Los 18.b Flashcards
(11 cards)
What are the two exchange rate regimes when a country does not have its own currency?
Formal dollarization (using another country’s currency).
Membership in a monetary union (e.g., European Union using the euro).
What about if a country does have it’s own currency?
Various regimes, including currency boards, fixed peg arrangements, and managed floating exchange rates.
What is formal dollarization?
Formal dollarization occurs when a country uses the currency of another country. The country cannot have its own monetary policy since it does not issue currency.
What is a currency board arrangement?
A currency board arrangement is a commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. For example, Hong Kong uses a currency board with U.S. dollars.
What is a conventional fixed peg arrangement?
a country pegs its currency within margins of ±1% versus another currency or a basket that includes the currencies of its major trading or financial partners. The monetary authority can maintain exchange rates within the band by purchasing or selling foreign currencies in the foreign exchange markets (direct intervention). In addition, the country can use indirect intervention, including changes in interest rate policy, regulation of foreign exchange transactions, and convincing people to constrain foreign exchange activity. The monetary authority retains more flexibility to conduct monetary policy than with dollarization, a monetary union, or a currency board. However, changes in policy are constrained by the requirements of the peg.
Horizontal Bands:
In this system, the currency can fluctuate within a wider band (e.g., ±2%) relative to another currency or basket of currencies. This gives the monetary authority more flexibility than with a conventional peg.
What is a crawling peg?
A crawling peg is an exchange rate system in which the currency’s exchange rate is periodically adjusted, usually to account for inflation differences relative to the currency it is pegged to.
Passive crawling peg: Adjustments happen periodically without advance notice.
Active crawling peg: A series of planned, announced adjustments over time, which can influence inflation expectations and add predictability to domestic inflation.
Monetary policy is limited in a similar way to a fixed peg arrangement
What is a managed and independently floating exchange rate?
In a managed floating exchange rate system, the monetary authority influences the exchange rate in response to economic indicators like the balance of payments, inflation, or employment, but without a specific target exchange rate.
An independently floating exchange rate is determined by the market, with intervention by the monetary authority only to reduce short-term fluctuations, not to target a specific exchange rate.
What is the balance of payments?
The balance of payments refers to the difference between a country’s total exports and imports. Capital flows must offset imbalances in trade
How do capital flows offset trade imbalances?
For example, if a country has a trade deficit (more imports than exports), capital inflows (such as foreign investment in assets) offset the deficit, balancing the payments.
What is the relationship between the balance of trade and capital flows?
The balance of trade (exports - imports) must be offset by capital flows (savings - investment + government revenue - spending). A trade deficit leads to an inflow of foreign capital to balance the payments.
What role do capital flows play in exchange rates in the short term and long term?
Capital flows adjust more rapidly than trade flows, spending, or savings, and are the primary determinant of exchange rates in the short and intermediate term.
In the long term, exchange rates are primarily determined by trade flows, as asset prices and savings/investment decisions adjust over time.
