balance of payments (BOP)
a statement of account that shows all transactions between the residents of one country and the rest of the world for a given period of time
current account
the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers
trade balance
the net of merchandise exports and merchandise imports
trade deficit
when merchandise imports exceed merchandise exports for a country
services balance
the net of exports of services and imports of services
income balance
the net of investment income from abroad and investment payments to foreigners
balance of transfers
the net of transfer payments going overseas and inflows from abroad
financial account
consists of domestic-country- owned assets abroad, foreign- owned assets in the domestic country, and net financial derivatives
risk premium
the added return required by investors for risk associated with a security or asset
foreign direct investment (FDI)
encompasses purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services
statistical discrepancy
reconciles any imbalance between the current account and financial account to ensure that all debit and credit entries in the balance of payments statement sum to zero
foreign exchange markets
a global network of international banks and currency traders that trade different countries' currencies
exchange rate
the price at which one currency can be converted to another currency
independent floating exchange rate system
system that sets the values of major currencies based on their demand and supply in world currency markets
managed floating exchange rate system
system that determines the value of some currencies partly by demand and supply in the foreign exchange market, and partly by active government intervention in the foreign exchange market
fixed exchange rate system
system in which the country pegs its currency at a fixed rate to a major currency or basket of currencies, while the exchange rate fluctuates within a narrow margin around a central rate
spot market
exchange that trades currencies on a real-time basis for immediate delivery
bid-ask spread
the difference between bid and ask prices of a currency; the transaction fee earned by the bank
direct quotes
prices of a foreign currency in dollars, or the number of dollars per one unit of foreign currency)
indirect quotes
the reciprocal of the direct quote, or the prices of a dollar (for example) in foreign currency terms
forward market
exchange that enables purchases and sales of currencies in the future with prices (or the forward rate) established at a previous time
forward rate
the price at an earlier time of a currency in terms of another currency established for future delivery in the forward market
discount
in the forward market, the selling of a currency at a spot rate that is less than the forward rate
premium
in the forward market, the selling of a currency at a spot rate that is more than the forward rate
hedge
insurance that reduces future risk
inflation
an increase in the prices of goods and services caused by the supply of money exceeding the demand for goods and services
gold standard
monetary system that pegs currency values to the market value of gold
Bretton Woods Agreement
the 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar
International Monetary Fund (IMF)
financial authority established under the Bretton Woods Agreement in 1944 to help ensure the stability of the international monetary and financial system
Smithsonian Agreement
the 1971 decision allowing the United States to devalue the dollar against other countries' currencies, thereby beginning the breakdown of the 1944 Bretton Woods Agreement
Jamaica Agreement
the 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets
special drawing right (SDR)
a basket of currencies consisting of dollars, euros, pounds, and yen created by the International Monetary Fund (IMF) for use as a benchmark to value the currencies of different countries
clean float currency
monetary system with minimal government intervention; largely market determined
dirty float currency
monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies
dollarization
the practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country
hard currencies
leading world currencies of developed industrialized countries, including the U.S. dollar, European euro, Japanese yen, and British pound sterling
soft currencies
emerging market countries' currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values
law of one price
principle stating that identical goods should sell for the same price in different countries according to local currencies
arbitrage
buying goods in a lower priced market and selling them in a higher priced market to make profits
purchasing power parity (PPP)
theory stating that a basket of goods should have approximately the same prices across different countries
big mac index
calculation using the cost of a McDonald's restaurant sandwich to assess the relative values of currencies
interest rate parity (IRP)
theory stating that interest rates on bonds in different countries should be the same, as investors would buy and sell these bonds to make arbitrage profits until this condition holds
covered interest rate parity
principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
uncovered interest rate parity
principle implying that expected future spot exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another