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Flashcards in Midterm Review Deck (24):

Drivers of currency demand

-Demand: demand for foreign goods. Eg. Canadian buying Turkish goods. Must convert to Lira to buy goods


Official reserves

-in a free floating system, these do not change


What are the components of a monetary policy trilemma

1 Free capital mobility
2 Exchange rate management
3 Monetary autonomy



-current account + capital account + official reseves = 0

*credits are inflow, debits are outflow


Fischer effect asumptions

real interest rate equals to the nominal interest rate minus the expected inflation rate.

shows how the money supply affects nominal interest rate and inflation rate as a tandem.


Relative PPP

states that the exchange rate between the home currency and any foreign
currency will adjust to reflect changes in the price levels of the two countries.

For example, if inflation is
5% in the United States and 1% in Japan, then the dollar value of the Japanese yen must rise by about 4%
to equalize the dollar price of goods in the two countries


Five parity conditions result from arbitrage activities:

Purchasing power parity (PPP)
Fisher effect (FE)
International Fisher effect (IFE)
Interest rate parity (IRP)
Forward rates are unbiased predictors of future spot rates (UFR)


How to cope with a current account deficit

-depreciate currency
-boost savings rate
-end foreign ownership of assets


According to the Fisher effect, countries with higher inflation rates

have higher interest rates



price levels should be equal
worldwide when expressed in a common currency

two "levels"


Drivers of currency supply

foreign country’s demand for local goods
¥ e.g. Turkish demand for Canadian goods means Turks convert TL to C$ in order to buy.


Uncovered interest parity

difference in interest rates between two countries is equal to the expected change in exchange rates between the countries' currencies.


Current Account deficit due to

-low private savings
-high private investment
-large government deficit


Quoting currency

S1,2 - amount of currency 1 required to buy a unit of currency 2 → if S1,2 rises, currency 1 has depreciated

S1,2 = S2/S1


Interest rate parity

interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.


Interest Rate Parity (IRP) theory, we know that the currency that is at a "forward discount", i.e., the one that buys

one that buys less in the forward market than in the spot market, is the currency with the higher interest rate, higher inflaiton, expect depreciation  


F1,2(n) > S1,2

Currency 2 trades at a forward premium
Currency 1 trades at a forward discount


What is sterilized intervention

intervention in the currency market while simultaneously engaging in open market operation
-in the long term it Is ineffective and depletes foreign reserve accounts


Possible explanations for higher interest rates

higher inflation expectations


Best conditions for PPP

1. Over long term
2. short run during periods
of hyperinflation since with high inflation changes in the general level of prices quickly swamp the effects
of relative price change


Are current account deficits bad?

-it depends what it is being used to finance
-if you are financing high ROI investments, its okay
-bad if you are using it to consumer more today at the expense of tomorrow


Trading at forward premium ie. F>S

Currency that trades at a premium has lower interest rates, currency appreciates, possibly lower inflation


Trading at forward discount

implies higher interest rate,
-higher inflation
-lower exchange rate


International fischer effect

currency with low inflation is expected to appreciate