money flow in the opposite direction. ex. when a sony is purchased dollars must be exchanged for yen to complete the transaction.
the rate at which on currency is transformed into another.
when one unit buys more units of foreign currency
when one unit buys less units of foreign currency
the terms appreciate and depreciate apples to changes in floating rates
if rates are fixed by the government and adjusted so that they buy less foreign currency
if rates are fixed by the government and adjusted so that they buy more foreign currency
trade in goods and services
suppose you want to buy a BMW. you need to come up with Euros to pay for it. Demand for a countries goods lead to a demand for its currency
suppose you want to buy European stocks or bonds. You need to get Euros to do so. Demand for a country's financial assets leads to a demand for its currency. (this is not economic investment, I)
suppose you want to build a factory in france, again you need euros. direct foreign investment in a country leads to a demand for its currency.
demand of euros
1. trade in goods and services
2. financial flows
3. physical investment
supply of euros
comes from europe's demand for US goods, assets and direct foreign investment in the US
What happens if there was a boom in the US? What is the effect on US demand for Euros?
people in the US want to buy more of all goods, including goods made in Europe, so demand for Euros rises. As a result, the Euro appreciates against the $. This can be shown as an increase in the supply of $
demand for US goods and serves, financial assists and FDI in US
us demand for eurozone goods and services, financial assets, and FDI in eurozone
effect of $/E exchange rate of a recession in Europe
the supply line decreases
effect of increased US investment in European stock exhanges
the demand increases
effect of a rise in real interest rates in the Euro Zone while the US rates are stable
supply decreases and demand increases
Purchasing Power Parity (PPP) theory of exchange rates
holds that the exchange rates between any two countries adjusts to reflect differences in price levels between the two countries
-makes definite predictions about how inflation affects exchange rates.
$depreciation vs. Euro= inflation US- inflation Europe
When did the PPP suffer major breakdowns?
1980-85 and 1995-2002. During both these periods, the US experiences higher inflation rates than Germany and Japan, but the $ appreciated sharply against the DM and Yen during both these periods
Why does PPP fail?
1. trade is not totally free
2. goods are not homogenous
3.the price of non-traded goods (housing, haircuts) does not need to be equal across countries even under completely free trade
trade is not totally free
there are tariff and quota barriers to trade. also, transportation costs provide some natural protection. all these factors allow the types of price wedges across countries that were not permitted in out steel example
goods are not homogenous
the US and Germany both produce cars, but they are not identical. this also allows prices to differ in ways not allowed in the steel example.
in the short run
other factors may dominate price levels as determinants of exchange rates
when does your exchange rate DEPRECIATE (medium run)
if you are growing faster than your trading partners, your demand for their goods will faster then their demand for your goods.
effect of US growing faster then Europe
demand and supply increases
flows around the world looking for the highest rate of return.
a rise in a country's real interest rate will...
lead to an appreciation of its currency.
when were the US real rates very high?
-simultaneously a large capital inflow into the US and a very large appreciation of the dollar.
a depreciation is associated with:
1. higher inflation(real vs. nominal exchange rate)
2. faster growth
3. lower real interest rates
fixed exchange rates
are set by government decisions and maintained by government actions.
what happens when the supply of $ exceeds demand?
the US is running a BOP deficit. the ffed must pay out 30 DM to fill in the gap between supply and demand. (it buys up excess supply of $)
what happens if a country runs persistent BOP deficits?
it will eventually run out of foreign exchange. At this point, a devaluation must take place.
what can widen the BOP deficit?
if speculators sense that a devaluation may occur in the future, they will sell the currency before it is devalued. This would be shown both as an increased supply $ and a decrease demand for $. can force a devaluation sooner, or even make necessary a devaluation which would not have occurred otherwise.
what happened in 1971?
it was a fear such as a run against the dollar which lead a breakdown in the system of fixed exchange rates.
why will germany never be forced to revalue its currency upward?
the german central bank supplies additional DM (it can print as many of these as it likes) and accumulates $. since it can accumulate reserves indefinitely it will never be forced
balance of payments
the difference between the supply and demand for a currency (in the foreign exchange market), excluding central bank transactions
*** consists of the current account and capital account
** irrelevant under fixed exchange rates
why are central bank transactions excluded from the balance of payments?
because they will step in and pay balance
inclues international purchase and sales of goods and services, cross-border interest and dividend payments, and cross-border gifts to and from both private individuals and governments
what is the broadest measure of trade deficit?
includes purchases and sales of financial assets to and from citizens and companies of other countries. it also includes foreign direct investment.
under a float what does the current account+the capital account =
the central bank neither buys or sells foreign currency, so
supply=demand in foreign exchange markets
when was the gold standard?
when was there no central bank till
when was US off gold?
under the gold standard
each countries currency is defined in terms of gold.
what is the gold standard?
a form of a fixed exchange rate system.
under the gold standard how was each countries money supply determined?
by how much gold it has
what happens during the gold standard if a country has the equivalent of a BOP deficit
gold flows out and the money supply falls. this RAISES interest rates which attracts foreign capital. It also REDUCES P and Y, which discourages imports and encourages exports. All of these effects will help close the BOP deficit.
under a fixed exchange rate what is important for trade flows?
changes in price level
In the surplus countries...
the money supply is rising, so interest rates decrease while P and Y increase
All the automatic adjustments help close what?
What is under the gold standard?
automatic adjustments, but it could involve a monetary contraction which is otherwise undesirable
What are determined by gold discoveries?
world-wide price movements
When does the gold standard collapse and what is it replaced by?
collapses for good in 1930s and replaces in 1944 with the Bretton Woods system
how long did the bretton woods system last for
What was the basis of the bretton woods system?
the dollar $
What did all countries in the Bretton woods system do?
fixed their exchange rate to the $ and the $ was fixed ro gold at $35/oz.
What was set up to manage the bretton woods system?
what could the IMF do?
1. was empowered to make loans to countries running short of foreign exchange.
2. authorize changes in the exchange rates if there was a "fundamental disequilibrium"
what encouraged speculative attacks on weak currencies?
devaluations.. it is not clear how much stability the bretton woods system provided
what was the one country that could not devalue and why?
anchor of the system, since the dollar was fixed in terms of gold.
what happened because of the surplus nations not revaluing?
the dollar became overvalued and the US ran persistent BOP deficits in the 1960s into the early 1070s.
What lead nixon to suspend the gold conversion in 1971?
the persistent loss of foreign reserves.
if the US is running a BOP deficit what does it need to do?
either increase demand for the $, or reduce its supply
How do we increase the demand for the $, or reduce its supply?
A reduction in AD will reduce GDP and therefore, the demand of imports. As a result, the supply of $ decreases. It will also decrease P, which at a fixed exchange rate will stimulate demand for exports (increase demand for $) (increase demand for $). In addition, a tight monetary policy will raise interest rates and attract foreign capital.
how can BOP deficit be closed?
following a restrictive monetary and fiscal policy.
the policy of stabilizing the exchange rate forces a country to give up what?
give up on stabilizing the domestic economy when the two conflict.
are quite volatile and this introduces uncertainty into the international transactions
foreign exchange markets
can be used (at a price) to reduce some of the risk associated with exchange rate fluctuations. Using the forward market, you can lock in rates up to a year into the future
Under a float
successful speculators must buy low and sell high. this should stabilize the price of the currency. Thus, in contrast to fixed rates, under a float, successful speculation should be stabilizing.
how many countries does the Euro Zone consist of?
The IMF after the bretton woods system
survived. it loans foreign exchange to countries during periods of crisis. typically, this means an exchange rate crisis under fixed exchange rate system. IMF loans come with strings attached and this is often controversial
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