Chapter 4: The International Flow of Funds and Exchange Rates

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Special Drawing Right

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

Foreign Exchange Markets

a global network of international banks and currency traders that trade different countries' currencies

Balance of Payments

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

Inflation

an increase in the prices of goods and services caused by the supply of money exceeding the demand for goods and services

Arbitrage

buying goods in a lower priced market and selling them in a higher priced market to make profits

Big Mac Index

calculation using the cost of a McDonald's restaurant sandwich to assess the relative values of currencies

Financial Account

consists of domestic-country-owned assets abroad, foreign owned assets in the domestic country, and net financial derivatives

Soft Currencies

emerging market countries' currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values

Foreign Direct Investment

encompasses purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services

Forward Market

exchange that enables purchases and sales of currencies in the future with prices (or the forward rate) established at a previous time

Spot Market

exchange that trades currencies on a real time basis for immediate delivery

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

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

Hard Currencies

leading world currencies of developed industrialized countries, including the U.S. dollar, European euro, Japanese yen, and British pound sterling

Gold Standard

monetary system that pegs currency values to the market value of gold

Clean Float Currencies

monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies

Dirty Float Currencies

monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies

Direct Quotes

prices of a foreign currency in dollars, or the number of dollars per one unit of foreign currency

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

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

Law of One Price

principle stating that identical goods should sell for the same price in different countries according to local currencies

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

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

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

Independent Floating Exchange Rate System

system that sets the values of major currencies based on their demand and supply in world currency markets

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

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

Current Account

the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers

Risk Premium

the added return required by investors for risk associated with a security or asset

Bid-Ask Spread

the difference between bid and ask prices of a currency; the transaction fee earned by the bank

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

Trade Balance

the net of merchandise exports and merchandise imports

Balance of Transfers

the net of transfer payments going overseas and inflows from abroad

Dollarization

the practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country

Forward Rate

the price at an earlier time of a currency in terms of another currency established for future delivery in the forward market

Exchange Rate

the price at which one currency can be converted to another currency

Indirect Quotes

the reciprocal of the direct quote, or the prices of a dollar (for example) in foreign currency terms

Purchasing Power Parity

theory stating that a basket of goods should have approximately the same prices across different countries

Interest Rate Parity

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

Trade Deficit

when merchandise imports exceed merchandise exports for a country


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