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?

When supply increases, the home currency loses value relative to foreign currency due to higher availability, making it less valuable in comparison.

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. This dependence on foreign exchange rates means that the country must prioritize maintaining the fixed rate over domestic economic conditions.

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?

Sterilization refers to the actions taken by a central bank to neutralize the effects of foreign exchange interventions on the domestic money supply, typically by buying or selling government securities.