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Introduction
In this chapter we look at:
Foreign exchange fundamentals; in particular
the balance of payments and exchange rate regimes. Describe the factors that cause a nations currency to appreciate or depreciate. International parity relations. Define and discuss the International Fisher relation.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Introduction
Discuss the implications of the parity
relationships combined.
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Balance of Payments
The balance of payments tracks all financial
flows crossing a countrys borders during a given period (a quarter or a year). A balance of payments is not an income statement nor a balance sheet. The convention is to treat all financial inflows as a credit to the balance of payments.
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Balance of Payments
An export, for example, creates a financial
inflow for the home country, whereas an import creates an outflow. There are two main categories: Current account Financial account
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Current Account
Covers all current transactions that take place in
the normal business of residents of a country. Dominated by the trade balance, the balance of all exports and imports. Made up of: Exports and imports (trade balance) Services Income Current transfers
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Current Account
It also covers:
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Financial Account
Covers investments by residents abroad and
investments by nonresidents in the home country. It includes: Direct investment made by companies. Portfolio investments in equity, bonds and other
securities of any maturity. Other investments and liabilities (such as deposits or borrowing with foreign banks and vice versa).
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Financial Account
The sum of the current and financial
accounts should be zero. Question: What if the overall balance is negative? Answer: The central bank can use up part of its reserves to restore a zero balance.
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Disadvantage
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Currency Board
Today some countries try to maintain a
fixed exchange rate regime against the dollar or euro. This is done through a currency board The supply of home currency is fully backed by an equivalent amount of that major currency.
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Advantages
country.
Reduces exchange rate volatility in the short run. Also encourages monetary discipline for the home Can induce destabilizing speculation.
Disadvantage
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Linear approximation
= F/S -1 rFC - rDC
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Parity Relations
The purchasing power parity relation,
linking spot exchange rates and inflation. The International Fisher relation, linking interest rates and expected inflation. The uncovered interest rate parity relation, linking spot exchange rates, expected exchange rates and interest rates. The foreign exchange expectation relation, linking forward exchange rates and expected spot exchange rates.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Relative PPP
Focuses on the general across the board inflation
rates.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
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Relative PPP
This claims that the percentage movement of
the exchange rate should be equal to the inflation differential between the two economies
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(1 + rFC)/(1 + rDC) = (1 + E(IFC))/(1 + E(IDC)) Linear approximation rFC rDC E(IFC) - E(IDC)
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Example
Question: How are the nominal and real
interest rates calculated? Answer: Nominal interest rate is observed in the marketplace. The real interest rate is calculated from the observed interest rate and forecasted inflation.
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BOP Components
Current Account Capital account Financial account Official reserve account
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Exhibit 2.6:
Exchange Rate Dynamics
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