Principles of Economics Unit 29 Review: Exchange Rates & Global Capital Flows

Key Concepts and Definitions

• Exchange rate measures the value of one currency in terms of another currency
• Nominal exchange rate unadjusted for inflation (market exchange rate)
• Real exchange rate adjusted for differences in price levels between countries
• Appreciation increase in the value of a currency relative to another currency
• Depreciation decrease in the value of a currency relative to another currency
• Fixed exchange rate system government or central bank maintains a specific exchange rate
• Floating exchange rate system market forces of supply and demand determine the exchange rate
• Balance of payments record of a country's international transactions over a specific period (usually a year)

Exchange Rate Systems

• Fixed exchange rate system government or central bank intervenes to maintain a predetermined exchange rate
  • Requires sufficient foreign exchange reserves to buy or sell currency in the market
  • Provides stability and predictability for international trade and investment
• Floating exchange rate system exchange rate determined by market forces of supply and demand
  • Allows automatic adjustment to economic shocks and imbalances
  • Can lead to exchange rate volatility and uncertainty
• Managed float system combination of fixed and floating exchange rates
  • Central bank intervenes to influence the exchange rate within a certain range
  • Provides some flexibility while maintaining control over extreme fluctuations
• Pegged exchange rate system currency's value is fixed to another currency or a basket of currencies (U.S. dollar, euro)
• Currency board system strict form of a fixed exchange rate with full convertibility and backing by foreign reserves (Hong Kong dollar to U.S. dollar)

Factors Influencing Exchange Rates

• Interest rates higher interest rates attract foreign capital, increasing demand for the currency and causing appreciation
• Inflation rates higher inflation rates lead to currency depreciation as the purchasing power decreases
• Economic growth and stability strong economic performance and political stability increase demand for a country's currency
• Government debt and deficits high levels of government debt and budget deficits can lead to currency depreciation
• Current account balance a current account surplus increases demand for the currency, while a deficit decreases demand
• Speculation and market sentiment expectations about future economic and political developments can influence exchange rates
• Central bank interventions buying or selling currency in the foreign exchange market to influence the exchange rate
• Geopolitical events and risks political instability, conflicts, or changes in international relations can impact exchange rates

Balance of Payments

• Current account records trade in goods and services, income, and unilateral transfers
  • Trade balance exports minus imports of goods
  • Services balance exports minus imports of services (tourism, transportation, financial services)
  • Primary income balance income from foreign investments minus payments to foreign investors
  • Secondary income balance unilateral transfers (remittances, foreign aid)
• Capital account records capital transfers and acquisitions/disposals of non-produced, non-financial assets
• Financial account records transactions in financial assets and liabilities between residents and non-residents
  • Direct investment acquisition of a lasting interest and control in a foreign enterprise
  • Portfolio investment purchases of foreign securities (stocks, bonds) without a controlling interest
  • Other investment includes loans, currency and deposits, and trade credits
• Errors and omissions balancing item to ensure the balance of payments sums to zero
• Official reserve assets foreign currency reserves held by the central bank to intervene in the foreign exchange market

International Capital Flows

• Foreign direct investment (FDI) long-term investment in a foreign country involving control and management of the enterprise
  • Greenfield investment establishing a new venture or expanding an existing one
  • Mergers and acquisitions (M&A) acquiring or merging with an existing foreign company
• Portfolio investment short-term investment in foreign financial securities without a controlling interest
  • Equity securities stocks and shares in foreign companies
  • Debt securities government and corporate bonds issued by foreign entities
• International bank lending cross-border lending by banks to foreign borrowers (governments, corporations, households)
• Official development assistance (ODA) concessional financing and grants provided by governments and international organizations to developing countries
• Remittances transfers of money by foreign workers to their home countries
• Push factors conditions in the source country that encourage capital outflows (low interest rates, economic slowdown)
• Pull factors conditions in the recipient country that attract capital inflows (high interest rates, economic growth, favorable policies)

Exchange Rate Policies and Interventions

• Monetary policy central bank adjusts interest rates to influence exchange rates and manage inflation
  • Higher interest rates attract foreign capital, leading to currency appreciation
  • Lower interest rates discourage foreign capital, leading to currency depreciation
• Fiscal policy government spending and taxation decisions impact exchange rates through their effect on economic growth and inflation
• Capital controls restrictions on international capital flows to manage exchange rate stability and financial risks
  • Inflow controls limits on foreign investment and borrowing to prevent excessive appreciation and speculative bubbles
  • Outflow controls limits on domestic residents' ability to invest abroad to prevent capital flight and depreciation
• Foreign exchange interventions central bank buys or sells foreign currency in the market to influence the exchange rate
  • Sterilized intervention offsetting the impact on the money supply through open market operations
  • Unsterilized intervention allowing the money supply to change, affecting interest rates and inflation
• International coordination multilateral agreements and institutions (IMF, G20) to promote exchange rate stability and prevent competitive devaluations

Global Financial Markets

• Foreign exchange market decentralized market for buying, selling, and exchanging currencies
  • Spot market immediate exchange of currencies at the current market rate
  • Forward market agreement to exchange currencies at a predetermined rate on a future date
  • Futures market standardized contracts to buy or sell currencies at a specific price and date
• International bond market market for debt securities issued by governments, corporations, and international organizations in foreign currencies
  • Sovereign bonds issued by national governments to finance public expenditures and debt
  • Corporate bonds issued by companies to raise capital for investments and operations
• International stock market market for equity securities issued by companies and traded on foreign exchanges
  • Cross-listing shares of a company traded on multiple exchanges in different countries
  • American Depositary Receipts (ADRs) U.S. securities representing ownership in foreign company shares
• Eurocurrency market market for deposits and loans in currencies outside their country of origin (Eurodollars)
• Offshore financial centers jurisdictions with favorable tax and regulatory environments for international financial transactions (Cayman Islands, Luxembourg)

Economic Impacts and Trade-offs

• Competitiveness and trade appreciation makes exports more expensive and imports cheaper, potentially worsening the trade balance
  • Depreciation makes exports cheaper and imports more expensive, potentially improving the trade balance
  • Marshall-Lerner condition sum of export and import price elasticities must exceed 1 for depreciation to improve the trade balance
• Inflation and purchasing power appreciation can help control inflation by making imports cheaper and reducing domestic demand
  • Depreciation can increase inflation by making imports more expensive and increasing domestic demand
  • Pass-through effect extent to which exchange rate changes are reflected in import prices and consumer prices
• Economic growth and stability appreciation can dampen economic growth by reducing net exports and domestic demand
  • Depreciation can stimulate economic growth by increasing net exports and domestic demand
  • J-curve effect temporary worsening of the trade balance after depreciation before improving in the long run
• Financial stability and risk appreciation can attract speculative capital inflows, leading to asset bubbles and financial instability
  • Depreciation can trigger capital outflows and increase the burden of foreign currency-denominated debt
  • Currency mismatches differences in the currency composition of assets and liabilities, exposing entities to exchange rate risk
• Policy trade-offs balancing exchange rate stability, monetary autonomy, and free capital mobility (impossible trinity)
  • Flexible exchange rates allow monetary autonomy and free capital mobility, but not exchange rate stability
  • Fixed exchange rates and free capital mobility require giving up monetary autonomy
  • Capital controls allow exchange rate stability and monetary autonomy, but not free capital mobility