Foreign Exchange: Key Concepts, Rates, and Systems in International Finance

Which of the following refers to foreign exchange?

The act of trading different nations' moneys

What is the exchange rate set for an immediate trade called?

Spot exchange rate

What is the exchange rate set now for a trade occurring in the future called?

Forward exchange rate

Why is the U.S. dollar called a vehicle currency?

It is used as an intermediary between two other currencies

What happens to foreign currency and U.S. dollars when U.S. exports increase rapidly?

Increase in supply of foreign currency and increase in demand for U.S. dollars

What happens to euros and U.S. dollars when U.S. imports from the EU increase?

Increase in demand for euros and increase in supply of U.S. dollars

In which exchange rate system do governments intervene to keep rates steady?

Fixed exchange rate system

Under a floating exchange rate system, a fall in a currency's price is called what?

Depreciation

If the exchange rate is 0.89 CAD per USD, how many USD are needed to buy a 2.5 CAD good?

$2.81

If the dollar appreciates against the peso, what happens to U.S. exports to Mexico?

They become more expensive

If the exchange rate changes from $2.00/£ to $2.01/£, what happens to the dollar?

The dollar has depreciated

Under a fixed exchange rate system, a large fall in a currency's value is called what?

Devaluation

If the exchange rate changes from $1.45/€ to $1.37/€, what happens?

The euro depreciates and the dollar appreciates

If Japan's price level rises faster than Britain's, what happens to the yen?

The yen depreciates against the pound

What does the law of one price state?

Identical goods should have the same price worldwide

When does the law of one price hold best?

When transportation costs are close to zero

What causes the dollar to appreciate?

An increase in the demand for dollars

If a country has a fixed exchange rate, what must the central bank do?

Buy and sell currencies to maintain the rate

If the exchange rate changes from $2.00/€ to $1.98/€, what happens to the dollar?

The dollar appreciates

An investment exposed to exchange-rate risk is called what?

Uncovered investment

An investment hedged against exchange-rate risk is called what?

Covered investment

If the expected uncovered interest differential is positive, which investment is favored?

invest abroad

Under a flexible exchange rate system, what happens when demand for yen increases?

The dollar-yen exchange rate falls

What are exchange controls?

Restrictions on converting domestic currency into foreign currency

What are capital controls?

Government limits on international financial investments

What exchange rate regime allows markets to determine rates without intervention?

Clean float

What regime involves government intervention to influence market rates?

Managed float

What is an adjustable peg?

A fixed rate that may be changed if disequilibrium occurs

Which exchange rate regime is best for high-inflation countries wanting a peg?

Crawling peg

Under unsterilized intervention to stop depreciation, what happens to money supply?

Money supply falls

Under sterilized intervention, what happens to money supply?

It remains unchanged

What is sterilization?

Reversing the monetary effects of FX intervention

If a country is continuously losing foreign reserves, what will speculators do?

Sell the country's currency

Which factors shift demand for the euro to the right?

Higher EU interest rates, higher foreign incomes, and appreciation expectations

When Americans decrease demand for Japanese goods, what happens?

Supply of dollars falls and demand for yen falls

To defend a fixed exchange rate under downward pressure, what must a central bank do?

Buy domestic currency and sell foreign currency

What happens when U.S. residents buy more Toyota stock?

Dollar depreciates

A decrease in German willingness to invest in dollar assets shifts demand for what?

Dollars to the left

If Canada wants to defend a fixed exchange rate above market value, what should it do?

Sell Canadian dollars and buy U.S. dollars

If Thailand's baht faces appreciation pressure under a peg, what must officials do?

Sell baht and buy dollars

If Chile's peso faces depreciation pressure under a peg, what must officials do?

Buy pesos and sell dollars

What happens to money supply when Cuba sells pesos to defend a peg?

Money supply increases and interest rates fall

How does a depreciating peso affect net exports?

Imports fall, exports rise, net exports increase

If Mexico changes a fixed rate from 1.5 to 3.0 pesos per dollar, what occurs?

Peso is devalued

If the euro's market rate rises from 1.15 to 1.30 dollars per euro, what occurs?

Euro appreciates

If Mexico changes a fixed rate from 1.5 to 0.75 pesos per dollar, what occurs?

Peso is revalued

How do you identify the home country from an exchange rate quote?

numerator

If an exchange rate is quoted as pesos per dollar, which country is home?

Mexico

What causes demand for a currency to increase?

Higher exports, higher foreign income, higher interest rates, or expected appreciation

What happens to a currency when demand increases?

It appreciates

What causes supply of a currency to increase?

Higher imports or residents investing abroad

What happens to a currency when supply increases?

It depreciates

What is appreciation?

A rise in the value of a currency

What inputs are used to calculate PPP?

Prices only

What does PPP NOT use?

The market exchange rate

If an exchange rate is foreign currency per dollar, how do you find dollars needed?

Divide the foreign price by the exchange rate

What is a clean float exchange rate system?

A system where the market fully determines the exchange rate

What happens to interest rates when money supply increases?

Interest rates fall

What happens to interest rates when money supply decreases?

Interest rates rise

What does a negative uncovered interest differential indicate?

invest at home

What does continuous reserve loss signal about a fixed exchange rate?

It is unsustainable

In FX graphs, what goes on the vertical axis?

The exchange rate

In FX graphs, what goes on the horizontal axis?

Quantity of currency

What does a tourism boom do to currency demand?

Shifts demand to the right

What does a decrease in imports do to currency supply?

Shifts supply to the left

What must be drawn on a fixed exchange rate graph?

Supply, demand, fixed-rate line, and excess supply or demand

What happens when actual exchange rate exceeds implied rate?

The foreign currency is overpriced

What happens when implied exchange rate exceeds actual rate?

The foreign currency is underpriced

If Britain maintains a fixed exchange rate and the pound is under depreciation pressure, what happens to money supply under unsterilized intervention?

The British money supply will fall

If Britain maintains a fixed exchange rate and the pound is under depreciation pressure, what happens to money supply under fully sterilized intervention?

The British money supply will remain unchanged

If Britain uses sterilized intervention to defend the pound under depreciation pressure, what will British monetary authorities do domestically?

The British monetary authorities will be buying British government bonds

Why can Britain only intervene in the foreign exchange market for a limited time when defending a fixed exchange rate?

The British government will run out of official international reserves

What is the action to reverse the effect of official intervention on the domestic money supply called?

Sterilization

In a sterilized intervention, a country buys domestic currency to defend a peg and also does what?

Uses a policy in the domestic economy to prevent the domestic money supply from changing