication to sell) of the currency vis-à-vis another;
  3. channels and triangles, which plot the historic trading range of the currency pair, and flag potential ‘breakouts;’
  4. indicators, measuring moving averages and “momentum oscillators” which indicate changes over time, and where trading is taking the market and when.
70
Q

What are some assets held between countries?

A
  • corporate stocks and bonds
  • government securities
  • real estate
  • commercial bank deposits
71
Q

A country’s currency will _______ by an amount equal to the excess of domestic inflation over foreign inflation. The exchange rate quoted in terms of foreign currency per domestic currency will _________ by an amount equal to the excess of foreign inflation over domestic inflation.

A

A country’s currency will DEPRECIATE by an amount equal to the excess of domestic inflation over foreign inflation. The exchange rate quoted in terms of foreign currency per domestic currency will INCREASE by an amount equal to the excess of foreign inflation over domestic inflation.

72
Q

What does the U.S. current account deficit represent?

A

Current account deficit has little to do with inherent ability of a country to sell goods in world market; rather it indicates imports were needed to meet the domestic demand for goods and services.

73
Q

Why would a country devalue its currency?

A
  • Fix balance of payment issues - incentivizes exports
74
Q

What market factors exhibit changes where an increase in the factor results in an appreciation of the dollar’s exchange value and vice versa? (similar effects: increase = appreciates and decrease = depreciation)

A
  • foreign demand for U.S. exports
  • foreign demand for U.S. assets
  • U.S. interest rates (relative to foreign countries)
  • U.S. productivity (relative to foreign countries)
75
Q

What market factors exhibit changes where a decrease in the factor results in an appreciation of the dollar’s exchange value and vice versa? (opposites)

A
  • U.S. demand for foreign exports
  • U.S. demand for foreign assets
  • U.S. price levels (relative to foreign nations)
  • U.S. real income (relative to foreign nations)
  • U.S. trade restrictions (relative to foreign nations)
76
Q

What is the marginal propensity to import (leakage) formula

A

m = marginal propensity to import (leakage)

**spending multiplier**

= Change in imports (at margin)

Change in real national income

77
Q

What is the marginal propensity to save (“leakage”) formula?

A

s = marginal propensity to save (leakage)

**spending multiplier**

= change in savings (at margin__)

change in real national income

78
Q

True or False: Fixed exchange rates tend to be used primarily by small, developing nations whose currencies are anchored to a key currency such as the U.S. dollar.

A

True

79
Q

True or False: Managed floating exchange rates combine market-determined exchange rates with foreign exchange market intervention to take advantage of the best features of floating exchange rates and fixed exchange rates.

A

True

80
Q

True or False: The term crawling peg implies that par value changes are implemented in a large number of small steps. The crawling peg mechanism has been used primarily by nations having high inflation rates.

A

True

81
Q

According to the monetary approach over the long run…

A

Depreciation merely raises the domestic price level.

82
Q

Define the Marshall-Lerner condition

A
  • The trade balance will be neither helped nor hurt if the sum of the demand elasticities equals 1.
  • If the sum of the demand elasticities is less than 1, depreciation will worsen the trade balance.
  • Depreciation will improve the trade balance if the currency depreciating nation’s demand elasticity for imports plus the foreign demand elasticity for the nation’s exports exceeds 1.
83
Q

Special Drawing Right (SDR)

A

An artificial currency unit based on a basket of four currencies established by the IMF.

84
Q

How are exchange rates determined?

A

Five alternative views:

  1. Elasticity approach
  2. Balance of payment or “absorption” approach
  3. Monetarist approach
  4. Portfolio Balance Approach
  5. Purchasing Power Parity

AEM 2300 Trade & Finance (4 decks)

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