L14-15: Exchange rate basics

Flashcards covering key concepts from the Exchange Rate Basics lecture.

Define the exchange rate (S).

The domestic currency price of one unit of foreign currency.

According to the definition used in the module, does an increase in S imply an appreciation or depreciation of the home currency?

Depreciation of the home currency and an appreciation of the foreign currency.

How does currency depreciation affect export and import prices?

Currency depreciation generally makes exports cheaper and more competitive in foreign markets, while imports become more expensive for domestic consumers.

Define the bilateral exchange rate.

The exchange rate between two specific currencies, indicating how much of one currency is needed to purchase one unit of the other currency.

What is the effective or trade-weighted exchange rate?

The effective or trade-weighted exchange rate is a measure that considers a country's exchange rate against multiple currencies, weighted by the amount of trade conducted with each currency, reflecting the overall strength of the home currency in global markets.

What is the difference between spot and forward exchange rates?

Spot rates involve buying/selling currency now; forward rates are contracts for future exchange at a pre-specified price.

Define bid rate.

The rate at which dealers buy currency A (sell currency B).

Define offer/ask rate.

The rate at which dealers sell currency A (buy currency B).

What are major sources of demand for foreign exchange?

Importers, outgoing foreign investment, and speculators.

What are major sources of supply for foreign exchange?

Exporters, incoming foreign investment, and speculators.

What determines the equilibrium value of foreign exchange or exchange rate?

The intersection of the demand and supply curves of foreign exchange.

Define a completely flexible (or freely) floating exchange rate.

An exchange rate whose level is determined exclusively by the supply and demand for the currencies involved, with no outside intervention.

How can a government maintain a fixed exchange rate?

The central bank can sell foreign currency and buy domestic currency in the foreign exchange market.

Think of it like this: the country's bank can step in. If the country's money is worth too little, the bank sells foreign money and buys its own. This makes the country's money look better.

what’s a convertible exchange rate

A type of exchange rate that allows for currency to be exchanged freely and without any restrictions, enabling conversion between domestic and foreign currencies.

Why is a fixed exchange rate incompatible with an independent monetary policy?

A fixed exchange limits its ability to adjust interest rates and control inflation independently, as these adjustments could alter the exchange rate.

What is a 'managed float' or 'dirty float'?

A 'managed float' or 'dirty float' is when a country's central bank steps in to nudge the currency value without setting a fixed rate. They might buy or sell their own money to keep things stable, but they don't promise to keep the currency at a specific price.

What does 'sterilization' mean when a central bank is involved in currency markets?

When a central bank tries to affect how much a country's money is worth compared to others (foreign exchange intervention), it can change the amount of money in circulation.

'Sterilization' is what they do to make sure these actions don't mess up the country's money supply. Basically, it's like hitting the reset button on the money supply after they've been buying or selling currency.