Reading 2.6

trade in good and services affect exchange rates through

1. trade flows

2. purchasing power

3. competitvness and sustainability of the current account

how do trade flows impact exchange rate

small impact when financed

with no financing flows w large trade flows in fx markets indicate crisis

what does PPP imply

prices of goods and services in different counties should reflect changes in exchange rates

with ppp expected exchange rate movements should follow what e

expected inflation rate differentials

with PPP the expecteed change in real exchange rates should be

zero

what does PPP work well and not well explaning

not well in explaining short term exchange rate changes

better for long term and when inflation differences are large and are determined through money supply

why does real exchange rates differ than PPE predicted

-trade barriers

-certain goods may not be traded

-PPP does not account for capital flows

-exchange rates influenced by economic development

how does restrictions on capital flows affect exchange rates

more restriction - sensitvity increase relative to current acount balance wh

when does current account balances have the largest influence on exchange rates

when they are persistent and sustained

*length is more previlants

structurual imbalances in the current acount can exist from

1. fiscal imbalances

2. things affected savings decision

3. resource abundancy

4. availability of investment opps

3 big areas for the implications on capital flows

uncovered IRP

implication on capital mobility

portfolio balances and compositions

how to find expected percent change in the exchange rate- capital mobility

find the differences in nominal short term interest rates, risk premiums

3 stages in relative improvements in investment opps in a country

1. exchange rate initially significantly appreciate

2. investors then expect a reversal

3. in long run it will revert

what does UIRP state

exchange rates should equal difference in nominal interest rates

what does UIRP say matters and doesnt

only interset rates matters.. not the premium differentials

what type of trades confirms the imporatance of inclduing risk premiums in exchange rates

carry trades

what does hot money refer to

when capital flows into a countr given exchange rate differenticals wh

what problems do hot money create

monetary policy

1. MP effectibity limited

2. firms use short term financing to fund long term inevstmetns.. increasing market risk

3. exchange rates overshoot- creating business disruption

how do central banks try to counter effects of hot money flows

1. currency markets- selling government securities to limit the grwoth of bank reserves/ mainintaing interst rate targets

Portfolio balance approach to exchange rates

rate influence by inevstors desired allociation to assets in diff countries

supply of asset can require rate adjsutmens and changes in risk premiums

Portfolio balance approah: why can strong economic growth weaken a countrys currency

more growth- more assets available- a weaker ccy is needed to help attract investors

factors that mitigate the weakening currency affect of portoflio balance

• home country bias

• investors funding growth with financial flows and foreign direct investment

• high growth rates are from small countries

what can large current account deficiets do to exchange rates

weaken themmi

mitigating factors for large current account deficits and exchange rates

1. deficits due to lg investments spending are easy to finance if expected to be profitable

2. reserve cccy countries face less pressure bc everyone wants USD