International Money and Finance Flashcards
Definition of exchange rate (def. 2)
-> The exchange rate is expressed as the amount of foreign currency that equals one unit of domestic currency (foreign currency is always 1).
-> When the exchange rate (S) increases it means that the price of the foreign currency has increased, which results in the foreign currency appreciating.
The spot exchange rate
Price for immediate transaction
The forward exchange rate (2)
(1) price & (2) transaction date is certain.
*There is no risk involved - however F and S are closely correlated.
Hedgers
Enter forward market to protect themselves.
Speculators
Agents that hope to make a profit by accepting exchange rate risk.
Arbitrageurs
Riskless profit based on interest rate differentials.
-> Forward premium
is when the forward exchange rate represents an appreciation for that currency compared to the current spot.
-> Forward discount
forward exchange rate quotation represents a depreciation.
Nominal exchange rate (S)
The price of one currency in terms of another
Real exchange rate (Sr)
Corrects for price differences
Exchange rate regimes (3)
(1) Fixed exchange rate: the central bank buys/ sells currencies to keep the exchange rates fixed.
(2) Floating exchange rate: The exchange rate is only determined by supply and demand.
(3) Intermediate regimes: Central bank influences rate
Retail clients
Dutch importer who needs dollars
(Commercial banks) banks
- Sell dollars to importer
- Buy dollars from another bank
Forex (FX) brokers
Intermediary for banks: gains from economies of scale
Central banks (ECB, Fed, …)
Intervene (i.e. buy/sell H currency) to influence the value of H currency
GDP
Value added WITHIN the country
GNP
Value added by all the nation’s factors of production
*Value added = total sales - intermediary purchases
*Value added = final sales - intermediary exports - intermediary imports
Private savings (S) (3)
= Output (Y) - Tax (T) - Consumption (C)
Government deficit surplus
= Tax (T) - Government spendings (G)
Total savings
= Private savings + Government savings
Formula GDP (Y)
Y = C + I + G + X - M - T
National Savings Identity (CA) (4)
CA = S - I + T - G
Current Account = private savings surplus + govt. budget surplus
*Related to national income identity but with international focus
- Current account, CA
-> Income flows
a. Goods accounts/trade balance (exports-imports) (visible trade)
b. Service account (services, transportation)
c. Income account (Interest, profits, dividends)
d. Unilateral transfers account (Gifts, EU contribution, fall in domestic income due to payment to foreigners)
- Capital and financial account, (K or KA)
-> Changes in assets & liabilities of the private sector and non-central-bank public sector. Plus and minus depends on if it is cash in or out flow.
a. Portfolio investment (stocks, bonds)
b. Direct investment (physical capital)
c. Nonfinancial, non-produced assets (patents, copyrights)
d. Capital transfers (asset ownership transfers, debt forgiveness)
- Settlements account (ORA). (3)
-> Transaction by the Central Bank
a. Official forex intervention (buying H currency at forex market)
b. Selling gold
c. Borrowing from IMF or foreign CBs
Balance of payments and its accounts
- Current account (CA)
- Capital and financial account (K or KA)
- Settlements account (ORA)
-> BoP = CA + K + ORA
Net international investment position (NIIP)
Total value = H-owned assets (real & financial) in F – F-owned assets in H
NIIP changes due to two reasons (2)
A. Current Account: net issuance of new assets
B. Valuation effects: changes in the valuation of existing assets
- Local currency value of assets
- Exchange rate
Internal Balance (IB)
- Full employment
- Stable prices (or stable inflation)
External balance (EB)
- CA equilibrium (because a long-run deficit or surplus is problematic)
X-Axis (Swan Diagram) (3)
Absorption = domestic spending = Consumption (C) + Investment (I) + Government spending (G)
Y-Axis (Swan Diagram)
Real exchange rate Sr = (SP/P) *quantifies competitiveness
Disadvantages of Swan: (2)
(1) Focus on EB not IB
(2) No international capital movements
Mundell - Fleming model
3 Market equilibria:
Internal focus (focus on Y):
(1) IS: equilibrium on the goods market – Output/ Income
(2) LM: equilibrium in the money market – Interest rate
External focus (focus on r):
(3) BP: equilibrium on the forex market – Exchange rate
Macroeconomic trilemma I
Fixed exchange rate & perfect capital mobility
⇒ Is monetary policy effective?
- If the country increases M, the interest will decrease and therefore also the exchange rate. To keep the exchange rate fixed, the country will have to sell foreign currency and buy domestic one. This action to keep the exchange rate fixed cancels out the effects of the monetary expansion.-> NOT possible
Macroeconomic trilemma II
floating exchange rate & perfect capital mobility ⇒ is fiscal policy effective?
Fiscal policy increases government spendings -> financed with debt (inflow foreign capital) -> appreciates the currency -> less competitive exports -> decreases the current account -> decreases output (Y) and interest rates also find a new equilibrium.
-> NOT possible
PPP law of one price (def.)
-> It states that the price levels between two countries should be equal (=law of one price) this is achieved by the exploitations of arbitrage opportunities. This means that goods in each country will cost the same once the currencies have been exchanged power parity (PPP)
*Invalid in the short run.
-> P = S * P
Deviation from PPP (3)
Economic reasons
- Trade costs and 1. Trade costs and impediments -> goods arbitrage ↓
- Tradables vs. non-tradables (see next slides)
- Productivity differentials: Balassa-Samuelson
Balassa-Samuelson explanation
-> In rich countries the productivity for tradables is higher and therefore the prices for all products.
Limitations of PPP (3)
- Cannot explain large fluctuations in the exchange rate
- Ignores money and capital flows
- Ignores exchange rate expectations
Uncovered Interest Parity (UIP) (def.)
-> UIP implies that the expected rate of return on domestic and foreign bonds is equal. The effects of the future exchange rate equal the interest rate benefits out (r = r* + Es°).
What are the three markets to clear?
Flexible (goods) price - Clearing conditions
- Money market
- Goods market
- Bonds market
- Money markets (m)
Flexible (goods) price - Clearing conditions
-> Cleared by prices
Money supply ↑; leads to a depreciation of the currency S↑; P ↑ to hold PPP
- Goods market (i)
Flexible (goods) price - Clearing conditions
-> Cleared by exchange rate.
Domestic income rises ↑-> domestic prices ↑ -> exchange depreciates to hold PPP.
- Bonds market (r)
Flexible (goods) price - Clearing conditions
-> Cleared by interest rates.
Interest rates increase ↑; exchange rates appreciate ↑; future expected exchange rate decrease ↓ (regressive expectation); interest rate decreases ↓ to hold UIP
Flexible (goods) price - Deficits of the model (3)
- Assumes that PPP continuously holds.
- Prices are flexible upwards and downwards like exchange rates.
- Floating exchange rates are adopted.
Real interest parity (RIP)
- Open economies have equal real interest rates in the long run (UIP & PPP)
-> RIP: r = r* + Ep° - Ep *°
Exchange rate equation variables (3)
- Relative money supply
- Real income
- Real interest rate
Expectations matter (2)
-> Current exchange rate depends on expected future depreciation
a. Es *↑ -> r↑ -> md↓ -> p↑ -> s↑
-> Exchange rate is like an asset price (can be volatile considering future expectations)
Sticky price modle assumptions (4)
- For short and long run
- Goods prices and wages are sticky
- PPP NOT assumed
- Overshooting is possible
Different categories
Sticky price model - clearing conditions
- Money market
- International bond market
- Domestic good market
- Money market
Sticky price model - clearing conditions
-> cleared by r (interest rate)
Equilibrium: m,s = m,d
- Money market cannot be cleared by prices because prices are sticks, therefore it must be done by the interest rate.
- International bonds market
Sticky price model - clearing conditions
-> cleared by s (exchange rate)
Equilibrium (UIP): r = r*+Es° (where regressive expectations -> cheap currency is expected to appreciate)
- Domestic good market
Sticky price model - clearing conditions
-> cleared by p (goods prices)
Phillips curve p°= π (d-y) (changes in price level because of inflation, π determines how fast the prices adjust because of excess demand)