chapter 10 business

Devaluation

Intentionally lowering the value of a

nation's currency. Devaluation Jowers the price of a country's exports on world markets and increases the price of its imports because the value of the country's currency is now lower on world markets. A gov ernment might devalue its currency to give its domestic companies an edge over competition from other countries. But devaluation reduces the buying power of consumers in the nation. It can also

allow inefficiencies to persist in domestic companies because there would then be Jess pressure to contai n production costs.

revaluation

Intentionally raising the value of a nation's currency. Revaluation has the opposite effects: It increases the price of exports and reduces the price of imports.

Purpose of stable exchange rates

stable exchange rates improve the accuracy of financial planning and make cash-flow forecasts more precise.

Purpose of predictable exchange

Managers also prefer that movements in exchange rates be predictable. Predictable exchangeratesreducethelikelihood thatcompanieswillbecaughtoffguardbysuddenandunexpectedrate changes. They also reduce the need for costly insurance (usually by currency hedging) against possible adverse movements in exchange rates.

efficient market view

View that prices of financial instruments reflect all publicly available information at any given time.

inefficient market view

View that prices of financial

instruments do not reflect all publicly available information.

Forecasting Techniques: Fundamental Analysis

Technique that uses statistical models based on fundamental economic indicators to forecast exchange rates.

Forecasting Technique: Technical analysis

Technique that uses chans of past trends in currency prices and other factors to forecast exchange rates.

law of one price

Principle that an identical item must have an identical price in all countries when the price is expressed in a common currency. For this principle to apply, products

must be identical in quality and content in each country and be entirely produced within each country.

PPP Purchasing Power Parity Theory:

. Although the law of one price holds for single products, PPP theory is

meaningful only when applied to a basket ofgoods.Economic forces, says PPP theory, will push the actual market exchange rate toward that

determined by PPP. Ifthey do not, arbitrage opportunities will arise. PPP holds for internationally traded products that are not restricted by trade barriers and that entail few or no transportation costs. T

Role of Inflation in Purchasing Power

Inflation is the result of the supply and demand for a currency. If additional money is injected into an economy that is not producing greater output, people will have more money to spend on the same amount of products as before. As growing demand for productsoutstrips stagnant supply, prices will rise and devour any increase in the amount of money that

consumers have to spend. Therefore, inflation erodes people's purchasing power.

Fisher effect:

Principle that the nominal interest rate is the sum of the real interest rate and the expected rate of inflation over a specific period.

international Fisher effect

Principle that a difference in nominal interest rates supported by two countries· currencies will cause an equal but opposite change in their spot exchange rates.

international monetary system

Collection of agreements and insti tutions that govern exchange rates.

gold standard

International monetary system in which nations link the value of their paper currencies to specific values of gold.

fixed exchange-rate system

System in which the exchange rate for converting one currency into another is fixed by internationalagreement.

Bretton Woods Agreement

Agreement (1944) among nations to create a new international mon etary system based on the value of the US dollar.

fundamental disequilibrium

Economic condition in which a trade deficit causes a permanent negative shift in a country's bal

ance of payments.

special drawing right (SOR)

IMF asset whose value is based on a "weighted basket" of five currencies.

Smithsonian Agreement

Agreement (1971) among IMF members to restructure and strengthen the international mon etary system created at Bretton Woods.

Jamaica Agreement

Agreement (1976) among IMF

members to formalize the existing system of floating exchange rates as the new international monetary system.

managed float system

Exchange-rate system in which cur rencies float against one another, with governments intervening tostabilize their currencies at particu lar target exchange rates.

free float system

Exchange-rate system in which currencies float freely against one another, without governmentsintervening in currency markets.

currency board

Monetary regime based on an explicit commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.