TOPIC 3 - Key international prices

Question 1

direct exchange rate

Answer 1

units of national currency per one unit of foreign
currency

Question 2

indirect exchange rate

Answer 2

units of foreign currency per one unit of national currency

Question 3

Cross exchange rates

Answer 3

exchange rate between two currencies, which is set through their respective exchange rate with a third currency

Question 4

Bilateral exchange rate

Answer 4

value of one currency with respect to another currency

Question 5

nominal exchange rate

Answer 5

value of one currency with respect to another currency/other currencies without correction due to the different price evolution in the countries which use those currencies

Question 6

real exchange rate

Answer 6

value of one currency with respect to another currency/other currencies with correction due to the different price evolution in the countries which use those currencies

Question 7

effective exchange rates

Answer 7

value of one currency with respect to a basket of other currencies, each of them weighted by a weight factor coming from the importance of each partner in the trade activity of the country of interest

Question 8

NEER

Answer 8

nominal effective exchange rate: product of bilateral exchange rates accounted by their trade weight

Question 9

REER

Answer 9

real effective exchange rate

Question 10

Fixed exchange rates

Answer 10

type of exchange rate regime in which a currency’s value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

Question 11

intermediate exchange regime

Answer 11

exchange rate regime that combines fixed and floating regime, such as a pegged rate with horizontal bands, it can fluctuate +- 1 % with respect to central rate

Question 12

floating exchange rate

Answer 12

market determined exchange rate, no set trend by authorities (CB can intervene for short periods)

Question 13

exchange rate flexibility

Answer 13

How floating the exchange rate is, completely fixed or floating.

Question 14

higher exchange rate flexibility (upsides (4) and downsides (3))

Answer 14

(+) simple management
(+) avoiding attacks (lower reserves required)
(+) automatic stabalizer against shocks
(+) higher degree of autonomy to macroeconomic policy
(-) higher uncertainty
(-) barrier to economic integration
(-) not be used as foreign anchor (cannot maintain the exchange rate at a fixed level by selling and buying foreign currency)

Question 15

Which exchange rate is suitable for developed, undeveloped and emerging countries?

Answer 15

developed - floating exchange rate
developing - fixed exchange rate (to gain credibility)
emerging - managed floating

Question 16

to appreciate the currency (3)

Answer 16

• rising the interest rate
• cutting barriers to foreign investment
• FX market intervention (buying national currency

Question 17

to depreciate the currency (3)

Answer 17

• lowering the interest rate
• building barriers to foreign investment
• FX market intervention (selling national currency

Question 18

IMS

Answer 18

international monetary system
- one or more currencies play a key role and is used in international transactions

Question 19

what is the exorbitant privilege

Answer 19

when a country issuing the global reserve currency gets an advantage
- way of financing economic growth cheaply
- when the situation is basically a monopoly in that role a country have enourmos advantage.

Question 20

Triffin dilemma

Answer 20

The country issuing the global reserve currency must be willing to supply the world with an extra quantity of its currency to fulfill world demand for foreign exchange reserves (the liquidity problem).
However, to generate that additional supply, the central country must suffer an increasing current account deficit (= financial account surplus) (the adjustment problem)
But, for how long is going to be credible that country (i.e., the lenders will trust that country will be able to pay its increasing debt?) (the trust problem)

Question 21

dilemma today

Answer 21

no liquidity problem, but adjustment problem and trust problem.

Question 22

Short term interest rates

Answer 22

Mainly determined by monetary policy

Question 23

Goal of monetary policy

Answer 23

• Macroeconomic
  ↳ Price stability
  ↳Output equal to natural output
• Financial
  ↳ Stability in the financial banking system

Question 24

Who controls the monetary policy

Answer 24

The Central bank, which is independent form politics and markets

Question 25

Necessary conditions for conventional monetary policy to work

Answer 25

• Usual operation of the banking system
• Keeping the option to generate a negative real interest rate (ie. avoid liquidity trap)

Question 26

Non-conventional monetary policy instruments

Answer 26

1. Change in injecting liquidity
2. Quantitative easing
3. Qualitative easing
4. Forward guidance
   ↳ measures often lead to depreciation

Question 27

Risk of monetary policy

Answer 27

• CPI inflation
• Asset inflation
• Losses faced by the CB
• Increasing inequality
• Penalty for risk-averse savers
• Fiscal dominance

Question 28

Long term interest rates

Answer 28

In the long term and through the cycles, real interest rate is determined by
the profitability of physical capital and the evolution of economic growth and productivity

Question 29

Determination of interest rates for long-term bonds equation

Answer 29

R = r + λr + πê +λπ

Question 30

Define variables in long-term interest rates bonds equation

Answer 30

R - interest rate for long-term bonds

Real components:
r - real interest rates
λr - real interest rate premium

Inflation components:
πê - expected inflation
λπ - inflation premium

Question 31

Reasons for downward trend in long term interest rates (last 3 decades)

Answer 31

1. ▽r - interest rate down:
   Higher saving rates (due to income inequality, aging western population, and emerging countries) and lower investment
2. ▽λr interest rate premium:
   Financial markets development and innovations (higher options for hedging risks)
3. ▽πê inflation:
   Growing credibility of monetary policy, globalization pushes down prices and costs
4. ▽λπ inflation premium:
   Lower volatility in the business cycle (steady production, monetary policy stabilization, integration in the world economy)