Week 11 Flashcards
(26 cards)
What is an exchange rate, and how is it quoted?
The exchange rate is the price of one currency in terms of another. It can be quoted as the foreign currency per unit of domestic currency (e.g., USD per AUD) or domestic currency per unit of foreign currency (e.g., AUD per USD).
Differentiate between nominal and real exchange rates.
The nominal exchange rate is the actual market rate between two currencies. The real exchange rate adjusts the nominal rate by price levels, showing the relative purchasing power and competitiveness of goods.
What is the formula for the real exchange rate (RER)?
Real Exchange Rate RER = e * P_f / P, where:
e = nominal exchange rate,
P = domestic price level,
P_f = foreign price level.
What does the theory of Purchasing Power Parity (PPP) state?
PPP suggests that identical goods should sell for the same price internationally once prices are converted to a common currency, based on the Law of One Price (LOOP).
What are the limitations of PPP in practice?
PPP may not hold due to transportation costs, trade barriers, market imperfections, and non-traded goods. It’s more reliable over the long term rather than in the short term.
Why do individuals and firms demand foreign currencies?
Demand arises for purchasing foreign goods/services, making investments, tourism, or speculative purposes, affecting exchange rates through shifts in supply and demand.
What is the impact of an increase in the demand for a currency?
Increased demand for a currency raises its value (appreciates it) relative to others, while decreased demand causes depreciation.
How do interest rate differentials impact the exchange rate?
Higher domestic interest rates attract foreign investment, leading to currency appreciation. Lower rates do the opposite, often causing depreciation.
What factors influence the nominal exchange rate in the short run?
Short-run rates are influenced by interest rate differentials, financial flows, and speculation in the forex market, leading to frequent fluctuations.
What drives the nominal exchange rate in the long run?
In the long run, fundamental factors like inflation rates, productivity, and purchasing power parity (PPP) play a more significant role in exchange rate determination.
What are the primary types of exchange rate systems?
Fixed exchange rates: Central banks maintain a set rate by intervening in forex markets.
Flexible (floating) exchange rates: Rates are determined by market forces without direct intervention.
What are the advantages and disadvantages of a fixed exchange rate?
Advantages include exchange rate stability, reducing uncertainty for trade and investment. Disadvantages are loss of independent monetary policy and the need for large reserves to defend the fixed rate.
What is the Policy Trilemma in an open economy?
The Policy Trilemma states that a country can only achieve two of the following three goals:
- Exchange rate stability,
- Full monetary policy autonomy,
- Free capital mobility.
How does the trilemma affect a country’s choice of exchange rate system?
Countries must prioritize two of the three, e.g., under a fixed rate and free capital mobility, monetary policy autonomy is limited.
What role does a central bank play in a fixed exchange rate system?
The central bank buys or sells its currency to maintain the fixed rate, using foreign reserves to balance supply and demand in the forex market.
What is a speculative attack, and how does it affect a fixed exchange rate?
A speculative attack occurs when investors sell a currency expected to devalue, forcing the central bank to use reserves to defend the rate, potentially leading to a currency crisis.
What does it mean for a currency to be overvalued or undervalued?
An overvalued currency is priced higher than its market value, often due to artificial support by the central bank. An undervalued currency is priced lower, promoting exports.
How can a country manage an overvalued currency under a fixed exchange rate?
Strategies include devaluation, imposing restrictions on transactions, or using reserves to buy domestic currency.
Why is the real exchange rate significant for competitiveness?
The real exchange rate reflects the relative price of domestic and foreign goods, impacting trade balances. A depreciated real rate makes exports cheaper and imports more expensive, improving competitiveness.
How does a nominal depreciation impact the real exchange rate?
Nominal depreciation generally leads to real depreciation, boosting exports and reducing imports, provided domestic prices do not adjust proportionally.
What are the Terms of Trade (TOT)?
TOT measures the relative prices of exports to imports, calculated as TOT = (Export Prices / Import Prices) × 100. Higher TOT means more imports can be purchased with the same amount of exports.
What is the Trade Weighted Index (TWI)?
The TWI measures the value of a currency against a basket of major trading partners’ currencies, weighted by trade shares, providing a comprehensive view of overall exchange rate trends.
How do interest rates impact the exchange rate?
Higher interest rates attract foreign capital, leading to currency appreciation, while lower rates often cause depreciation as capital flows out.
How does inflation affect exchange rates in the long run?
Higher domestic inflation tends to depreciate the currency as it reduces purchasing power and makes exports less competitive.
