International Money and Finance
Summary
Blue = lecture, Black = book
Chapter 1: The Foreign Exchange Market
Currencies are bought at the foreign exchange market
§1.2: Exchange Rate Definitions
Exchange rate = the price of one currency in terms of another
o Domestic currency units per unit of the foreign currency: takes €1.35 to buy £1 =
€1.35/£1 (H per F)
Used in theoretical economic literature
Rise in the exchange rate means that more euros are need to purchase £1 so
the pound appreciated or euro depreciated.
o Foreign currency units per unit of domestic currency: takes £0.7407 to buy €1 =
£0.7407/€1 (F per H)
Rise means that more pounds are needed to buy €1 so the pound
depreciated or euro appreciated. When the £ appreciates, it increases in
value -> exchange rate decreases
Used in the course
When exchange rate increases = higher price of F currency = loss of value of H money
o Same as price increase = higher price of good = loss of value of H money
Exchange rate exists with 2 prices, the bid and offer price. At the bid price, the bank buys the
currency, at the offer rate, the bank is selling. The difference is the bid-offer spread = gross
profit margin of the bank
§1.3: Characteristics and Participants of the Foreign Exchange
Market
Foreign exchange market:
o Worldwide
o Exists of commercial banks, foreign exchange brokers, authorized agents
US dollar is most traded because widely used to make international transactions. Sometimes
it’s cheaper to first buy dollars and then the currency you want
Main participants:
o Retail clients: people who need foreign exchange for operating their businesses.
Operate by placing buy/sell orders at the commercial banks
o Commercial banks: carry out buy/sell orders from retail clients and buy/sell on their
own to alter the structure of their assets and liabilities in different currencies. Deal
directly with other banks or through brokers. Other financial institutions as merchant
banks do the same
o Foreign exchange brokers: intermediary for banks, gain from economies of scale
Advantage: they gather many quotations from banks so the best one is
chosen quickly and at low cost.
Disadvantage: small brokerage fee needs to be paid, not in bank to bank deal
Each financial centre has a few that conduct their exchanges
, o Central banks: they intervene to influence their currency rate. Under a fixed
exchange rate system, authorities need to buy with excess supply and sell with
excess demand
§1.4: Arbitrage in the Foreign Exchange Market
Arbitrage = exploitation of price differentials for riskless guaranteed profits.
Financial centre arbitrage: makes sure that the rate quoted in NY is the same as in London.
Otherwise you buy in London (if lower) and sell in NY. This goes on until the rate coincides
Cross currency arbitrage: when you can buy more for the same price through a different
currency. The increased demand increases the prices (appreciates), lowers the exchange rate
o Say it is cheaper to buy £ with dollars through euro, then euro sees increased
demand
§1.5: The Spot and Forward Exchange Rates
Spot Exchange Rate: quotation between 2 currencies for immediate transaction. Normally
there is a 2-day lag between purchase and exchange because of paperwork and payment
o Notation: St for rate at time t
Forward exchange rate: rate of exchange where currencies are exchanged some time in the
future (30 days, 90, etc.)
o Price and transaction date are certain, no risk involved.
o Notation: Ft (or Ft,1+t)
§1.6: Nominal, Real and Effective Exchange Rates
Nominal exchange rate = the exchange rate that prevails at a given date. Is the amount of US
dollars is needed for £1. Is only the price of one currency in terms of the other without
considering purchasing power of goods/services. Is also in index form. Doesn’t say anything
about competitiveness on the international market
Real exchange rate = nominal exchange rate adjusted for relative prices between countries.
If UK has inflation, the competitiveness with the US has gone down, so depreciation.
o
o Sr = index of real exchange rate. S = index of nominal exchange rate. P = index of
domestic price level (US). P* = index of foreign price level
Effective exchange rate = measure of whether the currency is appreciating or depreciating
against a weighted basket of foreign currencies. So if you trade 50% with Europe and 50%
with the US, 0.5 will be attached to the US exchange rate and 0.5 to the European exchange
rate. In order to say something about the competiviness, you need the real effective
exchange rate index
§1.7: A Simple Model of the Determination of the Spot Exchange
Rate
Simple model of exchange rate determination: basic principle: the exchange rate can be
analysed like a price as in supply and demand model.
Demand for foreign exchange: the demand is a derived demand: they are wanted because of
what they can buy. If the £ appreciates against the dollar (exchange rate of $/£ rises) -> price
of UK exports to US ↑ -> demand for exports ↓ -> demand for £ ↓. The simple model
depends on UK exports. Any factor that increased demand for exports (rise in US income,
, higher price in US, US wanting more UK products), increases demand for £ and shifts the
demand curve to the right.
Supply of foreign exchange: supply of pounds is the UK demand for dollars. If the pound
appreciates -> cost of US export ↓ -> demand for US exports ↑ -> demand for dollars ↑ ->
amount of £ supplied in the foreign exchange market ↑ -> upward-sloping supply of pounds.
Will shift to the right if: increase in UK income, UK wants more US exports, rise in UK prices.
Equilibrium exchange rate is determined by the intersection of the supply and demand
curves
§1.8: Alternative Exchange Rate Regimes
Floating exchange rate regime: authorities don’t intervene with buying or selling their
currency, they allow their currency to change due to fluctuations in supply and demand
o Includes: managed floating with no predetermined path, independently floating
Fixed exchange rate regime: many countries have fixed their exchange rate against the $.
o Includes: no separate legal tender, currency board, other fixed pegs, pegs within
horizontal bands, crawling pegs
o Non-sterilized intervention = buying/selling £ affects the money supply and interest
rates. When there is an increase in demand for £ -> demand shifts to the right ->
pound wants to appreciate. BoE sells Q1 – Q2 £ by buying $ so the supply ↓ ->
weakens the exchange rate back to the start with an increase of BoE reserves of $ ->
M ↑ and UK interest rate ↓. Both the increased amount of £ in circulation and lower
interest rate weakens the exchange rate so effective but risks inflation
o Sterilized intervention = restore the money supply and interest back to before the
intervention. When there is an increase in demand, M ↑ -> BoE sterilizes the effect
by selling UK Treasury bills -> M ↓ -> price of Treasury bills ↓ -> interest rate ↑. This
increased the attractiveness of £ in the foreign exchange market so demand goes up
again. So not effective.
o Banks still use the sterilized intervention in the hope of having a psychological impact
on market participants. They can still keep their targets while they sell pounds and
lower the demand in the very short run. Most traders don’t count bank intervention
unless it is non-sterilized
§1.9: The Determination of the Forward Exchange Rate
Hedgers = agents (usually firms) use forward exchange rate to protect themselves against
exchange rate risk, the risk of loss due to adverse exchange rate movements
o Main reason for forward markets
Arbitrageurs = agents (usually banks) that want to make riskless profit out of the differences
between interest rates, known as forward discount or forward premium.
o Forward premium = when the forward exchange rate quotation for the currency
represents an appreciation
o Forward discount = when the forward exchange rate quotation represents an
depreciation
F = forward exchange rate quotation, S = spot exchange rate quotation
o Covered interest parity (CIP): condition that continually holds because of
arbitrageurs. Combines spot and forward exchange rates and home and foreign
interest rates.
, Investing €1 at home will give you 1+r. Investing €1 in US deposit will give
you 1/S x (1+r*) x F euros (convert to $ (1/S) -> US deposit yields 1/S x (1+r*)
-> convert/sell at the same time on forward market to 1/S x (1+r*) x F euros)
F = one-year forward exchange rate, S = spot exchange rate, r = one-year
domestic interest rate, r* = one-year foreign interest rate
Crucial condition, perfect capital mobility (you can invest in US)
r* ↑ -> r < r* + (F-S)/S = return in US is bigger than at home so arbitrageurs
invest abroad. Buy on the spot (demand ↑) to exploit higher return ->
foreign currency appreciates, S↑. Sell dollars through the forward (supply
↑) to avoid risk -> depreciates on forward market, F↓. -> (F-S)/S = F/S - 1↓
until r = r* + (F-S)/S -> CIP is restored
F = S x (1+r)/(1+r*). But unrealistic. When F ↓ -> arbitrageurs buy spot (and
sell forward to avoid risk) -> S↓ (and F drop is mitigated). So F also affects S
Integration lowers arbitrage profits and capital markets are integrated now:
CIP holds + capital control was abolished -> perfect capital mobility
o If the domestic interest rate is higher than the foreign interest rate, domestic
currency is at forward discount
Speculators = agents that hope to make a profit by accepting exchange rate risk
o They are willing to take risk. They want to exploit when the forward market isn’t the
same as the expected future spot rate. If they expect a cheap $ so F>E -> sell
expensive $ forward and expect to buy cheap $ back at spot market at t+1
Chapter 2: The Balance of Payments
Deficits may lead to the government raising interest rates or reducing public expenditure to
reduce imports. For a country with a fixed exchange rate and continuous deficits there could
be speculative attacks to devalue the currency, or there could be calls for protection against
foreign imports or capital controls to defend the exchange rate
Countries can lend abroad -> national savings need not equal investment
o International capital flows
o Countries can build up international assets, e.g., Japan (or debts: US)
o Global imbalances: one of the key international problems
National income accounts
o Composition of a country’s income/production: national focus
o Important terms: GNP, GDP, national income, consumption, …
o GDP = value added of all goods and services that are produced within a country
o GNP = value added of all goods and services that are produced by a nation’s factors
of production
Value added -> intermediate purchases are not counted
Produced: income received by nation’s factors of production -> product =
income
GNP = GDP + net factor income abroad (e.g., interest, dividend, profits
earned abroad) (net means receipts – payments to F)
o Gross National Disposable Income (GNDI) = GNP + net unilateral transfers
Best measure of national income
o GDP is used for national income when:
Summary
Blue = lecture, Black = book
Chapter 1: The Foreign Exchange Market
Currencies are bought at the foreign exchange market
§1.2: Exchange Rate Definitions
Exchange rate = the price of one currency in terms of another
o Domestic currency units per unit of the foreign currency: takes €1.35 to buy £1 =
€1.35/£1 (H per F)
Used in theoretical economic literature
Rise in the exchange rate means that more euros are need to purchase £1 so
the pound appreciated or euro depreciated.
o Foreign currency units per unit of domestic currency: takes £0.7407 to buy €1 =
£0.7407/€1 (F per H)
Rise means that more pounds are needed to buy €1 so the pound
depreciated or euro appreciated. When the £ appreciates, it increases in
value -> exchange rate decreases
Used in the course
When exchange rate increases = higher price of F currency = loss of value of H money
o Same as price increase = higher price of good = loss of value of H money
Exchange rate exists with 2 prices, the bid and offer price. At the bid price, the bank buys the
currency, at the offer rate, the bank is selling. The difference is the bid-offer spread = gross
profit margin of the bank
§1.3: Characteristics and Participants of the Foreign Exchange
Market
Foreign exchange market:
o Worldwide
o Exists of commercial banks, foreign exchange brokers, authorized agents
US dollar is most traded because widely used to make international transactions. Sometimes
it’s cheaper to first buy dollars and then the currency you want
Main participants:
o Retail clients: people who need foreign exchange for operating their businesses.
Operate by placing buy/sell orders at the commercial banks
o Commercial banks: carry out buy/sell orders from retail clients and buy/sell on their
own to alter the structure of their assets and liabilities in different currencies. Deal
directly with other banks or through brokers. Other financial institutions as merchant
banks do the same
o Foreign exchange brokers: intermediary for banks, gain from economies of scale
Advantage: they gather many quotations from banks so the best one is
chosen quickly and at low cost.
Disadvantage: small brokerage fee needs to be paid, not in bank to bank deal
Each financial centre has a few that conduct their exchanges
, o Central banks: they intervene to influence their currency rate. Under a fixed
exchange rate system, authorities need to buy with excess supply and sell with
excess demand
§1.4: Arbitrage in the Foreign Exchange Market
Arbitrage = exploitation of price differentials for riskless guaranteed profits.
Financial centre arbitrage: makes sure that the rate quoted in NY is the same as in London.
Otherwise you buy in London (if lower) and sell in NY. This goes on until the rate coincides
Cross currency arbitrage: when you can buy more for the same price through a different
currency. The increased demand increases the prices (appreciates), lowers the exchange rate
o Say it is cheaper to buy £ with dollars through euro, then euro sees increased
demand
§1.5: The Spot and Forward Exchange Rates
Spot Exchange Rate: quotation between 2 currencies for immediate transaction. Normally
there is a 2-day lag between purchase and exchange because of paperwork and payment
o Notation: St for rate at time t
Forward exchange rate: rate of exchange where currencies are exchanged some time in the
future (30 days, 90, etc.)
o Price and transaction date are certain, no risk involved.
o Notation: Ft (or Ft,1+t)
§1.6: Nominal, Real and Effective Exchange Rates
Nominal exchange rate = the exchange rate that prevails at a given date. Is the amount of US
dollars is needed for £1. Is only the price of one currency in terms of the other without
considering purchasing power of goods/services. Is also in index form. Doesn’t say anything
about competitiveness on the international market
Real exchange rate = nominal exchange rate adjusted for relative prices between countries.
If UK has inflation, the competitiveness with the US has gone down, so depreciation.
o
o Sr = index of real exchange rate. S = index of nominal exchange rate. P = index of
domestic price level (US). P* = index of foreign price level
Effective exchange rate = measure of whether the currency is appreciating or depreciating
against a weighted basket of foreign currencies. So if you trade 50% with Europe and 50%
with the US, 0.5 will be attached to the US exchange rate and 0.5 to the European exchange
rate. In order to say something about the competiviness, you need the real effective
exchange rate index
§1.7: A Simple Model of the Determination of the Spot Exchange
Rate
Simple model of exchange rate determination: basic principle: the exchange rate can be
analysed like a price as in supply and demand model.
Demand for foreign exchange: the demand is a derived demand: they are wanted because of
what they can buy. If the £ appreciates against the dollar (exchange rate of $/£ rises) -> price
of UK exports to US ↑ -> demand for exports ↓ -> demand for £ ↓. The simple model
depends on UK exports. Any factor that increased demand for exports (rise in US income,
, higher price in US, US wanting more UK products), increases demand for £ and shifts the
demand curve to the right.
Supply of foreign exchange: supply of pounds is the UK demand for dollars. If the pound
appreciates -> cost of US export ↓ -> demand for US exports ↑ -> demand for dollars ↑ ->
amount of £ supplied in the foreign exchange market ↑ -> upward-sloping supply of pounds.
Will shift to the right if: increase in UK income, UK wants more US exports, rise in UK prices.
Equilibrium exchange rate is determined by the intersection of the supply and demand
curves
§1.8: Alternative Exchange Rate Regimes
Floating exchange rate regime: authorities don’t intervene with buying or selling their
currency, they allow their currency to change due to fluctuations in supply and demand
o Includes: managed floating with no predetermined path, independently floating
Fixed exchange rate regime: many countries have fixed their exchange rate against the $.
o Includes: no separate legal tender, currency board, other fixed pegs, pegs within
horizontal bands, crawling pegs
o Non-sterilized intervention = buying/selling £ affects the money supply and interest
rates. When there is an increase in demand for £ -> demand shifts to the right ->
pound wants to appreciate. BoE sells Q1 – Q2 £ by buying $ so the supply ↓ ->
weakens the exchange rate back to the start with an increase of BoE reserves of $ ->
M ↑ and UK interest rate ↓. Both the increased amount of £ in circulation and lower
interest rate weakens the exchange rate so effective but risks inflation
o Sterilized intervention = restore the money supply and interest back to before the
intervention. When there is an increase in demand, M ↑ -> BoE sterilizes the effect
by selling UK Treasury bills -> M ↓ -> price of Treasury bills ↓ -> interest rate ↑. This
increased the attractiveness of £ in the foreign exchange market so demand goes up
again. So not effective.
o Banks still use the sterilized intervention in the hope of having a psychological impact
on market participants. They can still keep their targets while they sell pounds and
lower the demand in the very short run. Most traders don’t count bank intervention
unless it is non-sterilized
§1.9: The Determination of the Forward Exchange Rate
Hedgers = agents (usually firms) use forward exchange rate to protect themselves against
exchange rate risk, the risk of loss due to adverse exchange rate movements
o Main reason for forward markets
Arbitrageurs = agents (usually banks) that want to make riskless profit out of the differences
between interest rates, known as forward discount or forward premium.
o Forward premium = when the forward exchange rate quotation for the currency
represents an appreciation
o Forward discount = when the forward exchange rate quotation represents an
depreciation
F = forward exchange rate quotation, S = spot exchange rate quotation
o Covered interest parity (CIP): condition that continually holds because of
arbitrageurs. Combines spot and forward exchange rates and home and foreign
interest rates.
, Investing €1 at home will give you 1+r. Investing €1 in US deposit will give
you 1/S x (1+r*) x F euros (convert to $ (1/S) -> US deposit yields 1/S x (1+r*)
-> convert/sell at the same time on forward market to 1/S x (1+r*) x F euros)
F = one-year forward exchange rate, S = spot exchange rate, r = one-year
domestic interest rate, r* = one-year foreign interest rate
Crucial condition, perfect capital mobility (you can invest in US)
r* ↑ -> r < r* + (F-S)/S = return in US is bigger than at home so arbitrageurs
invest abroad. Buy on the spot (demand ↑) to exploit higher return ->
foreign currency appreciates, S↑. Sell dollars through the forward (supply
↑) to avoid risk -> depreciates on forward market, F↓. -> (F-S)/S = F/S - 1↓
until r = r* + (F-S)/S -> CIP is restored
F = S x (1+r)/(1+r*). But unrealistic. When F ↓ -> arbitrageurs buy spot (and
sell forward to avoid risk) -> S↓ (and F drop is mitigated). So F also affects S
Integration lowers arbitrage profits and capital markets are integrated now:
CIP holds + capital control was abolished -> perfect capital mobility
o If the domestic interest rate is higher than the foreign interest rate, domestic
currency is at forward discount
Speculators = agents that hope to make a profit by accepting exchange rate risk
o They are willing to take risk. They want to exploit when the forward market isn’t the
same as the expected future spot rate. If they expect a cheap $ so F>E -> sell
expensive $ forward and expect to buy cheap $ back at spot market at t+1
Chapter 2: The Balance of Payments
Deficits may lead to the government raising interest rates or reducing public expenditure to
reduce imports. For a country with a fixed exchange rate and continuous deficits there could
be speculative attacks to devalue the currency, or there could be calls for protection against
foreign imports or capital controls to defend the exchange rate
Countries can lend abroad -> national savings need not equal investment
o International capital flows
o Countries can build up international assets, e.g., Japan (or debts: US)
o Global imbalances: one of the key international problems
National income accounts
o Composition of a country’s income/production: national focus
o Important terms: GNP, GDP, national income, consumption, …
o GDP = value added of all goods and services that are produced within a country
o GNP = value added of all goods and services that are produced by a nation’s factors
of production
Value added -> intermediate purchases are not counted
Produced: income received by nation’s factors of production -> product =
income
GNP = GDP + net factor income abroad (e.g., interest, dividend, profits
earned abroad) (net means receipts – payments to F)
o Gross National Disposable Income (GNDI) = GNP + net unilateral transfers
Best measure of national income
o GDP is used for national income when:
