IMF - Block 1 Flashcards
What happens when the euro appreciates, and how does it relate to exchange rates?
When the euro appreciates, it means that the euro increases in value, and this is reflected in a decrease in the exchange rate relative to a foreign currency.
What is the preferred exchange rate definition used in this course?
In this course, the preferred exchange rate definition is “home per foreign,” where the exchange rate represents the price of a foreign currency in domestic currency.
What is the correct answer regarding the relationship between the euro’s appreciation and the exchange rate, given the exchange rate definition used in the course?
When the euro appreciates, the exchange rate decreases.
What is the risk premium in the context of forward market transactions, and why does it exist?
The risk premium is the additional amount paid in a forward market transaction to avoid risk and uncertainty. It exists because the forward exchange rate may differ from the expected future spot rate.
What is the purpose of a forward market, and how does it benefit traders in foreign exchange transactions?
The forward market allows traders to fix the price and quantity of a future foreign exchange transaction in advance, eliminating the uncertainty and risk associated with future spot exchange rates. This benefit provides a hedge against potential adverse price movements.
What is the key difference between a forward market transaction and a spot market transaction?
In a forward market transaction, a contract is signed for a future exchange rate, while a spot market transaction occurs at the current market rate.
Can you provide an example of how forward contracts are used by traders and investors?
For instance, an exporter expecting payment in a foreign currency months from now can sell that currency forward. Similarly, an investor buying foreign currency to invest in foreign bonds can sell the proceeds of the investment forward, reducing exchange rate risk.
What problem do forward contracts solve for traders and investors in international transactions?
Forward contracts help traders and investors avoid the exchange risk associated with uncovered contracts when they have future payments or transfers involving foreign currencies.
Why is it stated that the phrase “Depreciation of the exchange rate” is strictly incorrect?
The phrase is considered incorrect because an exchange rate can only increase or decrease; it cannot “lose value.”
What are intermediate exchange rate regimes, and how do central banks act in them?
Intermediate exchange rate regimes involve central banks taking actions to influence exchange rates. In reality, very few rates are perfectly fixed or floating, but for theoretical and educational purposes, extreme fixed and floating regimes are convenient.
What are the characteristics of fixed exchange rate regimes, and what instruments do central banks use in these regimes?
Fixed exchange rate regimes involve central banks acting to keep the exchange rate at an official level. Instruments used in these regimes include forex interventions, interest rates, and capital controls.
How do different exchange rate regimes vary in terms of central bank (CB) interference?
Exchange rate regimes differ in their central bank (CB) interference. Fixed regimes involve CB actions to maintain the rate at an official level, while floating regimes do not involve CB interference.
List the type of fixed exchange rate systems (in the order of decreasing fixity)
-No separate legal tender (e.g., countries with euro, Ecuador has US $)
– Currency board (e.g., Hong Kong $ vs. US $)
– Other fixed pegs
– Pegs within horizontal bands
– Crawling pegs.
What is the crawling peg system?
A crawling peg is a system in which the exchange rate is adjusted periodically or continuously but within a predetermined range, it provides more flexiblity but still offers a degree of stability compared to a floating exchange rate system
Give a real world example of a crawling peg?
The State of Kuwait employed a crawling peg to manage its currency’s exchange rate, the Kuwaiti Dinar is periodically adjusted within a specificed range in relation to a basket of various currencies, including the U.S. Dollar
What is the spot exchange rate, and how is it defined?
The spot exchange rate represents the price for an immediate transaction, although it is typically effective two days after the deal. For example, if you pay €0.86 to get one dollar now, the exchange rate is €0.86/$. It is denoted as St for the rate at time t.
Why is the future spot rate (St+1) considered risky, and how does it affect financial transactions?
The future spot rate is risky because it can change, impacting the cost of transactions. For example, if you expect St+1 to be the same as St (€0.86/$), but it increases to €0.88/$, your actual cost will be higher. This uncertainty makes St+1 risky at time t.
How can one avoid the risk associated with the future exchange rate St+1?
To avoid the risk in future exchange rates (St+1), one can enter into a forward contract. A forward exchange rate, such as €0.87/$ to get one dollar next month, provides certainty and eliminates risk.
What are the two types of multilateral spot rates, and what do they measure?
The two types of multilateral spot rates are (nominal) effective rates and real effective rates. Effective rates are trade-weighted averages of indices of nominal and real rates, respectively. They measure overall competitiveness in international trade.
What is a nominal effective exchange rate, and how is it calculated?
A nominal effective exchange rate is a trade-weighted average of nominal exchange rates, considering a country’s trade relationships with its partners. It reflects the overall value of a country’s currency in international trade. To calculate it, you take a weighted average of bilateral exchange rates.
What does a nominal effective exchange rate help assess?
A nominal effective exchange rate helps assess a country’s currency strength or weakness in international trade by considering its trade relationships and the average value of its currency concerning its trading partners.
What is a real effective exchange rate, and why is it important?
A real effective exchange rate adjusts nominal effective rates for differences in price levels (inflation) between countries. It is essential because it provides a more accurate measure of a country’s trade competitiveness.
What is the core equation used to calculate the Real Exchange Rate (RER)?
he core equation for calculating the Real Exchange Rate (RER) is RER = eP/P, where “e” represents the nominal exchange rate (e.g., dollar-euro exchange rate), “P” is the average price of a good in one currency area (e.g., the euro area), and “P” is the average price of the same good in another currency area (e.g., the United States).
How is the Real Exchange Rate (RER) calculated in the Big Mac example with specific price values?
To calculate the RER in the Big Mac example, you multiply the nominal exchange rate (e=1.36) by the price in Germany (e.g., 2.5 euros) and divide it by the price in the other currency (e.g., $3.40). This gives us a real exchange rate of 1.2.
What are the participants in the forward market, and what are their motivations?
The participants in the forward market include hedgers (such as importers and exporters looking to avoid risk in the future exchange rate), arbitrageurs (typically banks seeking riskless or risk-free profits), and speculators who take deliberate risky positions to make profits in expectation.
How do speculators take advantage of the forward market?
Speculators take advantage of the forward market by making predictions about future exchange rates. For example, if they expect a currency to be cheaper in the future, they sell that currency in the forward market to profit from the difference between the forward rate and their expected spot rate.
What does it mean to “go short” in the context of the forward market?
“Going short” in the forward market means deliberately taking an open position by selling a currency you do not currently possess. It involves entering into a forward contract to deliver the currency in the future without owning it at the time of the contract.
How does perfect capital mobility relate to the covered interest parity?
Perfect capital mobility implies that individuals can easily convert between currencies and access foreign interest rates. Covered interest parity is a condition where the interest rate of one currency should be equal to the interest rate of another currency plus the forward discount. It assumes perfect capital mobility.
What does “going short” mean in the forward market?
“Going short” in the forward market involves selling a currency through a forward contract without owning it initially, with the expectation of profiting from a future depreciation of that currency.
Can you provide an example of “going short” (bear approach) in the forward market?
Let’s say you anticipate the euro’s value will decrease. You enter a forward contract to sell 10,000 euros in three months at a predetermined rate, like 1 EUR = 1.18 USD. If the euro depreciates, you buy euros at a lower rate in the spot market to fulfill the contract, making a profit. If the euro appreciates, you may incur a loss.
How does an increase in the US interest rate (R star) impact the exchange rates (S and F) according to the lecture? r= r* x ((F-S)/S)
When the US interest rate increases, it affects the returns from investments in the US and at home. This, in turn, leads to a higher demand for US investments, causing the US dollar to appreciate (S goes up) and the forward exchange rate (F) to decrease until equilibrium is reached.
What is the balance of payments?
The balance of payments is a statistical record of all economic transactions between residents of a reporting country and residents of the rest of the world during a specified time period, typically a year. It provides insight into a country’s imports, exports, financial transactions with other nations, and changes in foreign currency reserves.
How often are the statistics included in the balance of payments typically reported?
The usual reporting period for all the statistics in the balance of payments is a year. However, some of these statistics are also published on a more frequent basis, such as monthly or quarterly.
What information does the balance of payments reveal about a country’s economic activities?
The balance of payments reveals how many goods and services a country has been exporting and importing, whether the country has been borrowing from or lending money to the rest of the world, and whether the central monetary authority (usually the central bank) has increased or reduced its foreign currency reserves.
What are the names of the sub-accounts in the BOP?
The current account, the capital and the financial account
What is the current account balance?
The current account balance is the sum of the visible trade balance and the invisible balance, reflecting a country’s economic transactions with the rest of the world over a specific period.
What is the purpose of including ‘unilateral transfers’ in the invisible balance?
‘Unilateral transfers’ in the invisible balance account for payments or receipts with no corresponding quid pro quo, meaning there is no direct exchange of goods or services. Examples include migrant workers’ remittances, pension payments to foreign residents, and foreign aid. These receipts and payments redistribute income between domestic and foreign residents. Payments are recorded as a debit (a fall in domestic income), while receipts are recorded as a credit (an increase in income).
How is the balance of trade in goods, also known as the “Visible Account,” related to the current account balance?
The balance of trade in goods (Visible Account) is a component of the current account balance. It specifically records the trade of tangible (physical) goods, encompassing items such as consumer goods, machinery, and raw materials. This component reflects the flow of funds related to physical goods in international trade.
What is the Balance of Trade in Services, also known as the “Invisible Account”?
The Balance of Trade in Services, referred to as the “Invisible Account,” is a component of the current account balance. It is dedicated to recording the trade of services, encompassing a wide range of services such as bank transactions, insurance policies, and hotel stays.
How does the “Invisible Account” differ from the “Visible Account” in the context of the current account balance?
While the “Visible Account” (Balance of Trade in Goods) deals with the trade of physical, tangible goods, the “Invisible Account” (Balance of Trade in Services) focuses on the trade of intangible services. This distinction highlights the economic transactions related to services like banking, insurance, and hospitality, rather than physical products.
Why is the concept of perfect capital mobility important in the context of covered interest parity (CIP)?
Perfect capital mobility is essential for covered interest parity (CIP) to work effectively. It allows arbitrageurs to exploit differences in interest rates between countries and ensures that the three critical transactions involved in CIP can be carried out seamlessly.
What is the national savings identity?
The national savings identity is a concept that states that private net savings (S minus I) plus government net savings (T minus G) equals the current account balance.
What is the relationship between the current account and asset flows?
The current account is directly linked to asset flows. For example, when a country like the US has a current account deficit, it means there is an outflow of assets, such as bonds, to other countries.
Is there a difference between asset outflow and capital inflow?
Asset outflow refers to assets like bonds leaving a country, while capital inflow refers to funds or money coming into a country. They are related but represent different aspects of financial transactions.
How do current accounts and capital accounts relate to financial planning?
The current account and capital account are components of the balance of payments. The current account primarily deals with trade in goods and services, while the capital account covers financial transactions, including asset purchases and sales. Both are essential for understanding a country’s economic and financial position.
Why are exports recorded as credit entries?
Exports are recorded as credit entries because they represent an inflow of money or economic value into the country. In accounting, a “credit” entry typically signifies an increase in assets or a source of funds, which aligns with the financial impact of exports.
What does a credit entry in accounting indicate?
In accounting, a credit entry usually indicates an increase in assets or a source of funds. When a country exports goods or services and receives payment for them, this payment is recorded as a credit entry because it increases the country’s assets and provides a source of funds.
How do exports contribute to a country’s financial records?
Exports contribute positively to a country’s financial records because they result in an increase in the country’s assets. The revenue generated from exports can be used to invest in domestic businesses, pay off debts, support economic growth, or finance various activities, making exports a source of funds recorded as credit entries.
What do “capital inflows” and “capital outflows” refer to in simpler terms?
“Capital inflows” and “capital outflows” refer to the movement of money in and out of a country’s financial system.
Why are “capital inflows” represented as positive entries in the ledger (credits)?
Capital inflows are recorded as positive (credits) because they signify money coming into the country from abroad, such as when the country borrows money, foreign residents invest in the country, or the country sells its investments to foreigners.
: What’s a simple way to understand why “capital inflows” are recorded as positives?
Think of capital inflows as similar to your country exporting IOUs (promises to pay) or selling a share in its businesses to foreigners. It’s recorded as a positive because it’s like receiving money from outside.
Why are “capital outflows” represented as negative entries in the ledger (debits)?
Capital outflows are recorded as negatives (debits) because they signify money leaving the country and going abroad, such as when the country lends money, buys assets in other countries, or invests in foreign businesses.
What are the three accounts involved in balance of payments?
The three accounts in balance of payments are the current account, the capital account, and the financial account.
How are international transactions booked?
International transactions are booked using the principle of double entry bookkeeping, where each transaction is recorded with both a debit and a credit entry.
What does it mean when there’s an imbalance in the balance of payments?
An imbalance in the balance of payments suggests that there might be an error or discrepancy in the bookkeeping, and it can be considered an error detection tool.
How would you define the basic rule of bookkeeping for international transactions?
The basic rule is that if there’s an export of goods, services, or assets, it’s recorded as a positive (+) because it’s a capital inflow, and if there’s an import, it’s recorded as a negative (-) because it’s a capital inflow.
Where are export of assets and import of assets typically listed in the balance of payments?
The export of assets is typically listed in the capital and financial account, whereas the import of assets is recorded in the current account.
Can a balance of payments be in deficit, and if so, which parts of it?
Yes, a balance of payments can be in deficit. It typically refers to a deficit in the current account or the combination of the current account and the capital and financial account.
How does exchange rate regime affect the official reserves account (ORA) and the balance of payments?
In a floating exchange rate regime, where the central bank does not interfere in the foreign exchange market, the ORA is typically zero, and the balance of payments should be in equilibrium. In a fixed exchange rate regime, the central bank may need to buy or sell currency to maintain the exchange rate, leading to changes in the ORA.
What was the impact of structural problems in Thailand during the East Asian crisis?
Structural problems in Thailand led to speculators questioning the fixed exchange rate of the Thai baht to the US dollar, which caused a significant devaluation of the Thai baht.
When are central banks are more likely to intervene in the foreign exchange market?
Central banks are more likely to intervene when there is a fixed exchange rate that needs to be maintained, as in the case of Denmark and the Danish krone’s peg to the euro.
What is the Marshall–Lerner condition in economics?
The Marshall–Lerner condition is an economic concept used to evaluate the impact of a currency devaluation on a country’s balance of payments.
What does the Marshall–Lerner condition specify regarding the effects of a currency devaluation?
It specifies that for a devaluation to improve a country’s balance of payments, the sum of the price elasticities of demand for a country’s exports and imports must be greater than one.
How does the condition relate to the responsiveness of demand for exports and imports?
The condition is based on the responsiveness of demand to price changes; if demand for exports and imports is highly responsive, a devaluation is more likely to have a positive impact on the balance of payments.
What happens if the sum of these elasticities is less than one according to the Marshall–Lerner condition?
If the sum of these elasticities is less than one, the condition suggests that a devaluation may not lead to an improvement in the balance of payments. This may occur when demand for exports and imports is relatively inelastic.
How do short-run and long-run elasticities of demand typically differ?
In general, short-run elasticities are lower than long-run elasticities, with long-run elasticities usually being approximately twice as great as short-run elasticities.
What is the J-curve effect, and when does it typically occur?
The J-curve effect is the phenomenon where, in the short run, the Marshall–Lerner condition may not be fulfilled, but it tends to hold over the longer run
Why might devaluation work differently for industrialized countries compared to developing ones?
Devaluation might work better for industrialized countries because they face competitive export markets, making their price elasticity of demand for exports relatively elastic. In contrast, developing countries heavily dependent on imports may have very low price elasticity of demand for imports.
What is the underlying idea of the J-curve effect in international economics?
The J-curve effect suggests that in the short run, changes in a country’s exchange rate may lead to a deterioration in its current account as export volumes don’t immediately increase and import prices rise. However, over time, export volumes start to grow, and import volumes decline, improving the current account balance.
Why does the J-curve effect involve a time lag in the improvement of a country’s current account?
The J-curve effect involves a time lag because it takes time for consumers and producers to adapt to changes in exchange rates. Consumers may switch from foreign imports to domestically produced goods gradually, and domestic producers need time to expand export production.
How does imperfect competition play a role in the J-curve effect?
Imperfect competition is a factor in the J-curve effect because it affects how foreign exporters and domestic industries respond to changes in exchange rates. Foreign exporters may reduce their export prices to maintain market share, and domestic industries might lower their prices to limit the impact of increased exports by the devaluing country. These actions depend on the presence of super-normal profit margins in imperfectly competitive markets.
What impact might higher import prices have on export prices in the context of the J-curve effect?
When import prices rise due to a devaluation, workers may seek higher wages to compensate for the increased cost of imports. This, in turn, can lead to higher export prices, reducing the competitive advantage of the devaluation.
Can you provide an example of a study that found evidence of the J-curve effect?
Krugman’s analysis of the sharp depreciation of the US dollar during 1985–87 found a J-curve effect for the US current account. Initially, the deficit worsened, but after a lag of about two years, it improved, with long-run elasticities for imports and exports summing to 1.9, exceeding what is required by the Marshall–Lerner condition.
By whom was the Bretton Wood System created?
It was created by delefates from 44 countries after World War II
Which 3 institutions were created under the Bretton Wood System?
The International Monetary Fund, The World Bank and the World Trade Organization
What was the basis of the Breton Woods monetary system?
It was based on the arrangement that lasted until 1971, where the US dollar was tied to gold at a fixed price of $35 an ounce, creating a limited gold standard.
What were the main features of the Breton Woods agreements?
The agreements established fixed exchange rates for major currencies relative to the US dollar, with the US dollar acting as a global reserve currency. It also incorporated adjustable pegs to restore balance if a country’s payments were out of line.
What was the role of the US dollar in the Breton Woods monetary system?
The US dollar served as the linchpin, tied to gold at a fixed rate of $35 an ounce, and acted as the global reserve currency, influencing international trade and currency values.
How were currencies other than the US dollar connected within the Breton Woods system?
Other major currencies were pegged to the US dollar at fixed exchange rates, allowing conversion into dollars but not directly into gold, creating an indirect gold standard.
How did the United States tackle the challenge of maintaining global circulation of the dollar?
The US constantly printed new banknotes to ensure the dollar’s global circulation, leading to a decline in its real value compared to the gold that backed it.
What does the Triffin Dilemma state?
The Triffin Dilemma states: “It is impossible to simultaneously fix the national currency to gold and make this currency the main vehicle for international trade without negative consequences for the economy.”
What does the Dornbusch Exchange Rate Overshooting Model suggest about the impact of increased money supply on the domestic currency?
According to the model, an increase in money supply results in a short-term depreciation of the domestic currency that exceeds its long-term level.
Does the increase in money supply, according to the model, affect both nominal and real variables?
No, the model suggests that the increase in money supply impacts only nominal variables and doesn’t influence real economic variables.
Define the risk premium concerning currency exchange with an importer’s perspective.
The risk premium in currency exchange pertains to an importer’s approach to minimize uncertainty in currency fluctuations when paying for goods in a different currency. By engaging in forward contracts, the importer fixes an exchange rate for future transactions, transferring the risk of currency rate shifts to the contracting agent, and compensates for this risk by paying a fee, ensuring a set exchange rate. So win-win situation
Explain the implications of a money level shock in the long run
A money level shock leads to an increased absolute price level, yet in the long run, it doesn’t affect the relative scarcity of money in terms of goods. Consequently, while the price level changes, relative prices remain constant, causing no inflation and maintaining a steady real interest rate.
What distinguishes a money level shock from a money growth shock?
A money level shock impacts the price level without affecting the real interest rate. Conversely, a money growth shock involves alterations in the rate of change of the money supply, influencing the real interest rate due to changes in the velocity of money and subsequent inflation expectations.
Why does an importer pay a risk premium in a currency exchange?
The importer pays a risk premium to compensate the agent for taking on the risk of currency fluctuations. This premium, calculated as the difference between the forward rate and the expected future rate, acts as insurance against potential losses stemming from unfavorable changes in exchange rates between the contracted forward rate and the actual future rate.
the BP curve is _________ sloping ignoring limiting cases
upward
