week 24 Flashcards
what is the importance of exchange rates
domestic purchases are made with local currency, exchange rate measures the rate of conversion between currencies
exchange rates are set in the foreign exchange markets with a small number of exceptions
rates are determined by supply and demand
affect the value of imported goods and the value of financial investments made across borders
what is the nominal exchange rate
rate at which two currencies can be traded for each other
what is appreciation
an increase in the value of a currency relative to other currencies
what is depreciation
a decrease in the value of a currency relative to other currencies
what is the foreign exchange market
the market on which currencies of various nations are traded
exchange rate can be set independently or by agreement with a number of other governments
fixed rates can be set relative to the dollar, the euro or gold
what is a flexible exchange rate
an exchange rate whose value is not officially fixed but varies according to the supply and demand market for the currency in the foreign exchange market
what is a fixed exchange rate
an exchange rate set by official government policy
what is the real exchange rate
the price of the average domestic good relative to the price of the average foreign good when prices are expressed in a common currecny
how do you calculate real exchange rate
price of domestic good / price of foreign good in $
what does it mean if real exchange rate is high
domestic goods are expensive relative to foreign goods
net exports will be low when the real exchange rate is high
what is a strong currency
unrelated to a strong economy
reduce net exports, lowers domestic sales and profits
what is the law of one price
states that if transportation costs are relatively small, the price of an internationally traded commodity must be the same in all locations
what is purchasing power parity
the theory that nominal exchange rates are determined as necessary for the law of one price to hold
in the long run, the currencies of countries that experience significant inflation will tend to depreciate
how are dollars supplied in a foreign exchange market
anyone who holds dollars is a potential supplier
US households and firms are the most common suppliers
supply curve has a positive slope
the more foreign currency each dollar can buy, the larger the quantity of dollars supplied
what does the demand curve for dollars look like
demand curve has a negative slope
the more foreign currency needed to buy a dollar, the smaller the quantity demanded
makes US goods more expensive
what does the graph for the dollar-euro market look like
the market equilibrium of the exchange rate equates the quantities of the currency supplied and demanded in the foreign exchange market
how is the supply of dollars for euros determined
the preference for european goods, the stronger the preference the greater the supply of dollars
US real GDP, the higher the GDP, the greater the supply of dollars
real interest rate on European assets and the real interest rate on US assets - supply on dollars is higher if real interest rate on european assets is higher and on us assets in lower
how is the demand for dollars determined
preference for US goods - the stronger the preference, the greater the demand for dollars
the real GDP in europe - higher GDP, greater demand for dollars
real interest rate on european assets and real interest rate on US assets - supply of dollars greater if Euro interest rate is lower
how does monetary policy affect changes in dollar exchange rate
flexible exchange rates make monetary policy more effective
the FED tightens monetary policy, sets off a chain of domestic events
r increases, C and Ip decrease, PAE decreases, Y decreases
and international events
r increases, e* increases, NX decreases, PAE decreases, Y decreases
how do fixed exchange rates effect effect monetary policy
reduce the effectiveness of monetary policy as a stabilisation tool
how do govs establish fixed exchange rate
gov states the value of currency in terms of a major currency
attempt to maintain the fixed exchange rate at its existing level
what is devaluation
reduction in the official value of a currency
what is revaluation
increase in the official value of a currency
how do you fix an exchange rate
response to an overvalued currency
devalue the currency
impose trade barriers
purchase the currency - a country must hold international reserves
balance of payments deficit occurs if a country has a net decline in international reserves over a year
balance of payments surplus occurs if a country has a net increase in international reserves over a year
what are the benefits of fixed rates
predictability and stability in foreign transactions
certainty of future value of currencies
what are the disadvantages of fixed rates
sudden and unforeseen large changes are possible
predicting exchange rates over the long term is difficult under fixed or flexible rates
what is a speculative attack
a massive selling of domestic currency assets by financial investors
how is monetary policy effected by fixed and flexible exchange rates
flexible exchange rates can strengthen the impact of monetary policy
fixed exchange rates can prevent used of monetary policy to stabilise the economy
how is trade and economic integration effected by fixed and flexible exchange rates
fixed exchange rate proponents argue that fixed rates promote international trade
the risk of speculative attack may make the country less attractive to investors and trade
what are features of the euro
european central bank controls the currency
countries sacrifice some control to be part of the euro
economic conditions vary between countries and the central bank cannot respond to each
