Currency Exchange Rates and International Financial Markets

What is an exchange rate?

The price of one nation's currency in terms of another nation's currency.

What is the spot exchange rate?

The exchange rate for immediate delivery of currencies.

What is the forward exchange rate?

The exchange rate agreed upon today for a currency transaction at a future date.

What is a vehicle currency?

A commonly used currency (usually the U.S. dollar) used as an intermediary in currency trades.

What causes demand for a currency to increase?

Foreign demand for domestic goods and assets

Higher domestic interest rates

Expectations of appreciation

What causes supply of a currency to increase?

Domestic demand for foreign goods

Domestic demand for foreign assets

If Americans buy Japanese goods, what happens?

Supply of dollars ↑, demand for yen ↑.

If Americans buy Japanese stocks, what happens?

Supply of dollars ↑ → dollar depreciates.

Difference between devaluation and depreciation?

Depreciation: market-driven

Devaluation: government-driven under fixed rates

What are the main components of the Balance of Payments?

Current Account

Financial Account

Official Reserves

Statistical Discrepancy

What does the current account measure?

Net exports + services + income + transfers.

What does a current account deficit mean?

The country is a net borrower from the rest of the world.

What does the financial account measure?

Net purchases of financial assets.

What is a clean float?

Exchange rate determined entirely by market forces.

What is a managed (dirty) float?

Mostly market-determined, but with government intervention.

What is a fixed exchange rate?

Government sets and maintains a specific exchange rate value.

How does a central bank defend against depreciation?

Sells foreign reserves

Buys domestic currency

Domestic money supply ↓

How does a central bank defend against appreciation?

Buys foreign currency

Sells domestic currency

Domestic money supply ↑

What happens to reserves when defending depreciation?

Reserves fall.

What is sterilized intervention?

when a central bank buys or sells foreign currency to influence the exchange rate, and then uses domestic bond transactions to offset the resulting change in the money supply, so monetary conditions and interest rates remain unchanged.

Law of One Price?

Identical goods should sell for the same price when expressed in a common currency.

Absolute PPP?

The exchange rate between two countries equals the ratio of their price levels, so the same basket of goods costs the same in both countries when prices are converted into a common currency.

Relative PPP(purchasing power parity

Changes in exchange rates over time are driven by differences in inflation rates between countries.

Low-inflation country currency does what?

Appreciates over time.

Real exchange rate formula?

e * Pdomestic/​Pforeign​​

What does a higher Real exchange rate mean?

Domestic goods are relatively more expensive → lower competitiveness.

What raises demand for a currency in the short run?

Higher interest rates

Expected appreciation

Why do expectations matter in FX markets?

investors reposition portfolios based on expected future rates.

What is exchange-rate overshooting?

Short-run exchange rate moves past long-run equilibrium, then slowly returns.

Why does overshooting occur?

Prices adjust slowly, but asset markets adjust immediately

What is arbitrage?

Riskless profit from price inconsistencies

What is triangular arbitrage?

Arbitrage involving three currencies and cross rates.

What does arbitrage ensure?

Exchange rates are consistent across markets.

Americans buy foreign goods/assets → ?

Dollar supply ↑ → dollar depreciates.

Foreigners buy U.S. goods/assets → ?

Dollar demand ↑ → dollar appreciates.