W5 - Reversals and FOREX markets

Question 1

Where are sudden stops usually observed in the trade balance and why?

Answer 1

Phenomenon in the current account however sudden stops are usually reflected in the financial account (reductions in the financial account balance) so current account needs to become surplus instead to compensate for this. (When financial accounts stop getting money in)

Question 2

Define a sudden stop?

Answer 2

A sudden stop in terms of sudden large reductions in capital inflows

Question 3

What is the impact of high government spending on growth and why?

Answer 3

If the government spends a lot, this is going to have a negative effect on your GDP growth rate. (Crowding out). Openness here is not significant

Question 4

What are the 7 key findings of edwards?

Answer 4

1. Large current account deficits are not persistent
2. Major reversal in CA deficits are persistent and strongly associated with sudden stops
3. Major reversals in CA deficits are likely to lead to an exchange rate crisis
4. Large deficits and external debts are the best predictors of CA reversals
5. Reversals have a large negative effect on growth
6. More open countries suffer less
7. More flexible countries suffer less

Question 5

What is the nominal exchange rate?

Answer 5

The price of a foreign currency using your domestic currency

Question 6

How is the exchange rate determined?

Answer 6

By interaction between supply of and demand for foreign currency. Supply and demand comes from transactions in the balance of payments

Question 7

What are credits in the case of Forex markets?

Answer 7

Credits = the supply of foreign currency

Question 8

What are debits in the Forex market?

Answer 8

Demand for foreign currency

Question 9

What is the convention for the exchange rate?

Answer 9

The exchange rate is usually quoted as the price of the foreign currency in terms of the domestic currency

Question 10

What is exchange rate depreciation?

Answer 10

Means an increase in the price of a foreign currency which means that the domestic currency is worth less. If the government increases the price of foreign currency this is called a devaluation

Question 11

What is the benefit of an exchange rate appreciation?

Answer 11

Exchange rate appreciations attract foreign currency investments hence why many countries run a strong exchange rate

Question 12

What would happen if there was an excess demand for foreign currency?

Answer 12

Excess demand = balance of payments deficit
- Exchange rate depreciates
- Cheaper exports and more expensive imporst
- Exports grow and imports decrease
- Smaller balance of payments deficit

Question 13

Can the government choose the exchange rate?

Answer 13

The government can intervene directly in the exchange rate market, buying and selling foreign currency and affect its price and can use economic policies to stimulate private agents to increase or decrease their demand for foreign currency

Question 14

How can governments use monetary policy to impact the exchange rate?

Answer 14

Monetary policy can be used to set higher interest rates
- Domestic financial assets become more attractive to foreign investors
- Capital inflow = increase in the supply of foreign currency
- Exchange rate appreciation

Question 15

What do most governments want to see happen in their exchange rates and why?

Answer 15

Most governments want to see appreciation of their currency to have an influx of financial capital either through transacting in foreign currencies or using interest rates to effect the attractiveness of assets to foreign investors

Question 16

What is arbitrage?

Answer 16

Where price differences give rise to profit opportunities

Question 17

What does the real exchange rate measure?

Answer 17

The real exchange rate measures how expensive a foreign country is relative to the home country by tracking a basket of goods

Question 18

When does purchasing power parity hold (PPP)?

Answer 18

When prices expressed in the same currency are equalised at home and abroad

Question 19

What does a depreciation of the real exchange rate mean?

Answer 19

The relative purchasing power of the domestic currency decreases (Q increases)

Question 20

What does an appreciation of the real exchange rate mean?

Answer 20

An increase in relative purchasing power of the domestic currency (Q decreases)

Question 21

When does the law of one price hold?

Answer 21

When a good costs the same abroad and at home

Question 22

What are some reasons that the LOOP may not hold?

Answer 22

• International transportation costs
• Distribution costs
• Taxes

Question 23

What types of goods does the LOOP hold well for?

Answer 23

Commodities, luxury consumer goods

Question 24

What type of goods does the LOOP not hold as well for?

Answer 24

Personal services, housing, transportation, utilities

Question 25

When does absolute PPP hold?

Answer 25

If the real exchange rate Q is equal to 1

Question 26

Why is price data difficult to collect?

Answer 26

Because it is usually private information