LM7: capital flows and the FX market

Foreign exchange market (FX market)

A global decentralized market where currencies are traded, involving financial institutions, corporations, governments, and investors

Exchange rate

The price of one currency expressed in terms of another currency, indicating how much of one currency is needed to purchase another

Base currency

The first currency in a currency pair, representing the unit being priced

Price currency (quote currency)

The second currency in a currency pair, representing the amount needed to purchase one unit of the base currency

Nominal exchange rate

The observed exchange rate at a given point in time, not adjusted for inflation differences

Real exchange rate

The nominal exchange rate adjusted for relative price levels between two countries, reflecting the true purchasing power and competitiveness

Direct quotation

An exchange rate quote in which the domestic currency is the price currency

Indirect quotation

An exchange rate quote in which the domestic currency is the base currency

Bid-ask spread

The difference between the price at which a dealer is willing to buy a currency (bid) and sell it (ask), representing transaction costs and dealer profit

Spot exchange rate

The exchange rate for immediate delivery of currencies

Forward exchange rate

The agreed-upon exchange rate for a transaction that will occur at a future date

Exchange rate regime

The system by which a country manages its currency in relation to other currencies and the foreign exchange market

Currency board system

A fixed exchange rate system in which a country commits to exchanging its domestic currency for a foreign currency at a fixed rate, backed by reserves

Fixed parity (peg)

A system in which a country maintains its currency value within a narrow band relative to another currency

Managed float

A regime in which exchange rates are primarily determined by market forces but subject to occasional central bank intervention

Independently floating exchange rate

A system in which exchange rates are determined entirely by market supply and demand with minimal or no central bank intervention

Monetary union

An arrangement in which multiple countries share a common currency and monetary policy