MGCR 382 Midterm Flashcards
What is International trade and why does it occur? (4 reasons)
International trade is trade between the residents (individuals, businesses, nonprofit organizations, or other forms of associations) of two countries. Trade involves the voluntary exchange of goods, services, or money.
- International trade occurs because the parties to the transaction believe that they benefit from the voluntary exchange.
- Imports provide higher quality, less expensive, or more quality
- Export spark economic activity
- Improves competitiveness
What is the difference about abs. Adv. and comp. adv?
absolute advantage looks at absolute differences in productivity, while the comp. looks at relative productivity differences. The difference between the theories exists because comparative advantage incorporates the concept of opportunity costs in determining which good should be produced.
Why are leontif’s findings called a paradox?
Leontief’s findings are called a paradox because his research results on the U.S. trade position were not consistent with the intuitively correct Heckscher-Ohlin model, and were in fact, exactly the reverse of what the model predicted
What are country-level theories useful/not useful in explaining?
The country-level theories are useful for explaining interindustry trade (trade in which countries exchange goods produced in different industries) among nations; however, they are not helpful in explaining intraindustry trade (trade in which countries exchange goods produced in the same industry). The latter form of trade accounts for approximately 40 percent of world trade, yet cannot be predicted by country-level theories.
What’s the difference between inter and intra industry trade?
The difference between interindustry trade and intraindustry trade is that the former involves two countries exchanging goods produced in different industries (for example, the exchange of British raincoats for American beer), while the latter involves two countries exchanging goods produced in the same industry (for example, Ford exports American-made cars to Japan, while Mazda exports Japanese- made cars to the United States).
What is protectionism and what is the rationale behind it?
Protectionism is a form of government restrictions and incentives that are specifically designed to help a country’s domestic firms compete with foreign competitors at home and abroad. The rationale for such policies can be economic or noneconomic in nature.
What is the unemployment argument for government intervention for trade?
Governments often want to have high employment as displaced workers often do not find jobs that provide comparable compensation. Often unemployment benefits must be spent on living expenses instead of job skill training for a new job. However, to limit imports to increase employment, the cost must still be borne by the government.
What are the 4 economic rationales behind gov’t intervention in trade
Fighting unemployment,
protecting infant industries,
developing an industrial base,
economic relstionships w/ other countries
What are the four noneconomic rationales why governments interfere in trade
Maintaining essential industries
Promoting acceptable practices abroad
Maintaining/extending spheres of influence
Preserving national culture
What is the unemployment argument for government intervention for trade?
Governments want high employment as fired workers usually don’t find jobs that provide similar compensation. EI has to be spent on living expenses instead of training for a new job. However, to limit imports to increase employment, the cost is still paid by the gov’t.
What is the infant-industry argument? What are the rationale for this argument and what are the pitfalls?
I-I argument says gov’t should protect an emerging industry from foreign competition using subsidies, tarrifs, or quotas. Assumes that the industry requires gov’t intervention to grow. Pitfall: Could still not thrive on its own even with government protection
What is the industrialization argument?
Countries that are trying to develop an industrial base will be affected by imports of lower-priced foreign goods. Need to be protected by tarrifs/quotas.
Pitfalls of industrialization argument
Import restrictions may spur foreign direct investment as firms may invest in manufacturing in a country to avoid these regulations. However, if the industry is not able to grow and compete on the global level, local consumers will face the cost of paying higher prices for those products.
What is the argument for government intervening in trade to manage its economic relationship with other nations?
Governments want to improve their relative position compared to other countries.
Trade control can be used to improve the balance of payments, gain fair access to foreign markets, bargain trade agreements, and control prices. Policy is dependent on the other country and its’ trade practices.
What is the non-econ rationale maintaining essential industries?
Government deems certain industry important and protects it thru trade restrictions.
What is practicing acceptable practices abroad? (nonecon rat.)
Gov’t wants to promote what they deem acceptable practices by pressuring foreign governments to alter their stances on the issue at hand.
What is preserving national culture (nonecon rat.)?
Govts may want to intervene to preserve nat culture by limiting exports of items, deemed to be a part of their nat culture or limit imports that may conflict w their domestic values
What is the difference between a tariff and a quota?
Tarrif and quota both affect QUANTITY of products that are imported.
Tarrifs affect indirectly by putting a tax on the product while quotas put hard limit on quantity that can be imported.
T or F: A tarrif is more flexible than a quota
True. The quantity that is imported, based on supply and demand, can be affected in the shifts in world price. Quota on the other hand puts a fixed limit on the quantity that can be imported.
What is a subsidy & how do they affect trade?
Subsidy is a direct assistance by governments to boost competitiveness. Essentially, gov’t is decreasing the cost of production for the firm in order to allow it to compete on the global playing field.
What is globalization?
The development of an increasingly integrated global economy marked especially by free trade, free flow of capital, and the tapping of cheaper foreign labor
Producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries
Why have eurocurrencies and LIBOR remained the centrepiece of the global financial marketplace for so long?
- Eurocurrency market essentially a large money market relatively free from government regulation
- Narrow interest rate spread in the market (low volatility)
- Reference rate of interest for the eurocurrency market is the London Interbank Offered Rate (LIBOR)
How do you calculate EPS
EPS = earnings/num of shares
What is a truly floating currency value?
A truly floating currency value means that the government does not set the currency’s value or intervene in the marketplace, allowing the supply and demand of the market for its currency to determine the exchange value.
Diff between crawling peg and truly pegged system
In a crawling peg system, the government will make occasional small adjustments in its fixed rate of exchange in response to changes in a variety of quantitative indicators such as inflation rates or economic growth.
In a truly pegged exchange rate regime, no such changes or adjustments are made to the official fixed rate of exchange.
What is a currency board arrangement?
In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar.
What is dollarization?
In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.
What is the special drawing right?
The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations and is also the base against which some countries peg the exchange rate for their currencies.
If the ideal currency existed in today’s world, what three attributes wouldnit have?
(a) Exchange rate stability. The value of the currency would be fixed in relationship to other major currencies so traders and investors could be relatively certain of the foreign exchange value of each currency in the present and into the near future.
(b) Full financial integration. Complete freedom of monetary flows would be allowed, so traders and investors could willingly and easily move funds from one country and currency to another in response to perceived economic opportunities or risks.
(c) Monetary independence. Domestic monetary and interest rate policies would be set by each individual country to pursue desired national economic policies, especially as they might relate to limiting inflation, combating recessions, and fostering prosperity and full employment.
What are the four early country based theories of international trade
Mercantilism, absolute advantage, comparative advantage, relative factor endowments
What are the two modern from-based theories
Country similarity theory, new trade theory
Early country based theories are useful for describing trade in
Commodities
Modern firm based theories are useful and describing
Patterns of trade in differentiated goods
In early country based theories,______is an important component of the customers purchase decision
Price
When did firm based theories emerge
After WW2
Interindustry Trade
Trade in different industries
Intraindustry trade
Trade within the industry
What is mercantilism?
- 16th century economic philosophy that says country’s wealth measured by holdings of gold & silver
- say country’s goal should be to enlarge these holdings by promoting exports and discouraging imports
- modern supporters of these policies called neomercantilists or protectionists
What is absolute advantage? And who made it?
- Adam Smith attacked mercantilism (weakens a country, in the process of avoiding imports at all costs, it squanders a country’s resources producing goods it’s not suited to produce)
- Smith said free trade enlarges country’s wealth, and enables a country to expand the amount of goods and services available to it by specializing in the production of some goods and services and trading for others
What is comparative advantage and who made it?
Dave ricardo, relative productivity difference through lowest opportunity cost
What is the relative factor endowment theory and who created it?
Heckscher-Ohlin (H-O) theory: A country will have a comparative advantage in producing products that intensively use resources (factors of production) it has in abundance
Pattern of Comparative Advantage: export products that use plentiful factors of production and import products that need scarce factors of production
What is the Leontif paradox?
Leontief Paradox: Leontif believed that the US was a capital abundant and labour scarce economy therefore according to the HO theory he reasoned that the US should export capital intensive goods and import labour intensive goods
Why did firm based theories evolve? And why do they differ from country based?
Firm based theories evolved because
- growing importance of MNCs postwar
- inability of country based theories to explain intra industry trade
Unlike country based theories firm based theories incorporate factors such as quality, technology, brand names, and customer loyalty into explanations of trade flows
What is country similarity theory and who made it?
In 1961 Swedish Linder explained intraindustry trade:
- International trade in manufactured goods is from similarities of preferences among consumers in countries that are at the same stage of economic development
- His country similarity theory suggests that most trade in manufactured goods should be between countries with similar pc income and that intraindustry trade in manufactured goods should be common
- Linders theory is useful in explaining trade in differentiated goods such as cars, electronics, for which brand names and product reputations play an important role
What is New Trade Theory and who developed it?
New trade theory was developed in the 1970s by helpman, krugman, lancaster
- according to this theory, economies of scale occur if a firms AC of producing a good decrease as output of that good increases
- predicts that intra-industry trade will be commonplace
- also suggests MNCs within the same industry will compete with each other on a global basis as they attempt to expand their sales to capture scale economies
- once they have some competitive advantage they can leverage their strengths
What is foreign portfolio investment? Why do people invest in them?
- passive holdings of securities
- foreign portfolio investments will be motivated by attempt to seek a good rate of return while reducing risk that can come from geographically diversifying one’s investment portfolio
What is foreign direct investment?
- acquisition of foreign assets to control them
- FDI may take many forms, including purchase of existing assets in a foreign country, new investment in PPE, and participation in a joint venture with a local partner
What are the two main political factors for FDI decisions
- Avoidance of trade barriers
- Economic development incentives
What are some examples of direct price influencers
Tariffs also known as “duties”
Subsidies
Others(aids/loans to help companies w contracts, customs valuation)
What are the two types of trade control instruments
Directly limit the amount allowed to be traded
Indirectly affect the amount traded by directly influencing the prices of imports or exports
What is a tariff
A government levied tax on goods shipped internationally
- on goods entering leaving or passing through a country
3 types of tarrifs
Export, transit, import
What are the 3 types of quotas?
- Specific duty: When a country assesses a tariff on a per unit basis
- Ad valorem tariff: A tariff that is assessed as a percentage of the item’s value
- A compound duty is due when both a specific and an ad valorem tariff are assessed
What is the main direct quantity limiter? And what is the second?
Quota, embargo
Do trade restrictions affect services as well as manufactured and agricultural products?
Yes
What is an embargo?
Full stop on production
4 options for companies facing import competiton
Move abroad
Seek other niches
Be more efficient
Try to get protection
What is dumping?
Selling in another country at a lower price
Who pays for an import tariff?
The country bringing in the goods
What is pass through
How much is the company getting tariffed willing to pass along the tariff to the end customer
What is 100% pass through?
All tariff getting passed go to end customer
Direct quote + example
• Direct quote: Home currency price per unit of foreign currency – Eg: 5.04 Danish Krone/ $1 CAN is a direct quote in Denmark
What is an indirect quote.
• Indirect quote: Foreign currency price of the home currency – 0.68 EUR/ 1 $CAN is an indirect quote in Canada
What is a bid rate?
• The “Bid Rate”: The price at which an FX dealer is willing to buy currency
What is the ask rate?
• The “Ask Rate”: The price at which an FX dealer is willing to sell currency
What is the spread?
• The Spread: The difference between the bid and ask rates as quoted by an FX dealer
What is a mid rate?
Midway between the avg bid and offer rates among currency traders
How to calculate change in the exchange rate? (Solving for denom currency)
Ending-beginning
/beginning
What is an an arbitrage opportunity?
• An arbitrage opportunity is an opportunity to make a riskless profit by exploiting price differences
3 krys of arbitrage
Lock in rate
Put in as much as you can
Be fast
What is the spot exchange rate?
• Spot exchange rate: The price of foreign exchange to be delivered immediately (where “immediate” usually means within 2 business days)
What is the forward exchange rate?
• Forward exchange rate: Negotiated today for delivery at a pre-specified FUTURE date
What is the forward premium?
Measures the annualized % difference between spot and forward rates
How do u calculate forward premuim/discount? For the DENOMINATOR
(Forward-spot)/spot * 360/# days to settlement
Exchange rate formula to solve for numerator
Beginning-ending
/ending
What is a cross rate?
• Cross Rate: The exchange rate between two currencies calculated using a third currency
What is a eurocurrency
• Eurocurrencies are domestic currencies of one country on deposit in a second country
Ex: yen deposited in canada
• Any convertible (exchangeable) currency can exist in “Euro-” form (do not confuse this term with the European Euro)
2 purposes of eurocurrency markets
- money market device for excess corporate liquidity
- source of short-term bank loans
What is the reference rate of interest for eurocurrencies?
• Reference rate of interest is LIBOR- The London Interbank Offered Rate
When was modern eurocurrenct market born?
After WW2
The gold standard lasted from
1876 to 1913
Why did the gold standard stop working
Outbreak of World War I, which interrupted trade flows and free movement of gold
Impact of gold standard on trade flows and economy
Tf: trade dominated capital flows
Econ: increased world trade with limited capital flows
What happened to currencies in the inter war years? And the USD
Currencies were allowed to fluctuate in terms of gold and each other
Increasing fluctuations in currency values became realized as speculators short sold weak currencies
US devalued
When was the interwar period
Between the world wars 1914-1944
What was Bretton Woods
Established a US dollar-based monetary system and created the IMF and world bank
each country established its exchange rate vis-à-vis the USD and then calculated the gold par value of their currency
Devaluation makes your products relatively ______
Cheaper
Under Bretton Woods,
Participating countries agreed to try to maintain the currency values within _____ of par by buying or selling foreign or gold reserves
• Devaluation was not to be used as a competitive trade policy and up to a________ devaluation was allowed without formal approval from the IMF
1%, 10%
What was the IMF? And what is the Special Drawing Right?
The IMF was the key institution in the new international monetary system and was created to:
– Help countries defend their currencies against cyclical, seasonal, or random occurrences
– Assist countries having structural trade problems if they promise to take adequate steps to correct these problems
– Special Drawing Right (SDR) serves as a unit of account for the IMF and other international and regional organizations
When were fixed exchange rates and what did that look like?
• Bretton Woods and IMF worked well post WWII, but diverging fiscal and monetary policies and external shocks caused the system’s demise
– The US dollar remained the key to the web of exchange rates
• Heavy capital outflows of dollars became required to meet investors’ and deficit needs and eventually created a lack of confidence in the US’ ability to convert dollars to gold
• This lack of confidence forced President Nixon to suspend official purchases or sales of gold on Aug. 15, 1971
• Exchange rates of most leading countries were allowed to float in relation to the US dollar
• A year and a half later, the dollar came under attack again and lost 10% of its value
• By early 1973 a fixed rate system no longer seemed feasible and the dollar, along with the other major currencies was allowed to float
1944-73
When was the floating era and what was it like
– Exchange rates became much more volatile and less predictable than they were during the “fixed” period
– Several emerging market currency crises
– EMS restructuring (1992) and introduction of the Euro (1999)
1973-97
Whats the emerging era
Current era since 1997, growth in emerging market economies and currencies
What are the three elements of the impossible Trinity
Exchange rate stability, full financial integration, monetary independence
For exchange rate stability you must give up either
An independent monetary policy, or allowing the free movement of capital in and out of the country
What is full financial integration
The free movement of capital in and out of the country
What is monetary independence
An independent monetary policy
Exchange rate stability and full financial integration can occur when
Times are good, people aren’t concerned about the economy
What is a hard Peg
Extreme currency regime peg forms such as currency boards and dollarization
What is dollarization
Using another currency as your own
What is a soft peg
Fixed exchange rates where authorities maintain a set but variable band about some other currency, allows for small fluctuation, post Brettonwoods
What is a managed float
Market forces of supply and demand set the exchange rate, but with occasional government intervention
What is a free floatingExchange rate
Market forces of supply and demand are allowed to set the exchange rate with no government intervention
What kind of currency regimedo most countries have
Floating arrangements
• A nation’s choice as to which currency regime to follow reflects national priorities about all facets of the economy, including:
– inflation,
– unemployment,
– interest rate levels,
– trade balances, and
– economic growth
What are the pros of a fixed rate regime
- stability in international prices
- inherent anti-inflationary nature of fixed prices
What are the cons of a fixed rate regime
- Need for central banks to maintain large quantities of hard currencies and gold to defend the fixed rate
- Fixed rates can be maintained at rates that are inconsistent with economic fundamentals
Pros of a floating regime
Keep monetary independence and ability for money to go in and out
Con of a floating regime
Volatility
What are Currency boards
Exist when countries central bank commits to back it’s monetary base, money supply, entirely with foreign reserves at all times
Unit of the domestic currency cannot be introduced into the economy without an additional unit of foreign exchange reserves being obtained first
Arguments for dollarization
– No currency volatility and currency crises
– Greater economic integration with dollar based markets
Arguments against dollarization
– Loss of monetary policy
– Loss of power of seignorage
- central bank no longer lender of last resort
What are the two regime choices for emerging market
Free-floating regime
Currency board or dollarization
What is the balance of payments
The measurement of all international economic transactions between the residents of a country and foreign residents
Why is balance of payment data important
• BOP data is important for government policymakers and MNEs as it is a gauge of a nation’s competitiveness or health
– An indication of pressure on a country’s foreign exchange rate
- A signal of the imposition or removal of controls in various sorts of payments
– A forecast of a country’s market potential
What is a debit in the BOP
Associated with payment outflows (negative signs)
What is a BOP credit
Associated with payment in flows (positive sign)
What are the three main elements of actual process of measuring international economic activity
- Identifying an international economic transaction
- Understanding how transactions create debits and credits
- Understanding the bookkeeping procedures for BOP accounting
The BOP includes
– Exchange of Real Assets – exchange of goods and services for other goods and services or for monetary payment
– Exchange of Financial Assets – Exchange of financial claims for other financial claims
What is the balance of payments formula
Current account balance + capital account balance + financial account balance + reserve balance
Aka
(X-m)+(ci-co)+ (fi-fo)+FXB
FXB is the change in official monetary reserves
What are the four IMF exchange rates classifications
Hard pigs, soft pigs, floating arrangements, residual
What balance of payment account would a dividend from the US Apple stock go in to
Net income under current account
If I invest in US Apple stock what account under the BOP would that be
Net portfolio investment under financial account
What are the two push and pulls of exchange rate regimes
Policy rules (ability to make monetary decisions yourself), cooperation between countries
What are the two primary sub accounts of the BOP
Current account (measures the value of trade, investment income, and unilateral transfers) The capital/financial account (measures financial activity)
What are the four accounts of the BOP
Current, capital/financial, official reserves, net errors and omissions
What account under BOP: International McGill Student buys condo
Capital account
What does the current account of the BOP include
 • Goods Trade: export/import of goods
• Services Trade: export/import of services
• Income: predominately current income associated with investments and wages & salaries
• Current Transfers: financial settlements associated with change in ownership of real resources or financial items plus gifts and grants
• Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted
What does the capital account of the BOP include
Real estate • Capital account - transfers of fixed assets and acquisitions/disposal of non-produced/non-financial assets
What are the components of the financial account of the BOP
- Direct Investment – Net balance of long term capital which is dispersed from and into a country for the purpose of exerting control over assets.
- Portfolio Investment – Net balance of short term capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment.
• This capital is purely return motivated - Other Investment Assets/Liabilities – Consists of various short and long- term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade
What is the official reserves account of the BOP
Official Reserves: Held by official monetary authorities within a country
– Typically comprised of major currencies and reserve accounts held at the IMF
– The significance depends on whether the country is operating under a fixed exchange rate regime or a floating exchange rate system
What is capital mobility
• The degree to which capital moves freely cross-border is critically important to a country’s BOP
What is capital control
• A capital control is any restriction that limits or alters the rate or direction of capital movement into or out of a country
What is capital flight
– Characterized as rapid outflow of capital in fear of domestic political and economic conditions and policies
– Many heavily indebted countries have suffered capital flight, compounding their debt service problems
– Capital can be moved via international transfers, with physical currency, collectables or precious metals, money laundering or false invoicing of international trade transactions
 • A U.S. food chain imports wine from Chile:
– Debit to U.S. goods part of the current account, credit to Chilean goods part of the current account
• A U.S. resident purchases a euro-denominated bond from a German company:
– Debit to U.S. portfolio part of the financial account; credit to German portfolio of the financial account
• Singaporean parents pay for their daughter to study at a U.S. university:
– Credit to U.S. current transfers in current account; debit to Singapore current transfers in current account
• A U.S. university gives a tuition grant to a foreign student from Singapore:
– If the student is already in the United States, no entry will appear in the balance of payments because payment is between U.S. residents. (A student already in the United States becomes a resident for balance of payments purposes.)
– If the student is still in Singapore, it would be a debit to the U.S. current transfers in the current account; credit to Singapore current transfers in the current account.
What are the four components of the current account in the BOP
Net exports/imports of goods Net exports/imports of services Net income (investment income from direct and portfolio investment plus employee compensation) Net transfers (some sent home by migrants and permanent workers abroad, gifts, Grants and pensions)
What was China’s twin surpluses
Current and financial accounts were both positive, typically these relationships are in verses of one another. The reason for the twin surpluses is due to the exceptional growth of the Chinese economy. Between 2001 to 2012, china increased foreign exchange reserves by more than a tenfold increase. China is now able to manage its currency to maintain competitiveness worldwide. China can also maintain a relatively stable fixed exchange rate against other major currencies
If the demand for currency goes up in a fixed exchange rate, What happens to supply
Supply also goes up, I have to keep the relationship stable
If the demand for a Floating currency goes down what happens to supply?
Stays the same
Why did China’s BOP still balance with the twins surpluses
They had a lot of foreign exchange reserves, which goes into the negatives. Not your currency, getting a lot of foreign money in
Fixed exchange rate countries: what happens if current and financial accounts sum more than 0
Surplus demand exists
Government then must intervene in foreign ex. Market and sell domestic currency for foreign currencies/gold to bring BOP back to near 0
Fixed exchange rate countries: what happens if current and financial accounts sum less than 0
Excess suply of domestic currency
Government must intervene by buying the domestic currency with its reserves of foreign currencies and gold
Impact on trade/economy during interwar years
Increased barriers to trade/capital flows
Protectionism/nationalism
Impact on trade/economies in the fixed exchange rates
Capital flows begin to dominate trade
Expanded open economy
Impact on trade/economy during floating exchange rates
Capital flows dominate trade
Industrial economies increasingly open, emerging nations open slowly
Impact of emerging era on trade/economies
Selected emerging nations open capital markets
Capital flows drive economic development
What parity links expected inflation rate differential and expected exchange rate changes? What is their relationship?
Relative Purchasing power parity
The Law of one price states
that all else being equal (no transaction costs or restrictions) a product’s price should be the same in all markets
Formula: Price of a product according to LoOP
P$ x S = P¥
S- spot rate, yen/dollar
What is the Purchasing Power Parity (PPP) Exchange Rate?
S yuan/$= PI yuan/PI $
If S (actual) > S (PPP), is currency over/undervalued?
Overvalued
How do we calculate the degree to which a currency is overvalued/undervalued? (FORMULA)
Implied-Actual
/actual
If S (actual) < S (PPP), is currency over/undervalued?
Undervalued
What is Relative Purchasing Power Parity
the relative change in prices between countries over a period of time determines the change in exchange rates (relative PPP)
What is the relative ppp formula?
Spot rate in 1 year/Current spot rate is equal to 1+ expected inflation(home)/1 + expected inflation(foreign)
If p0=1 and p1=10 what is the rate of inflation?
900%
T or F: PPP is accurate in predicting future exchange rates
F
T or F: PPP holds up Well over the v long term but is poor as a short-term estimate
T
If you have higher inflation than me, the value of your currency will…
Go down compared to me
What is the relationship between expected exchange rate and expected inflation
Opposite
Fisher effect formula
Nominal rate of interest = real rate of interest + expected rate of inflation
According to the fisher effect, whats the relationship between relative interest rates and expected inflation rates
Move in same direction
What is the international Fisher effect
States that the spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries
• The International Fisher Effect predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away
Relationship between expected exchange rates and relative interest rates according to intl fisher effect
Opposite
• Justification for the International Fisher Effect is that investors must be rewarded or penalized to offset the expected change in exchange rates
Intl fisher effect formula
(S2-s1)/s1 *100 = i$ - i¥
Nominal income formula (approximate)
(1+rn) ≈ (1+rr) + (1+exp. inf.)
What is the relationship between expected inflation and nominal rates
Move in the same direction
Anytime you see a difference and posted rates between countries, It’s due to…
Why?
Expected inflation
Because real rates of return are the same in both countries
What do we mean by unbiassed forward rates
What is the Forward rate in one year or equal to? Spot rate one year from now
If expected exchange rate change goes up, what do we assume will happen to nominal interest rates
Go down
If forward exchange rates go down, what will happen to expect and exchange rate changes
Also go down
What is the forward rate?
An exchange rate quoted today for settlement at some future date
If a currency has a higher interest rate, it willl sell forward at a ____
Discount
If a currency has a lower interest rate, it willl sell forward at a ____
Premium
Difference between uncovered/covered interest parity
Covered: locked in because were locking in the rate using fwd contract
Forward premium/discount
The % difference between the spot and forward exchange rate, stated in annual percentage terms
How do you calculate forward premium/discount? For NUMERATOR
(spot - forward)/forward * 360/# days to settlement
Advantages of fixed exchange 2
Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses.
Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth.
Disadvantages of fixed rate 2
Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.
Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.
How does a crawling peg differ from a pegged exchange rate
Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations.
Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nation’s economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administratively—usually too late, too highly publicized, and at too large a one-time cost to the nation’s economic health.
What is meant by the term impossible Trinity and why is it impossible
Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability.
Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the world’s capital markets.
Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.
What’s the difference between a currency board arrangement and dollarization
In a currency board arrangement, the country issues its own currency but that currency is backed 100% by foreign exchange holdings of a hard foreign currency—usually the U.S. dollar. In dollarization, the country abolishes its own currency and uses a foreign currency, such as the U.S. dollar, for all domestic transactions.
What are special drawing rights
The Special Drawing Right (SDR) is an international reserve asset created by the IMF to supplement existing foreign exchange reserves. It serves as a unit of account for the IMF and other international and regional organizations and is also the base against which some countries peg the exchange rate for their currencies.
Defined initially in terms of a fixed quantity of gold, the SDR has been redefined several times. It is currently the weighted value of currencies of the five IMF members having the largest exports of goods and services. Individual countries hold SDRs in the form of deposits in the IMF. These holdings are part of each country’s international monetary reserves, along with official holdings of gold, foreign exchange, and its reserve position at the IMF. Members may settle transactions among themselves by transferring SDRs.
Main outcomes of dollarization, free floating, and currency boards from the perspective of emerging market nations?
Highly restrictive regimes like currency boards and dollarization require a country to give up the majority of its discretionary ability over its own currency’s value.
Currency boards, like that used by Argentina in the 1990s, restricted the rate of growth in the country’s monetary policy in order to preserve a fixed exchange rate regime. This proved to be a very high price for Argentine society to pay, and in the end, it could not be maintained.
Dollarization, an even more radical extreme in the adoption of another country’s currency for all exchange, removes one of a government’s major attributes of sovereignty.
In a free-floating regime, the government allows the foreign currency markets to determine the currency’s value, although the government does maintain sovereignty over its own monetary policy, which in turn has significant direct impacts on the currency’s value.
What institution provides the primary source of similar statistics for POP and economic performance worldwide
IMF, balance of payments statistics
What are three specific signals that a countries BOP data can provide
The BOP is an important indicator of pressure on a country’s foreign exchange rate, and thus on the potential for a firm trading with or investing in that country to experience foreign exchange gains or losses. Changes in the BOP may predict the imposition or removal of foreign exchange controls.
Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors.
The BOP helps to forecast a country’s market potential, especially in the short run. A country experiencing a serious trade deficit is not likely to expand imports as it would if running a surplus. It may, however, welcome investments that increase its exports.
What does it mean to describe the balance of payments as a flow statement
The BOP is not a balance sheet, it is a cash flow statement. Trucks the continuing flows of purchases and payments between a country and all other countries. Does not add up the value of all assets and liabilities of a country on a specific date like a balance she does for an individual from
Difference between real versus Financial asset
Real assets are goods and useful services. Financial assets are financial claims, such as shares of stock or bones
What are the main summary statements of the balance of payments accounts and what do they measure
Balance of goods (also called the balance of trade) measures the balance on imports and exports of merchandise
The balance on current account expands the balance on goods to include receipts and expenses for services, and compose, and unilateral transfers
The basic balance measures all of the international transaction that come about because of market forces
The overall balance is the total change in a countries foreign exchange reserves caused bye the basic balance plus any governmental action to influence for an exchange reserves
What is the relationship between the balance of payments and a fixed or floating exchange rate regime?
Fixed Exchange Rate System.
- government bears the responsibility to ensure that the BOP is near zero.
- If sum of current and capital accounts do not approximate zero, the government is expected to intervene in the foreign exchange market by buying or selling official foreign exchange reserves.
- If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervene in the foreign exchange market and sell domestic currency for foreign currencies or gold in order to bring the BOP back to near zero.
Floating Exchange Rate System.
- the government of a country has no responsibility to peg its foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically—in theory—alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit and a capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. Like all goods in excess Supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and BOP move back towards zero
What factors seem to play a role in governments choice to restrict Capital mobility
Insulating the domestic monetary and financial economy from outside markets
A political motivations over ownership and access interest
Our capital controls more likely to occur over capital and close as they are over capital outflows
No. Equally likely
Main assumption for the Fisher effect
Can move money freely
How to calculatte ann. Rate of return?
Profit/investment * num of yearly periods
