Exchange Rate
The number of units of one currency that can be exchanged for another.
Floating Exchange Rate System
System in which a currency's value is determined solely by the interplay of the market forces of demand and supply, instead of by government intervention
Most advanced economies use these.
Fixed Exchange Rate System
- The value of a currency is set relative to the value of another currency, or to the value of a basket of currencies.
- As the reference currency value rises and falls, so does the pegged currency.
- Many developing economies and some emerging markets us
Convertible Currency
Can be readily exchanged for other currencies
Hard Currencies
Most convertible currencies- universally accepted.
Ex: British pound, Canadian dollar, European euro, Japanese yen, and U.S. dollar.
Nonconvertible Currency
Not acceptable for international transactions
Equilibrium Point
The intersection of R1 and Q1, or where buyers (demand) and sellers (supply) meet.
Exchange rates are determined by supply and demand.
In a free market, how are exchange rates determined?
Inflation
Increase in the price of goods/services = money buys less than previously.
Hyperinflation
Persistent annual double/triple-digit rates of price increases.
Interest rates and inflation are positively related (high inflation=high interest).
Investors expect to be compensated for an inflation-induced decline in the value of their money- if inflation is running at 10% ? banks have to pay more than 10% interest
Relationship between interest rates and inflation and why
1. Demand for money grows more rapidly than supply; or
2. The central bank increases the money supply faster than the rise in national output.
Inflation occurs when:
International Monetary Fund (IMF)
An international agency that aims to stabilize currencies by monitoring the foreign exchange systems of member countries and lending money to developing economies.
Global Financial System
Consists of the collective financial institutions that facilitate and regulate flows of investment and capital funds worldwide.
It includes the national and international banking systems, the international bond market, and national stock markets.
Central Bank
Regulates the money supply and credit, issues currency, manages the rate of exchange, and controls the financial reserves held by private banks.
1. Buying and selling money in the banking system;
2. Increasing/decreasing interest rates to commercial banks; or
3. Buying and selling government securities, e.g. treasury bills and bonds.
Central Bank key functions
Currency Risk
Potential harm that arises from changes in the price of one currency relative to another.
Capital Flight
The rapid sell off by residents or foreigners of their holdings in a nation's currency or other assets, usually in response to a domestic crisis that causes investors to lose confidence in the country's economy.
Foreign Exchange
All forms of money that are traded internationally, including foreign currencies, bank deposits, checks, and electronic transfers.
Foreign Exchange Market
The global marketplace for buying and selling national currencies.
Trade Deficit
A condition in which a nations imports exceed its exports for a specific period of time.
Trade Surplus
A condition in which a nation's exports exceed its imports for a specific period of time.
Devaluation
Government action to reduce the official value of its currency, relative to other currencies.
Balance of Payments
The annual accounting of all economic transactions of a nation with all other nations.
International Monetary System
Institutional framework, rules, and procedures by which national currencies are exchanged for one another.