W5 - Reversals and FOREX markets Flashcards
Where are sudden stops usually observed in the trade balance and why?
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)
Define a sudden stop?
A sudden stop in terms of sudden large reductions in capital inflows
What is the impact of high government spending on growth and why?
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
What are the 7 key findings of edwards?
- Large current account deficits are not persistent
- Major reversal in CA deficits are persistent and strongly associated with sudden stops
- Major reversals in CA deficits are likely to lead to an exchange rate crisis
- Large deficits and external debts are the best predictors of CA reversals
- Reversals have a large negative effect on growth
- More open countries suffer less
- More flexible countries suffer less
What is the nominal exchange rate?
The price of a foreign currency using your domestic currency
How is the exchange rate determined?
By interaction between supply of and demand for foreign currency. Supply and demand comes from transactions in the balance of payments
What are credits in the case of Forex markets?
Credits = the supply of foreign currency
What are debits in the Forex market?
Demand for foreign currency
What is the convention for the exchange rate?
The exchange rate is usually quoted as the price of the foreign currency in terms of the domestic currency
What is exchange rate depreciation?
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
What is the benefit of an exchange rate appreciation?
Exchange rate appreciations attract foreign currency investments hence why many countries run a strong exchange rate
What would happen if there was an excess demand for foreign currency?
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
Can the government choose the exchange rate?
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
How can governments use monetary policy to impact the exchange rate?
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
What do most governments want to see happen in their exchange rates and why?
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
What is arbitrage?
Where price differences give rise to profit opportunities
What does the real exchange rate measure?
The real exchange rate measures how expensive a foreign country is relative to the home country by tracking a basket of goods
When does purchasing power parity hold (PPP)?
When prices expressed in the same currency are equalised at home and abroad
What does a depreciation of the real exchange rate mean?
The relative purchasing power of the domestic currency decreases (Q increases)
What does an appreciation of the real exchange rate mean?
An increase in relative purchasing power of the domestic currency (Q decreases)
When does the law of one price hold?
When a good costs the same abroad and at home
What are some reasons that the LOOP may not hold?
- International transportation costs
- Distribution costs
- Taxes
What types of goods does the LOOP hold well for?
Commodities, luxury consumer goods
What type of goods does the LOOP not hold as well for?
Personal services, housing, transportation, utilities
When does absolute PPP hold?
If the real exchange rate Q is equal to 1
Why is price data difficult to collect?
Because it is usually private information
