IER Notes 1 , 13-16

Trade Balance

Trade Balance

The difference between a country's total value of exports and imports.

Bilateral Trade Balance

The trade balance specifically between two countries.

Assumption of Balanced Trade

Economic model assumption where exports equal imports for each country.

Offshoring

Manufacturing processes spread across multiple countries in modern trade.

World Trade Map

Illustrates the flow of exports and imports globally.

Goods

Physical products traded between countries.

Services

Non-physical contributions to international trade like tourism and financial services.

Tariffs

Taxes on imported goods that can impact trade volumes.

Global Financial Crisis

The 2008-2009 crisis that slowed down international trade.

Free Trade Areas

Agreements aiming to reduce tariffs and promote trade.

Migration

Movement of people across borders.

Foreign Direct Investment (FDI)

Movement of capital across borders.

Horizontal FDI

Investment between companies in different industrialized countries.

Vertical FDI

Investment where a company from an industrialized country owns a facility in a developing country.

Globalization

Involves the flow of goods, services, people, and firms across borders, and the spread of culture and ideas globally.

Exchange Rates

The value of one currency in terms of another, influencing international trade, investment, and economic stability.

Current Account

The balance of payments tracking a country's economic transactions with the world, indicating surplus or deficit.

External Wealth

A country's net worth, calculated as foreign assets minus foreign liabilities, determining if it's a creditor or debtor nation.

Exchange Rate Behavior

Determined by factors like fixed or floating systems, supply and demand, interest rates, inflation rates, economic performance, political stability, and speculation.

Exchange Rate Crises

Occur when a currency rapidly loses value, leading to economic downturns, political instability, and the need for external assistance.

Defaults on Government Debt

Instances where countries fail to make payments on loans, impacting creditors and requiring careful assessment by international investors.

Financial Globalization

The trend towards openness in financial transactions since 1970, categorized by levels of financial openness among countries.

Financial Openness

The degree to which a country's financial system allows cross-border financial transactions, with a fully open economy having no restrictions on such transactions.

Capital Controls

Rules set by governments to manage money flow in and out of their economies, including limits on currency exchange, foreign investment restrictions, or border-crossing taxes.

Credit Ratings

Evaluations of a borrower's likelihood to repay debts, provided by credit rating agencies to help investors assess risk, where higher ratings indicate lower risk.

Country Risk

Extra risk faced by investors when investing in assets from a specific country, considering factors like political stability, economic performance, and debt default likelihood.

Exchange Rate Regimes

Systems dictating how a country manages its currency concerning others, with fixed regimes setting a specific value and floating regimes allowing market forces to determine the rate.

Governance

Institutions encompassing legal, political, social, and cultural structures within a society, crucial for shaping economic prosperity and stability.

Appreciation & Depreciation

Terms used to describe currency value changes over time, with appreciation indicating a currency gaining value and depreciation indicating a loss in value.

Multilateral Exchange Rates

Measure changes in a currency's value against multiple currencies, considering trade weights to calculate an average of bilateral changes for a broader view of currency performance.

Danish Krone

Maintains a fixed exchange rate against the euro with minimal variation.

Developing Countries

Depicts exchange rate behavior in emerging markets and developing nations like India, Thailand, South Korea, and Latin American countries.

Currency Union

Formed by multiple economies adopting a common currency with a central monetary authority.

Dollarization

Occurs when a country adopts the currency of another nation for various reasons like economic size and monetary management.

Forex Market

Where currencies are bought and sold electronically and globally, involving individuals, companies, and institutions.

Spot Contract

An immediate agreement between two parties to exchange currencies at the current rate.

Transaction Costs

Fees and commissions paid when buying or selling foreign currency, varying between retail and large transactions.

Derivatives

Contracts related to the spot contract, including forwards, swaps, futures, and options, used for different purposes like hedging and speculation.

Triangular Arbitrage

Involves trading between three currencies to profit from discrepancies in exchange rates, ensuring no risk-free profit opportunities exist in the market.

Cross Rates

Simplify currency trading by allowing indirect exchange through a third currency, facilitating practical transactions between different currency pairs.

Vehicle Currency

A currency used in international transactions that is not the home currency of the parties involved but acts as an intermediary, such as the U.S. dollar in global trades.

Covered Interest Parity (CIP)

A condition where the dollar return from dollar deposits equals the dollar return from euro deposits, adjusted for the forward exchange rate, eliminating potential profit from arbitrage.

Uncovered Interest Parity (UIP)

A theory stating that investors should be indifferent between returns on unhedged interest-bearing bank deposits in two currencies, without using forward contracts.

Law of One Price (LOOP)

States that identical goods sold in different places should have the same price when compared in a common currency, assuming no barriers like transportation costs or tariffs.

Purchasing Power Parity (PPP)

Focuses on comparing the prices of entire baskets of goods across different locations, aiming to determine if the basket's price is the same in both places to avoid profitable arbitrage opportunities.

Purchasing Power Parity (PPP)

The concept stating that price levels in different countries should be equal when expressed in a common currency, crucial for understanding exchange rates.

Real Exchange Rate

The ratio of price levels between two countries, indicating how many baskets of goods from one country are needed to purchase one basket from another.

Nominal Exchange Rate

The rate at which one currency can be exchanged for another, focusing on the value of currencies without considering price levels.

Real Depreciation

When more units of the home country's goods are needed to buy one unit of foreign goods, indicating a decrease in the real exchange rate.

Real Appreciation

When fewer units of the home country's goods are needed to buy one unit of foreign goods, indicating an increase in the real exchange rate.

Absolute Purchasing Power Parity (PPP)

States that the real exchange rate equals 1, implying that all baskets of goods should have the same price when expressed in a common currency.

Relative Purchasing Power Parity (PPP)

Focuses on the relationship between changes in prices and changes in exchange rates over time, rather than absolute price levels.

Inflation Differential

The difference in inflation rates between two countries, influencing the rate of depreciation of the nominal exchange rate according to Relative PPP.

Convergence to PPP

The gradual adjustment of price differences over time towards Purchasing Power Parity, with deviations diminishing at a rate of approximately 15% per year.

Money

A fundamental concept in economics serving as a store of value, unit of account, and medium of exchange in economic transactions.

Money Functions

Money serves as a cornerstone of economic activity by enabling value storage, economic transaction measurement, and goods/services exchange facilitation.

Measurement of Money

It includes various categories like Currency in Circulation, M0 (base money), M1 (currency + demand deposits), and M2 (M1 + less liquid assets).

Money Supply Determination

The central bank controls M0 directly through currency issuance and reserves, and indirectly influences broader measures like M1 through tools such as open market operations.

Demand for Money

The quantity theory of money links money demand to nominal income, where demand is proportional to nominal income and affected by inflation and real income changes.

Monetary Model of Prices

It explains how the price level is determined by the money supply, demand for real money balances, and real income, affecting inflation and price adjustments.

Monetary Model of Exchange Rate

Combines quantity theory of money and PPP to show how changes in money supply and real income impact exchange rates between countries.

Exchange Rate Forecasting

Based on the monetary approach, forecasts rely on expectations about money supplies, real income, and central bank policies, with attention to economic indicators.

Evidence for the Monetary Approach

Scatterplots from 1975 to 2005 support the relationship between money supply growth, inflation rates, and exchange rate depreciation, aligning with the monetary model's predictions.

Monetary Approach

The concept that variations in money supply growth rates are associated with similar variations in inflation rates and exchange rate depreciation across countries, supported by empirical evidence from scatterplots.

Hyperinflation

A sustained period with an inflation rate exceeding 50% per month, leading to prices doubling every few days and causing significant economic, social, and political crises.

Purchasing Power Parity (PPP) in Hyperinflations

Despite PPP's general poor performance in the short run, it tends to hold well during hyperinflations, showing a strong correlation between changes in prices and exchange rates.

General Model of Money Demand

A framework in macroeconomics explaining why individuals and firms hold money, incorporating factors like transactions demand and opportunity cost, and aiming to understand money demand variations with changes in economic conditions.

Long-Run Equilibrium in the Money Market

The state where real money supply equals the demand for real money balances, determined by the nominal interest rate and real income, crucial for understanding exchange rate determination and macroeconomic variables.

Fisher Effect

The concept stating that changes in expected inflation rates are fully incorporated into changes in nominal interest rates, predicting a one-for-one relationship between them in the long run.

Real Interest Parity (RIP)

The equalization of expected real interest rates across countries in the long run, dependent on Purchasing Power Parity (PPP) and Uncovered Interest Parity (UIP) assumptions, suggesting arbitrage opportunities lead to equalized real interest rates.

Real Interest Parity (RIP)

Implies that countries integrated into the global capital market will eventually share a common expected real interest rate, potentially leading to economic convergence.

Fisher Effect

States that the long-run expected nominal interest rate in a country equals the long-run world real interest rate plus the country's expected long-run inflation rate, showing how inflation impacts nominal interest rates.

UIP (Uncovered Interest Parity)

In equilibrium, the expected return on a foreign investment should equal the domestic interest rate plus the expected rate of depreciation of the domestic currency against the foreign currency, a fundamental equation in the asset approach to exchange rates.

Dollar Depreciation

When the dollar weakens relative to the euro, requiring more dollars to buy the same amount of euros, impacting investments and future returns.

Equilibrium in the FOREX Market

The no-arbitrage condition ensures no risk-free profits through arbitrage, with adjustments in exchange rates to maintain market equilibrium.

Asset Approach

Focuses on short-term fluctuations in exchange rates by analyzing factors related to asset markets, such as investor expectations, interest rates, and risk perceptions, complementing the monetary approach in understanding exchange rate dynamics.

FX Market Equilibrium

The state where the supply and demand for foreign exchange are balanced, determining the exchange rate.

Change in Domestic Interest Rate

Alteration in the domestic interest rate leading to shifts in the FX market due to changes in returns on domestic currency deposits.

Change in Foreign Interest Rate

Adjustment in the foreign interest rate causing shifts in the FX market due to variations in returns on foreign currency deposits.

Change in Expected Future Exchange Rate

Modification in the anticipated future exchange rate influencing shifts in the FX market due to alterations in expected returns from holding foreign currency.

Nominal Rigidity

The concept of prices being inflexible or predetermined in the short run, affecting the adjustment process of nominal interest rates.

Money Market Equilibrium

The balance between money supply and money demand, represented by Ms = Md, influencing nominal interest rates in the short run.

Sticky Prices

Prices that are slow to adjust in response to market conditions, impacting the determination of nominal interest rates in the short run.

Bond Yields

The return an investor receives from holding a bond, expressed as a percentage of the bond's face value, inversely related to bond prices.

Monetary Policy

Actions taken by central banks to control the money supply and influence interest rates to stabilize economies.

Open Market Operations (OMOs)

Central bank activities of buying or selling government bonds to adjust the money supply and impact interest rates.

Excess Supply of Money

Situation where real money demand is less than real money supply, leading to downward pressure on interest rates.

Equilibrium Restored

The process where interest rates adjust to bring the money market back to equilibrium in the short run.

Expansionary OMO

Central bank operation of buying bonds to increase the money supply, lower interest rates, and stimulate economic activity.

Contractionary OMO

Central bank operation of selling bonds to decrease the money supply, raise interest rates, and cool off an overheating economy.

Fisher Effect

The theory suggesting that nominal interest rates adjust with changes in expected inflation to maintain the real interest rate.

Asset Approach

Analyzing exchange rates by considering money supply, demand, and expected depreciation in one country.

Uncovered Interest Parity (UIP)

Equilibrium in the FX market where expected returns on investments in two currencies are equal.

Temporary Shock to Home Money Supply

Increase in money supply leading to lower interest rates, higher exchange rate (depreciation of the dollar).

Permanent Shock to Foreign Money Supply

Expansion of foreign money supply leading to lower foreign interest rates, causing the dollar to appreciate.

Overshooting

Exchange rate depreciation more than expected due to a permanent shock in the short run.

Fixed Exchange Rate Regime

Government intervention to maintain a fixed exchange rate without capital controls.

Trilemma

Incompatibility of fixed exchange rates, international capital mobility, and monetary policy autonomy.

Gross National Expenditure (GNE)

Total expenditure on final goods and services by consumers, businesses, and government.

Gross Domestic Product (GDP)

Value of all goods and services produced minus the value of intermediate goods.