Formulas Chapter 9

Formulas Chapter 9 - Chapter 9 - "Rotational...

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Chapter 5 Foreign Exchange Rate Determination Outline The international parity conditions that are covered in Chapter 4 represent one school of thought explaining what drives the exchange rates. This chapter introduces two other schools, namely the balance of payments approach and the asset market approach . Note that these theories are not mutually exclusive. While the three sets of theories are in conflict over certain points, each one of them might have some truth to it. After all, we don’t have any one theory that would predict exchange rates correctly all of the time. Part of the challenge in explaining the developments in foreign exchange markets is that the importance of different factors may vary over time. Also, some of the exchange rate determinants appear to be affected by the exchange rate itself. I. The Balance of Payments (BOP) Approach As Chapter 3 showed us, a country’s Balance of Payments is based on its Current Account Balance, Capital Account Balance, Financial Account Balance, and Reserve Balance. Overall, the BOP is supposed to balance, which means that a Current Account surplus (more exports than imports) is typically countered by a Capital/Financial Account deficit (more capital/financial outflows than inflows). A) In countries with fixed exchange rate systems, the monetary authority has an obligation to ensure that the BOP is in balance. A Current Account surplus indicates a surplus demand for the country’s currency in the world, and a Current Account deficit means that an excess supply of the domestic currency exists. Example: Country A has a fixed exchange rate system and a Current Account surplus. Foreigners need “country A dollars” to pay for their purchases. But, country A residents are not spending enough of their dollars on foreign goods to satisfy the world demand of the dollars. “The world” needs more “country A dollars” than what is being supplied to the world market. The government must react to the Current Account imbalance and intervene. In case of surplus demand of the domestic currency, the monetary authorities will sell domestic currency for foreign currencies. Likewise, too low demand must be supplemented by purchases of the domestic currency by the monetary authority of the country. If Current Account deficits continue to the point when the country faces a risk of running out of foreign currency reserves,
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Formulas Chapter 9 - Chapter 9 - "Rotational...

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