Chapter 7: Fixed Exchange Rates and Foreign Exchange Intervention

Managed floating exchange rate

The central bank “manages” the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility.

Sterilization

An offsetting effect used by the central bank when buying and selling of foreign bonds in the foreign exchange markets affects the domestic money supply.

Devaluation

Changes in a fixed exchange rate caused by the central bank.

A unit of domestic currency is made less valuable, so that more units must be exchanged for 1 unit of foreign currency.

Revaluation

Changes in a fixed exchange rate caused by the central bank.

A unit of domestic currency is made more valuable, so that fewer units must be exchanged for 1 unit of foreign currency.

Balance of payments crisis

Occurs when a central bank does not have enough official international reserve assets to maintain a fixed exchange rate.

Capital flight

Occurs when financial capital is quickly moved from domestic assets to foreign assets

Self-fulfilling crisis

Expectations of devaluation can cause a devaluation.

Expectations of revaluation can cause a revaluation.

Default risk

The risk that the country’s borrowers will default on their loan payments. Lenders therefore require a higher interest rate to compensate for this risk.

Exchange rate risk

If there is a risk that a country’s currency will depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign leaders.

Perfect substitutes

Deposits everywhere are treated as the same type of investment, because risk and liquidity of the assets are assumed to be the same.

Imperfect substitutes

Foreign and domestic assets may differ in the amount of risk that they carry.

Risk premium

p in the equation R=R*+((E^e-E)/E)p

Reserve currency system

One currency acts as official international reserves.

Gold standard

Gold acts as official international reserves that all countries use to make official international payments.

Bimetallic standard

The value of currency is based on both silver and gold.