Macro Exam 2

current account balance (CAB) equation

CAB = NX + Net interest income + Net transfers

E is determined by RER and the price levels. that is

E = RER x (P*/P)

Changes in the Exchange Rate

If demand for U.S. dollars increases and supply does not change, the exchange rate rises. If demand for U.S. dollars decreases and supply does not change, the exchange rate falls. If supply of U.S. dollars increases and demand does not change, the exchange rate falls. If supply of U.S. dollars decreases and demand does not change, the exchange rate rises.

how to calculate the U.S. interest rate differential

The U.S. interest rate minus the foreign interest rate

People buy U.S. dollars so that they can

buy U.S.-produced goods and services or U.S. assets.

foreign exchange market is a

competitive market

The demand for dollars is a

derived demand

Interest rate parity means

equal interest rates when exchange rate changes are taken into account.

At a given exchange rate, if world demand for U.S. exports increases, the demand for U.S. dollars...

increases and the demand curve for U.S. dollars shifts rightward.

At a given exchange rate, if the U.S. demand for imports increases, the supply of U.S. dollars on the foreign exchange market...

increases and the supply curve of U.S. dollars shifts rightward.

The lower today's exchange rate, other things remaining the same, the

larger is the expected profit from buying U.S. dollars and the greater is the quantity of U.S. dollars demanded today.

official settlements account

records the change in U.S. official reserves.

the higher the exchange rate, the

smaller is the quantity of U.S. dollars demanded in the foreign exchange market.

The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between

stocks and flows of financial capital.

The quantity of U.S. dollars supplied in the foreign exchange market is

the amount that traders plan to sell during a given time period at a given exchange rate.

U.S. official reserves

the government's holdings of foreign currency.

foreign exchange market

the market in which the currency of one country is exchanged for the currency of another.

RER is determined by

the real forces of demand and supply in the markets for goods and services

Speculation

trading on the expectation of making a profit. Speculation contrast with arbitrage, which is trading on the certainty of making a profit. Most foreign exchange transactions are based on speculation.

There are three balance of payments accounts...

1. Current account 2. Capital and financial account 3. Official settlements account If U.S. official reserves increase, the official settlements account is negative. The sum of the balances of the three accounts always equals zero.

The exchange rate influences the quantity of U.S. dollars demanded for two reasons...

1. Exports effect 2. Expected profit effect

The exchange rate influences the quantity of U.S. dollars supplied for two reasons:

1. Imports effect 2. Expected profit effect

This quantity of US dollars depends on many factors but the main ones are

1. The exchange rate 2. U.S. demand for imports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends on

1. The exchange rate 2. World demand for U.S. exports 3. Interest rates in the United States and other countries 4. The expected future exchange rate

Arbitrage in the foreign exchange market and international loans and goods markets achieves four outcomes...

1. The law of one price 2. No round-trip profit 3. Interest rate parity 4. Purchasing power parity

other influences on the quantity of U.S. dollars are

1. World demand for U.S. exports 2. U.S. interest rate relative to the foreign interest rate 3. The expected future exchange rate

current account records

1. receipts from exports of goods and services sold abroad, 2. payments for imports of goods and services from abroad 3. net interest paid abroad, and <net transfers (such as foreign aid payments) The current accounts balance = exports - imports + net interest income + net transfers.

what brings a change in the supply of dollars

A change in any influence on the quantity of U.S. dollars that people plan to sell, other than the exchange rate

net borrower

A country that is borrowing more from the rest of the world than it is lending to it

net lender

A country that is lending more to the rest of the world than it is borrowing from it

Interest Rate Parity

A currency is worth what it can earn. The return on a currency is the interest rate on that currency plus the expected rate of appreciation over a given period.

currency depreciation

A fall in the value of one currency in terms of another currency

currency appreciation

A rise in value of one currency in terms of another currency

No Round-Trip Profit

A round trip is using the currency A to buy currency B, and then using B to buy A. Arbitrage removes profit from all transactions of this type.

The Expected Future Exchange Rate

At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward.

Three possible exchange rate policies are

Flexible exchange rate Fixed exchange rate Crawling peg

Expected Profit Effect

For a given expected future U.S. dollar exchange rate, the lower the current exchange rate, the greater is the expected profit from holding U.S. dollars, and the smaller is the quantity of U.S. dollars supplied on the foreign exchange market.

The Law of Supply of Foreign Exchange

Other things remaining the same, the higher the exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market.

Expected Profit Effect

The larger the expected profit from holding U.S. dollars, the greater is the quantity of U.S. dollars demanded today.

Exports Effect

The larger the value of U.S. exports, the greater is the quantity of U.S. dollars demanded on the foreign exchange market.

Imports Effect

The larger the value of U.S. imports, the larger is the quantity of U.S. dollars supplied on the foreign exchange market. The higher the exchange rate, the greater is the value of U.S. imports, so the greater is the quantity of U.S. dollars supplied.

The Law of One Price

The law of one price states that if an item can be traded in more the one place, the price will be the same in all locations.

foreign exchange rate

The price at which one currency exchanges for another

other influences that change the supply of US dollars

U.S. demand for imports U.S. interest rates relative to the foreign interest rate The expected future exchange rate

A change in any influence on the quantity of U.S. dollars that people plan to buy, other than the exchange rate, brings a change in

US dollars

Purchasing Power Parity (PPP)

When two quantities of money can buy the same quantity of goods and services. equal value of money.

debtor nation

a country that during its entire history has borrowed more from the rest of the world than it has lent to it.

creditor nation

a country that has invested more in the rest of the world than other countries have invested in it.

crawling peg

an exchange rate that follows a path determined by a decision of the government or the central bank and is achieved by active intervention in the market. China is a country that operates a crawling peg. A crawling peg works like a fixed exchange rate except that the target value changes. The idea behind a crawling peg is to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

If the U.S. interest differential rises, the supply of U.S. dollars...

decreases and the supply curve of U.S. dollars shifts leftward

The lower the exchange rate, the

greater is the value of U.S. exports, so the greater is the quantity of U.S. dollars demanded.

government sector surplus or deficit

is equal to net taxes, T, minus government expenditure on goods and services G.

Net exports formula

is equal to the sum of government sector balance and private sector balance: NX = (T - G) + (S - I)

private sector surplus or deficit

is saving, S, minus investment, I.

exchange rate

is the price—the price of one currency in terms of another. determined in a market—the foreign exchange market.

fixed exchange rate

policy is one that pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply. A fixed exchange rate requires active intervention in the foreign exchange market.

flexible exchange rate

policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.

capital and financial account

records foreign investment in the United States minus U.S. investment abroad.

balance of payments accounts

records its international trading, borrowing, and lending

Arbitrage

the practice of seeking to profit by buying in one market and selling for a higher price in another related market.

real exchange rate

the relative price of U.S.-produced goods and services to foreign-produced goods and services. It measures the quantity of real GDP of other countries that a unit of U.S. real GDP buys The equation that links the nominal exchange rate (E)and real exchange rate (RER) is RER = (E x P)/P* where P is the U.S. price level and P* is the Japanese price level.