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A country’s current account balance equals the change in its net foreign wealth What accounts for most of the activity in the foreign exchange market Inter-Bank trading A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of the currency Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using the forward exchange rate are the same According to purchasing power parity prices of goods and services across countries reflect differences in interest rates After a permanent increase in the money supply the exchange rate overshoots in the short run Forward and spot exchange rates while not necessarily equal do move closely together The current (spot) exchange rate between currencies depends on interest rates and the expected future exchange rate Shortcomings of the doctrine of PPP include both a and b (Trade barriers and non-tradability of services) Overshooting means that helps explain why exchange rates are so volatile With interest parity an increase in the money supply at home causes the currency to gain value on the spot market The aggregate real money demand schedule L(R,Y) slopes downward because a fall in the interest rate raises the desired real money holdings of each household and firm in the economy The real exchange rate q, is defined as (ExP*)/P If the dollar interest rate is 10 % .... the euro interest rate is 6 % ... and forward market predicts a 5 % drop in the dollar’s value An investor should invest only in euros If people expect relative PPP to hold The difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, in the United States and Europe The aggregate money demand depends on all of above (interest rate, price level, real national income) The CA (current account) is equal to Y – (C + I + G) The expected real interest rate (re)in terms of the nominal interest rate (R) and expected inflation rate (e) is given by re = R - e Suppose that the one-year forward price of euros in terms of dollars is equal to $ 1.113 per euro. Further, assume that the spot exchange rate is $ 1.05 per euro, and the interest rate on dollar deposits is 10 percent and on euro it is 4 percent. covered interest parity does not hold If the dollar interests rate is 10 percent and the euro interest rate is 6 percent, then it is impossible to tell given the information. An increase in a country’s money supply causes its currency to depreciate in the foreign exchange market while a reduction in the money supply causes its currency to depreciate In the short-run, a temporary increase in the money supply shifts the AA curve to the right, increases output and depreciates the currency A foreign exchange swap is a spot sale of a currency combined with a forward repurchase of the currency A reduction in a country’s money supply causes its currency to appreciate in the foreign market The current (spot) exchange rate between currencies depends on the expected future exchange rate Powered by TCPDF (www.tcpdf.org)