IB Final MC

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5 mechanisms for establishing exchange rates: free float
managed float
fixed rate system
target zone agreement
hybrid system
free float: exchange rates determined by currency demand and supply
managed float: active government intervention in foreign exchange market to:
- smooth out exchange rate fluctuations
- reduce economic uncertainty associated with free float
target zone agreement: adjusting national economic policies to maintain exchange rate within specific margin around agreed-on fixed central exchange rates
fixed rate system: governments committed to maintain target exchange rates
- each central bank actively buys/sells its currency in foreign exchange market
- when exchange rate threatens to deviate from its stated par value by more than agree-on percentage
hybrid system: mix of both free and managed float, and other various types of pegged exchange rate relationships
benefits of floating rate system: - offset international differences in inflation rates (so trade, wages, employment and output would not have to adjust)
- currency depreciation in high inflation countries
- currency appreciation in low inflation countries
- real and nominal exchange rates stabilize over time
- no foreign exchange crisis since it acts as a shock absorber to cushion real economic shocks that change equilibrium exchange rate
costs of floating rate system: - excessive volatility
- uncertainty over future government policies
- exchange rate fluctuations actually has little to do with actual inflation
benefits of managed float: governments can reduce volatility associated with free float
cost of managed float: - inability of governments to recognize difference between temporary and permanent exchange rate disequilibrium
- government run risk of creating an exchange rate crisis and wasting reserves when trying to manage rates when permanent shifts occurred
benefits of target zone agreement: forces convergence of monetary policy to that of country
cost of target zone agreement: - requires political will to direct fiscal and monetary policies at that goal and not at purely national goals
- hard for countries to achieve
- key changes in equilibrium exchange rate cannot be reflected in actual exchange rates with a currency crisis occurring
benefits of fixed rate system: - currency stability
- absence of currency crisis
- more monetary discipline
costs of fixed rate system: - exchange rate cannot cushion effects of real economic shocks (i.e. devaluation)
- prices must adjust but lack of flexibility of many prices
- economic shocks can result to higher unemployment and less economic growth
benefits of hybrid system: - option to select system that best meet country's needs
cost of hybrid system: - most decisions based on political rather economic considerations
- no constraint on choices that government can make (can be bad or good)
effect of excessive movements of exchange rates: - indicates that there are profits to be earned by betting against the market
- exhibits phenomenon of overshooting (currency rates overreact to economic events and then return to equilibrium)
- no evidence that one could profit by betting rate movements are excessive
fall of bretton woods system: - conscious and explicit coordination of monetary policies is difficult
- us refused to follow economic policies that would maintain value of gold at high price
- stabilizing exchange rate requires dependence and subordination, not freedom for everybody to do their own things
european monetary system: - monetary policies should be coordinated and geared toward maintaining exchange rate parities
- coordination of policies will not always benefit all
EMU dominated by: germany
objective of parity conditions: to link:
exchange rates
interest rates
prices
law of one price: - identical goods sell for same price worldwide
- *one product at a point in time
- not every effective
purchasing power parity: - overall real price levels should be identical worldwide
- *basket of products at a point in time
stickiness of price and PPP: - prices are sticker (harder to change) but exchange rates are easier to change
- since prices are harder to change in the short run, PPP is more effective in the long run
big mac standard: economist developed this standard to track PPP
- comparing prices of big mac across countries
- finding overvalued/undervalued currencies
big mac standard flaws: - not tradeable
- cultural differences in the product
- production/ cost differences
when market < implied exchange rate: DC is overvalued
when market > implied exchange rate: DC undervalued
overvalued DC: - market assigning more value to DC than it should
- fewer DC needed to get 1 FC
relative purchasing power parity: - relative changes in price levels will be offset by changes in exchange rates
- *basket of products of over a period of time
- more effective since prices are sticky and tend to adjust over time
difference between short & long run: - not defined by time
- defined by how flexible your inputs are
long run and PPP: - PPP is a good descriptor
- inputs are flexible
short run and PPP: - PPP is a poor descriptor of exchange rate behavior
- at least 1 input is fixed (usually capital)
CPI: consumer price index
- measure of inflation
- no unit, just an index #
fisher effect: - relationship between nominal and real interest rates
- real returns are equalized across countries
the gold standard: - buy or sell paper currencies in exchange for gold
- created a fixed exchange system
par value: official price of currency in terms of gold
fixed exchange system: - price of given currency doesn't change relative to each another currency
- countries pegged value of currency to gold (par value)
sterling based gold standard: - pre WWI
- pounds was settler of transactions
collapse of gold standard: - during WWI
- normal transactions between allies stopped
post WWI: readopted gold standard despite inflation, unemployment, instability
- short lived
- uk couldn't maintain value of pound
- pound allowed to float
- can't redeem paper currency for gold at part value
bretton woods conference: -1944 - renew gold standard with lots of modifications
- created 2 new international organizations (international bank for reconstruction and development, international monetary fund)
- fixed exchange rate system (stability and between +- of par value)
international monetary fund objectives: ensure monetary system promotes international commerce
- monetary cooperation
- expansion and growth of int. trade
- exchange stability
- establish multilateral systems of payment
- help members
- lessen disequilibrium in int. BOP
end of bretton wood system: - runs on bank
- reliance on USD led to end of system

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Number of cards 44

Created By choi.michelle