Chapter 16 Macroeconomics

Dollarize

A country that is not the United Staes uses the U.S. dollar as its currency

Foreign Exchange Market

The market in which people use one currency to buy another currency

Largest market in the world economy

In 2019, about $5.3 trillion per day was traded

In 2019 U.S. real GDP was $21.4 trillion per year

Exchange Rate

Price of one currency expressed in terms of units of another currency

4 Groups of People or Firms Who Participate in the Foreign Exchange Markets

Firms that are involved in international trade of goods and services

Tourists visiting other countries

International investors buying ownership (or part-ownership) of a foreign firm

International investors making financial investments that do not involve ownership

Firms that Buy and Sell on International Markets

Cost for workers, suppliers, and investors measured in the currency of the nation where production occurs

Revenues from sales are measured in the currency of the different nation where their sales happened

Financial Investments that Cross International Boundaries and Require Exchanging Currency

Foreign Direct Investment (FDI)

Portfolio Investment

Foreign Direct Investment (FDI)

Purchasing a firm (at least 10%) or starting up a new enterprise in another country

Portfolio Investment

An investment in another country that is purely financial and does not involve any management responsibility

Hedge

Using a financial transaction as protection against risk

Guaranteeing a certain exchange rate in the future

Foreign Exchange Dealers

Banks and other firms that trade foreign exchange in the interbank market

Roughly 2,000 firms worldwide are foreign exchange dealers

U.S. economy has less than 100 foreign exchange dealers

Appreciating (or “strengthening”)

When the exchange rate for a currency rises, so that the currency is worth mroe in terms of other currencies

Depreciating (or “weakening”)

When the exchange rate for a currency falls, so that a currency is worth less in terms of other countries

Rate of Return

Motivation for investment (domestic or foreign)

If rates of return in a country are relatively high, then that country will tend to attract funds from abroad

If rates of return look relatively low, then funds will tend to flee to other economies

Changes in the expected rate of return will shift demand and supply for a currency

If a Country Experiences a Relatively High Inflation Rate Compared with Other Economies

Then the buying power of its currency is eroding

Will tend to discourage anyone from wanting to acquire or to hold the currency

Arbitrage

The process of buying a good and selling goods across borders to take advantage of international price differences

Purchasing Power Parity (PPP)

The exchange rate that equalizes the prices of internationally traded goods across countries

Two functions:

-For internation comparison of GDP and other economic statistics

-Exchanges rates will often get closer to it as time passes

A Central Bank will be Concerned about the Exchange Rate because

Movements in the exchange rate will affect the quantity of aggregate demand in an economy

Frequent substantial fluctuations in the exchange rate can disrupt internation trade and cause problems in nation’s banking system

A Nation May Adopt One of a Variety of Exchange Rate Regimes

Floating rates in which the foreign exchange market determines the rates

Pegged rates where governments intervene to manage rate’s value

A common currency where the nation adopts another country or group of countries’ currency

Floating Exchange Rate

A country lets the exchange rate market determine its currency’s value

-The U.S. dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy

-The major concern with this policy is that exchange rates can move a great deal in a short time

Soft Peg

An exchange rate policy in which the government usually allows the market to set the exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene

Hard Peg

An exchange rate policy in which the central bank sets a fixed and unchanging value for the exchange rate

Merged Currency

When a nation chooses to use another nation’s currency

-Eliminates foreign exchange risk

-A nation has given up on domestic monetary policy

Internation Capital Flows

Capital that flows across national boundaries as either portfolio investment or direct investment

Tobin Taxes

Taxes on international capital flows

-The goal of such policies is to reduce internation capital flows, in the hope that doing so will reduce the chance of large movements in exchange rates that can bring macroeconomic disaster

-Practical difficulty because national governments impose taxes, not international ones