Reading 18: Currency Exchange Rates Flashcards
Explain why expenditure must decline for there to be an improvement in the trade balance.
Currency depreciation can cause a short-term improvement in the trade balance as imports decrease and households rebuild their wealth by saving more. However, the savings rate will decline when real wealth has been replaced.
Only improvements in the fiscal balance (requiring less external capital) or increases in the real interest rate (and consequent higher savings) will result in higher savings and improvement in the trade balance.
How does fixed parity differ from a currency board system?
The country can choose to adjust or abandon the parity since there is no legislative commitment to maintaining the specified parity.
The target level of foreign exchange reserves is discretionary and is not linked to domestic monetary aggregates.
How are forward rates calculated when spot rates and forward points are known?
Spot rate \+ forward points 10,000 = Forward rate
How are forward rates calculated when spot rates and forward premium/(discount) are known?
Spotrate×(1+%premium/(discount))=Forwardrate
%premium/(discount)=Forward points
Spot rate
Distinguish between active and passive crawling pegs.
Under a passive crawling peg system, the exchange rate is adjusted frequently in line with the rate of inflation.
Under an active crawling peg system, the exchange rate is pre-announced for the coming weeks and changes are made in small steps.
Describe the functions of the foreign exchange market.
FX markets facilitate international trade in goods, services, and financial assets.
FX markets allow currency conversion.
FX instruments can be used to hedge exchange rate risk.
Speculation.
Distinguish between the direct currency quote and the indirect currency quote.
In a direct currency quote (DC/FC), the domestic currency is stated as the price currency and foreign currency is stated as the base currency.
In an indirect currency quote (FC/DC), the foreign currency is stated as the price currency and domestic currency is stated as the base currency.
Give the properties of an ideal currency regime.
No currency-related uncertainty regarding the prices of goods and services and values of real and financial assets.
Fully convertible to ensure unrestricted flow of capital.
Fully independent monetary policy in pursuit of domestic objectives.
Differentiate between a fixed exchange rate regime and a floating exchange rate regime.
Fixed – The central bank absorbs private capital flows to maintain the exchange rate. Interest rates or other asset prices adjust unless the bank is forced to let the exchange rate adjust.
Floating – Rapid exchange rate adjustment diminishes prospects for further movement.
Describe a cross rate.
An exchange rate between two currencies that is derived from each currency’s relationship with a third currency.
For example,
JPYEUR=USDEUR×JPYUSD
or
JPYEUR=USDEUR×(USDJPY)−1
Under what circumstances may a central bank intervene in FX markets?
The domestic currency no longer reflects underlying economic fundamentals.
Appreciation of the domestic currency is hurting the country’s exports.
The exchange rate has become too volatile for businesses to transact in the FX market.
Identify the characteristics of the real exchange rate and give the formula to calculate it.
Characteristics of the real exchange rate:
An increasing function of the nominal exchange rate (in terms of DC/FC).
An increasing function of the foreign price level.
A decreasing function of the domestic price level.
Real exchange rate DC/FC = SDC/FC × (PFC / PDC)
SDC/FC = Nominal spot exchange rate
PFC = Foreign price level quoted in terms of the foreign currency
PDC = Domestic price level quoted in terms of the domestic currency
Describe how forward exchange rates are calculated.
In a manner that ensures traders cannot earn arbitrage profits.
(1+id)=Sf/d(1+if)(1Ff/d)
Ff/d=Sf/d(1+if)(1+id)
