Index

• A • banks. See also central banks , 209 absolute PPP European , 19, 234, Big Mac standard and, 161–164 260–262, 277 fi guring, 157 European System of Central Banks, accountability, ECB, 262 260, 270 Africa Bank (the Fed), 218, international franchises in, 41 233–234 South African reserves, 249 International Bank for Reconstruction American-type options, 180 and Development, 215–216, 221 Andorra, 263 national central banks, 260 appreciation (revaluation) Swiss National Bank, 229–231 defi ned, 13 barter economy euro, 264 demand–supply framework, 71–75 , 28–32 exchange rates, 22 Argentina, 235 beggar-thy-neighbor policies, 210 asset approach to exchange rate Belgium determination, 89, 99–102. See also in European monetary system, 258 MBOP in European Union, 263 asset markets, 282, 292 London Gold Pool, 222 Atlantic Charter, 214 monetary agreement, 206 Australia role in establishment of EEC, 256 dollar–dollar rate exchange, 114 bid–ask spread, exchange rate, 35–37 gold reserves, 249 Big Mac standard , 209 overview, 161–162 money market, 129–131 unrealistic expectations, 280 Austria, 205–206, 263 using to evaluate currencies, 162 autonomous monetary policy, 251 bimetallic era monetary system COPYRIGHTEDoverview, MATERIAL 204 • B • U.S. and, 204–205 world, 205–206 balance of payments (BOP), 88, 199–200. bonds, downgrading, 269 See also MBOP BOP (balance of payments), 88, 199–200. Bancor, 215 See also MBOP Bank of England, 209

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Bretton Woods Conference (United overview, 181–182 Nations Monetary and Financial selling, 183–184 Conference in Bretton Woods) Canada American plan, 215–216 gold standard, 209 avoiding past mistakes, 213 Medicago, 40–41 British plan, 215 Onex Corporation, 42 ideological views, 214 capital account convertibility, 219 International Monetary Fund, capital fl ow restrictions 17, 219–220 fl oating exchange rates and, 228–229 overview, 212–213 IMF allowance of, 220 setting system, reasons for, 82 217–218 capitalism, factor in Bretton Woods . See also Bretton Conference, 214 Woods Conference carry trade, 153 collapse of, 223–225 central banks defi ned, 196 Bank of England, 209 deterioration of, 221–223 control of nominal money supply, 93–94 dollar shortage and Marshall Plan, currency board and, 234–235 220–221 direct interventions, 230–232 established at Bretton Woods dollarization, 234 conference, 217–218 European Central Bank, 19, 234, gold parity in, 247 260–262, 277 London Gold Pool, 222 European System of Central Banks, overview, 211–212 260, 270 Special Drawing Rights, 223 Federal Reserve Bank (the Fed), Britain 218, 233–234 bimetallic standard, 205 fl oating exchange rates and, 228 in European Union, 263 foreign exchange markets, 43 gold standard, 207–209 interventions, 275, 280, 282 London Gold Pool, 222 national central banks, 260 loss of superpower status, 220 Swiss National Bank, 229–231 proposal at Bretton Woods ceteris paribus conditions Conference, 215 applying real shocks to MBOP, 115–116 suspension of gold parity, 195 money demand curve, 92 Bulgaria, 263 money supply, 93–96 Business Day, 41 supply-demand framework, 73, 77–78 Businessweek, 42 chartist traders, 289 Chicago Mercantile Exchange (CME), 175 • C • China currency undervaluation, 237–238 California Gold Rush of 1849, 205 joint venture with Kellog, 41 call options soft pegs (crawling pegs), 238 defi ned, 179 Churchill, Winston, 256 exercising, 182–183

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 294294 33/26/13/26/13 33:01:01 PMPM Index 295

Civil War, U.S., 204–205 convergence criteria, Maastricht Treaty classical–neoclassical school of of 1992, 259–260, 263, 277 economics (long-run analysis of convertibility in currencies (current economics) account convertibility), 219 defi ned, 94 convertible paper money, 194–195 nominal shocks, 120 covered interest arbitrage, 145–150 CME (Chicago Mercantile Exchange), 175 CPI (consumer price index), 24, 58–60 Cold War, 221, 222, 277 crawling pegs (soft pegs) combined MBOP attracting foreign investors with, changes in exchange rate equilibrium 238–241 in, 112–113 defi ned, 232 exchange rate, 113–114 general discussion, 235–238 explicit money market, 113 credit risk, FX derivatives, 177 overview, 111–112 Crimean War, 206 commodity markets, 281, 292 cross rates commodity standard system, 196 under Bretton Woods system, 217–218 common currency (euro) exchange rate, 34–35 accomplishments of Euro-zone, 265–266 Cuba, 263 challenges of Euro-zone, 266–267 Cuban Missile Crisis in 1962, 222, 277 Economic and Monetary Union, 259–260 currency. See also domestic currency European Central Bank, 260 buying and selling in spot (derivative) European Monetary System, 258–259 markets, 46–47 European System of Central Banks, 260 currency crises, 239–246 Euro-zone member states, 263–264 euro versus other currencies, 264–265 history of European Union, 256 exchange rate as price of, 22 national central banks, 260 foreign, 32–33, 35–37 optimum currency area, 256–257 seignorage, 234 versus other currencies, 264–265 speculative attack, 241 overview, 255 using Big Mac standard to evaluate, sovereign debt crisis, 268–270 162–164 value of policy coordination in, 277 variables that affect depreciation concerted intervention, 275 (), 273 conditionality, IMF, 244–245 currency board, 197, 234–235 consumer price index (CPI), 24, 58–60 currency crises consumption basket anatomy and timeline, 239–241 calculating real exchange rate, 24 IMF and, 241–246 defi ned, 12 current account, BOP, 200 consumption correlation puzzle, 288 current account convertibility contractionary monetary policy (convertibility in currencies), 219 Australian, effects of, 130–131 Cyprus, 259, 263 defi ned, 129 Czech Republic, 263

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 295295 33/26/13/26/13 33:01:01 PMPM 296 International Finance For Dummies

• D • foreign exchange, marking-to-market process, 177–179 debasement, 193–194 foreign exchange, options, defi cits 168, 170, 179–187 current account, U.S., 221–222 foreign exchange, speculators, 170 monetizing the defi cit, 240 foreign exchange, volatility, 276, 279 trade, American plan for managing, determining exchange rate. See also 215–216 MBOP trade, British plan for managing, 215 asset approach, 99–102 defl ationary vortex, 210 microeconomic approach, 14 demand–supply framework overshooting, 281 barter economy, 71–75 prediction rules, 14–15 comparing demand-supply model and short-run rigidities (sticky prices), MBOP approaches to exchange rate 95–96, 281 determination, 131–133 through demand–supply framework, exchange rate determination, 14–15, 76–78 14–15, 76–78, 282 devaluation (depreciation) government interventions, 82–83 defi ned, 13 growth rate, 80 euro, 264 infl ation rate, 78–79 exchange rate, 28–32 interest rate, 81–82 variables that affect, 273 versus MBOP, 89 direct interventions using alternative exchange rate, 83–85 infl uence on exchange rates, 280 Denmark, 206, 258, 263 overview, 229 depreciation (devaluation) sterilized, 230, 282 defi ned, 13 unsterilized, 230 euro, 264 dirty fl oat, 66, 229 exchange rate, 28–32 dollar variables that affect, 273 dollar shortage and Marshall Plan, derivative (spot) markets 220–221 buying and selling currency in, 46–47 questioning privileged role of, 224 call options, 182–184 as reserve currency system, 217–218 covered versus uncovered interest , 225 arbitrage, 146–147 dollar exchange standard (Bretton forward contracts, 171–175 Woods system). See also Bretton put options, 184–186 Woods Conference derivatives collapse of, 223–225 defi ned, 167 defi ned, 196 foreign exchange, arbitrage, 176–177 deterioration of, 221–223 foreign exchange, forward contracts, dollar shortage and Marshall Plan, 140–141, 168–170, 171–175 220–221 foreign exchange, future contracts, established at Bretton Woods 168, 170, 175–179 Conference, 217–218

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 296296 33/26/13/26/13 33:01:01 PMPM Index 297

gold parity in, 247 monetary policy coordination, 19 London Gold Pool, 222 objectives, 260–261 overview, 211–212 transparency, 262 Special Drawing Rights, 223 ECON (European Parliament’s dollar market Committee on Economic and ceteris paribus conditions, 77–78 Monetary Affairs), 262 price, 76–77 Economic and Monetary Union (EMU), quantity, 76–77 259–260 dollar–euro exchange rate, 28–29, 83–85 economic development, import- dollarization, 197, 233–234 substitution strategy, 82 domestic currency Economist appreciation of, 104 Big Mac standard, 161–164 currency board, 197, 234 Swiss franc’s appreciation against euro, direct interventions, 229–230 229–232 dollarization, 197, 233 ECSC (European Coal and Steel effective exchange rate, 25 Community), 256 exchange rate as price of, 33–34 ECU (European Currency Unit), 256 fl oating, 241 Ecuador, 234 government interventions and, 82 EEC (European Economic Community), infl ation and, 159 224, 256, 257 multinational fi rms and, 13 effective exchange rate, 12, 25–26 pegged exchange rate regime, 17 effi cient markets hypothesis, 292 pegging to hard currency, 239 EFSF (European Financial Stability soft pegs, 235–236 Facility) domestic fi rms creating, 268 acquisition of foreign fi rms, 42 utilizing, 268–269 franchising, 41 empirical verifi cation, of IRP, 152 joint ventures with foreign fi rms, 41 employment factor, metallic standard licensing, 40–41 internal balance, 198–199 risk in, foreign subsidiary setting, 46 EMS (European Monetary System), domestic investment, 274 258–259 double-entry bookkeeping, 194 EMU (Economic and Monetary Union), downgrading bonds, 269 259–260 equilibrium, , • E • 107–111 equilibrium price, demand–supply ECB (European Central Bank) framework, 73–75 accountability, 262 ERM I (European Exchange Rate establishment of, 277 Mechanism I), 258 Governing Council, 261 ERM II (Exchange Rate Mechanism II), 259 independence, 261 ESCB (European System of Central injecting liquidity into fi nancial Banks), 260, 270 markets, 234 Estonia, 259, 263

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 297297 33/26/13/26/13 33:01:01 PMPM 298 International Finance For Dummies

EU (European Union) European Currency Unit (ECU), 256 history of, 256 European Economic Community (EEC), labor mobility, 267 224, 256, 257 lack of fi scal policy coordination, 277 European Exchange Rate Mechanism I euro (common currency) (ERM I), 258 accomplishments of Euro-zone, 265–266 European Financial Stability Facility challenges of Euro-zone, 266–267 (EFSF) Economic and Monetary Union, 259–260 creating, 268 European Central Bank (ECB), 260 utilizing, 268–269 European Monetary System, 258–259 European Monetary System (EMS), European System of Central Banks 258–259 (ESCB), 260 European Parliament’s Committee on Euro-zone member states, 263–264 Economic and Monetary Affairs history of European Union, 256 (ECON), 262 national central banks (NCB), 260 European Recovery Program (Marshall optimum currency area, 256–257 Plan), 221 versus other currencies, 264–265 European System of Central Banks overview, 255 (ESCB), 260, 270 sovereign debt crisis, 268–270 European Union (EU) value of policy coordination in, 277 history of, 256 euro–dollar exchange rate labor mobility, 267 effects of real shocks, 126–128 lack of fi scal policy coordination, 277 government interventions, 82–83 European-type options, 179–180 growth rate, 80 Euroskepticism, 269 infl ation rate, 78–79 exchange rate determination. See also interest rate, 81–82 MBOP Europe asset approach, 89, 99–102 dissatisfaction with Bretton Woods microeconomic approach, 14 system, 224 overshooting, 281 European-type option, 179–180 prediction rules, 14–15 European Central Bank (ECB) short-run rigidities (sticky prices), accountability, 262 95–96, 281 establishment of, 277 through demand–supply framework, Governing Council, 261 14–15, 76–78 independence, 261 exchange rate disconnect puzzle, 288–290 injecting liquidity into fi nancial Exchange Rate Mechanism II (ERM II), 259 markets, 234 exchange rate (nominal exchange rate). monetary policy coordination, 19 See also MBOP objectives, 260–261 absolutes and falsehoods, 20 transparency, 262 applying relative price to, 22–23 European Coal and Steel Community appreciation, 28–30 (ECSC), 256 appreciation (revaluation), 13

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 298298 33/26/13/26/13 33:01:01 PMPM Index 299

bid–ask spread, 35–37 exercise (strike) price, options, 179 calculating cross rates, 34–35 exercising combined MBOP, 113–114 call options, 182–183 in commodity standard system, 196 put options, 185–186 defi ned, 12 expansionary monetary policy, 251 depreciation, 28–30 expectations-based market system, 292 depreciation (devaluation), 13 expected real returns (parity curve), determining, 14 102–105 determining through demand–supply expiration (maturity) date, options, 179 framework, 76–78 explicit money market, 113 effective, 12, 25–26 export fi rms Euro-zone, 19 foreign exchange risk, 44–45 exchange rate regimes, 66–68 forward contracts and, 168–170 in fi at money system, 197 multinational companies, 40 fl oating (fl exible) exchange rate regime, external balance 12–13 metallic standard, 199–201 importance of, 13 reserve currency system, 220 infl ation rates and, 58 interest rates and, 61–65 • F • international monetary systems, 18–19 nominal, 23 FDI (foreign direct investment), 42, 238 output and, 55–57 the Fed (Federal Reserve Bank), overview, 21 218, 233–234 pegged exchange rate regime, 12–13 Federal Open Market Committee percent change, calculating, 27–28 (FOMC), 233 percent change, defi ned, 15 Federal Reserve Bank (the Fed), as price of currencies, 22 218, 233–234 as price of domestic currency, 33–34 Feldstein–Horioka puzzle, 287 as price of foreign currency, 32–33 fi at money random walk model, 152 defi ned, 16–17 real, 12, 23–25 exchange rate in, 197 short-term volatility, 15–16 overview, 195–196 type of money and, 16–18 fi nancial account, BOP, 200 visual approach to, 52–54 Finland, 263 exchange rate regimes. See also metallic Fisher equation, 140, 274. See also standard; pegged exchange rate International Fisher Effect (IFE) regime; post–Bretton Woods system fi xed exchange rate regime. See also defi ned, 66 metallic standard dirty fl oat, 66 advantages, 246–248, 253 fi xed, 219–220, 246–249, 253, 283 disadvantages, 248–249, 253 fl oating (fl exible), 12–13, 17–18, 227–232, IMF as manager of, 219–220 250–251, 253 metallic standard, 283 visualizing, 67–68

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 299299 33/26/13/26/13 33:01:01 PMPM 300 International Finance For Dummies

fl exible exchange rate regime. See foreign investment fl oating (fl exible) exchange rate adjusting expectations, 275 regime foreign direct investment, 42, 238 fl oating (fl exible) exchange rate interest rate differentials, 274 regime, 66 portfolio investment, 239, 241 advantages, 228, 250–251, 253 sources of returns, 274–275 defi ned, 12–13 forward contracts disadvantages, 228–229, 251, 253 export–import fi rms and, 168–170 intervention into, 229–232 forward contract backfi ring, 173–174 overview, 227–228 forward premium, 172–173 versus pegged exchange rate regime, forward rate, 171–172 17–18 future spot rate, 171–172 FOMC (Federal Open Market interest rate parity and, 140–141 Committee), 233 overview, 168 foreign currency. See also exchange rate forward discount regimes associated with forward contracts, bid–ask spread, 35–37 171–173 exchange rate as price of, 32–33 calculating, 144–145 foreign direct investment (FDI), 42, 238 defi ned, 144 foreign exchange (FX) derivatives forward premium arbitrage, 176–177 associated with forward contracts, forward contracts, 140–141, 168–170, 171–173 171–175 calculating, 144–145 future contracts, 168, 170, 175–179 defi ned, 144 marking-to-market process, 177–179 forward contracts, 172–173 options, 168, 170, 179–187 France speculators, 170 European Financial Stability Facility volatility, 276, 279 and, 268 foreign exchange markets in European monetary system, 258–259 asset approach to exchange rate London Gold Pool, 222 determination, 99–102 monetary agreement, 206 central bank interventions, 275 role in establishment of EEC, 256 central banks, 43 suspension of gold parity, 195 determining exchange rate through use of euro, 263 supply and demand model, 76–77 franchising, 41 equilibrium in, 107–111 Free Banking Era, 205 expected real returns (parity curve), free capital movement, 203 102–105 fundamentalist traders, 289 multinational fi rms, 40–42 future contracts, 168, 170, 175–176 overview, 39, 98 future spot rate. See also PPP real returns curve, 105–107 covered interest arbitrage, 146 risk, 43–46 forward contracts, 171–172 speculation with exchange rates, 46–50 overshooting and, 122–123 speculators, 42–43 uncovered interest arbitrage, 146

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 300300 33/26/13/26/13 33:01:01 PMPM Index 301

FV (future value), 141 gold standard. See also gold parity FX (foreign exchange) derivatives Bretton Woods era, 276–277 arbitrage, 176–177 convertible paper money and, 194–195 forward contracts, 140–141, 168–170, gold exchange standard, 207–208 171–175 holding, in U.S., 209–210 future contracts, 168, 170, 175–179 of pre-WWI era, 206–207 marking-to-market process, 177–179 replacement of by dollar reserve options, 168, 170, 179–187 currency, 218 speculators, 170 restoring, 208–209 volatility, 276, 279 Governing Council, ECB, 261 government bonds, 231 • G • government interventions demand–supply framework, 82–83 GATT (General Agreement on Tariffs and dollar–euro exchange rate, 85 Trade), 216 MBOP and, 88 GDP (gross domestic product), 55–57. graphical representation, IRP, 150–152 See also real GDP Great Depression, 209, 213 General Agreement on Tariffs and Trade Greece (GATT), 216 bailout, 269 General Theory of Employment, Interest, in European Union, 263 and Money, 214 interest rates, 268 Germany greenbacks, 205 European Financial Stability Facility Gresham’s Law, 194 and, 268 gross domestic product (GDP), 55–57. in European monetary system, 258–259 See also real GDP in European Union, 263 gross domestic product (real GDP), 80 hyperinfl ation, 208, 213, 247 Group of Ten, 225 interest rates, 268 growth rate London Gold Pool, 222 demand–supply framework, 78, 80 reparation payments, 213 dollar–euro exchange rate, 84 role of West Germany in establishment output and exchange rates, 55–57 of EEC, 256 GLOBEX, 176 • H • gold exchange standard, 207 gold parity hard pegs gold exchange standard, 207–208 currency board, 197, 234–235 London Gold Pool, 222 defi ned, 232 market price of gold under Bretton dollarization, 197, 233–234 Woods system and, 221–222 overview, 233 in reserve currency system, 247 herding behavior, asset markets, 292 role of BOP in, 200 heterogeneous traders, 289 suspension of, 195 HKMA (Hong Kong Monetary Gold Pool (London Gold Pool), 222 Authority), 235

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 301301 33/26/13/26/13 33:01:01 PMPM 302 International Finance For Dummies

holder, option, 179 demand–supply framework, 78–79 home bias in portfolio puzzle, 286–287 dollar–euro exchange rate, 84 home bias in trade puzzle, 285–286 factor in exchange rate determination, Hong Kong Monetary Authority 14–15 (HKMA), 235 hyperinfl ation, 208, 213, 247 Hungary, 263 nominal interest rates and, 274 hyperinfl ation, 208, 213, 247 relationship between exchange rate and, 58 • I • interbank market, 43 interdependence of macroeconomic IBRD (International Bank for conditions, metallic standard, Reconstruction and Development), 201–202 215–216, 221 interest rate parity (IRP) ICU (International Clearing Union), 215 calculating forward discount and IFE (international Fisher effect) forward premium, 144–145 linking to PPP, 156 covered interest arbitrage, 145–150 overview, 140 defi ned, 15 relating IRP and MBOP, 137 derivation of, 142–144 IMF (International Monetary Fund) empirical evidence on, 152 conditionality, 244–245 factors that interfere with, 153 currency crisis and, 241–246 forward contracts and, 140–141 insuffi cient funds, 221 graphical representation, 150–152 as manager of fi xed exchange rates, International Fisher Effect, 140 219–220 linking to PPP, 156 origins of, 17–18 versus MBOP, 138–139 as part of American plan at Bretton overview, 137–138 Woods Conference, 215–216 shortrun exchange rates and, 289 reason for, 216 uncovered interest arbitrage, 145 role in post–Bretton Woods era, 242–244 interest rates import fi rms demand–supply framework, 81–82 foreign exchange risk, 45 dollar–euro exchange rate, 84 forward contracts and, 168–170 foreign investment, 274 multinational companies, 40 nominal, 14–15, 61–65, 274 import-substitution strategy, economic real, 61–65, 81–82, 84–85, 89, 132 development, 82 spread, 268 independence, ECB, 261 intermediate foreign exchange regimes, Independent Treasury Act of 1840, 204 252–253 indirect interventions, 229, 280. See also internal balance monetary systems; trade restrictions metallic standard, 198–199 infl ation reserve currency system, 217–218, 220 comparing demand-supply model and International Bank for Reconstruction and MBOP approaches to exchange rate Development (IBRD), 215–216, 221 determination, 132–133 International Clearing Union (ICU), 215 defi ned, 58

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 302302 33/26/13/26/13 33:01:01 PMPM Index 303

international Fisher effect (IFE) forward contracts and, 140–141 linking to PPP, 156 graphical representation, 150–152 overview, 140 International Fisher Effect, 140 relating IRP and MBOP, 137 linking to PPP, 156 international investment. See foreign versus MBOP, 138–139 investment overview, 137–138 International Monetary Fund (IMF) shortrun exchange rates and, 289 conditionality, 244–245 uncovered interest arbitrage, 145 currency crisis and, 241–246 irrational (noise) traders, 289 insuffi cient funds, 221 Italy as manager of fi xed exchange rates, European Financial Stability Facility 219–220 and, 268 origins of, 17–18 in European monetary system, 258 as part of American plan at Bretton in European Union, 263 Woods Conference, 215–216 London Gold Pool, 222 reason for, 216 monetary agreement, 206 role in post–Bretton Woods era, 242–244 role in establishment of EEC, 256 international monetary systems. See monetary systems • J • International Stabilization Fund, 215–216. See also IMF Japan international syndicates, 224 current account convertibility, 219 interventions dissatisfaction with Bretton Woods central banks, 275, 280, 282 system, 224 concerted, 275 foreign direct investment, 42 fl oating exchange rates, 229–232 general trend over 40 years, 52 into foreign exchange markets, 43 gold exchange standard, 207 government, 82–83, 85, 88 growth rates in real GDP, 55–56 interwar years, monetary systems, nominal and real effective exchange 207–210 rate index, 53 Ireland pegging exchange rate, 67 in European monetary system, 258 percent change and consumer price in European Union, 263 index, 58 interest rates, 268 T-bill rate, 62–63 IRP (interest rate parity) yen-euro exchange rate, 265 calculating forward discount and joint ventures, 41 forward premium, 144–145 covered interest arbitrage, 145–150 • K • defi ned, 15 derivation of, 142–144 Kellogg, 41 empirical evidence on, 152 Kennedy, John F., 221 factors that interfere with, 153 Keynes, John Maynard, 214–215

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 303303 33/26/13/26/13 33:01:01 PMPM 304 International Finance For Dummies

Keynesian school of economics (short- marking-to-market process run analysis of economics) defi ned, 176 defi ned, 95–96, 214 overview, 177–179 nominal shocks, 120 Marshall Plan (European Recovery Kosovo, 263 Program), 220–221 maturity (expiration) date, options, 179 • L • MBOP (Monetary Approach to Balance of Payment). See also foreign labor mobility, EU, 267 exchange markets Latin Monetary Union, 206–207 basic assumptions, 88–89 Latvia, 263 combined MBOP, 111–114 Law of One Price, 157, 161, 163, 280 comparing demand-supply model and licensing, 40–41 MBOP approaches to exchange rate liquidity preference, 90 determination, 131–133 Lithuania, 259, 263 versus demand–supply framework, 89 London Gold Pool (Gold Pool), 222 versus interest rate parity, 138–139 long-run analysis of economics linking to PPP, 156 (classical–neoclassical school of money market, 90–92 economics) money market equilibrium, 96–98 defi ned, 94 money supply, 93–96 nominal shocks, 120 nominal shocks, applying to, 120–126 long-run effects nominal shocks, effects of, 128–131 Australian contractionary monetary overview, 87–88 policy, 130–131 real shocks, applying to, 115–120 of nominal shock with overshooting, real shocks, effects of, 126–128 123–124 Medicago, 40–41 of nominal shock without overshooting, menu cost, 95 121–123 metallic standard Luxembourg compared to other exchange rate in European monetary system, 258 regimes, 18 in European Union, 263 defl ationary vortex, 210 role in establishment of EEC, 256 external balance, 199–201 interdependence of macroeconomic • M • conditions, 201–202 internal standard, 198–199 Maastricht Treaty of 1992, 256, 259–260, overview, 197–198 270, 277 pure metallic standard, 193 macroeconomics of monetary systems. relationship to exchange rate, 16 See monetary systems role of BOP in, 200 maintenance margin, FX derivatives, 177 stability and, 283 Malta, 263 trilemma, 202–203 managed fl oat, 229 during wars, 212–213 market price, demand–supply Mexico, 42 framework, 73–75

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 304304 33/26/13/26/13 33:01:01 PMPM Index 305

microeconomic approach, exchange rate post–Bretton Woods, 227–232, 241–253 determination, 14 pre–Bretton Woods, 203–210 micro-states, European, 263 pure commodity standard, 192–194 Mill, John Stuart, 257 monetizing the defi cit, 240 Monaco money. See also currency; metallic dollarization, 233 standard use of euro, 263 convertible paper money, 194–195 Monetary Approach to Balance of defi ned, 191–192 Payment (MBOP). See also foreign fi at, 16, 195–197 exchange markets nominal money supply, 93–98 basic assumptions, 88–89 Quantity Theory of Money, 98, 120, 121, combined MBOP, 111–114 123–124 comparing demand-supply model and real money supply, 93–94 MBOP approaches to exchange rate money demand curve, 90–92 determination, 131–133 money market versus demand–supply framework, 89 Australia, 129–131 versus interest rate parity, 138–139 defi ned, 90 linking to PPP, 156 equilibrium, 96–98 money market, 90–92 Euro-zone money market-related money market equilibrium, 96–98 variables, 110–111 money supply, 93–96 explicit money market, 113 nominal shocks, applying to, 120–126 money demand curve, 90–92 nominal shocks, effects of, 128–131 U.S. money market–related overview, 87–88 variables, 109 real shocks, applying to, 115–120 money supply, 93–98 real shocks, effects of, 126–128 Montenegro, 263 monetary interdependence between Monthly Bulletin, ECB, 262 countries, 223–224 moral hazard, IMF and, 244–246 monetary systems multinational fi rms, 40–42 comparing alternatives, 246–253 convertible paper money and gold • N • standard, 194–195 exchange rates in commodity standard national central banks (NCB), 260 system, 196 NEER (nominal effective exchange exchange rates in fi at money rates), 30 system, 197 Netherlands factor in exchange rate determination, in European monetary system, 258 14–15 in European Union, 263 fi at money, 195–196 London Gold Pool, 222 metallic standard, 16, 18, 197–203, 210, role in establishment of EEC, 256 212–213 New Zealand, 209 overview, 191–192 Nixon, Richard, 225

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 305305 33/26/13/26/13 33:01:01 PMPM 306 International Finance For Dummies

noise (irrational) traders, 289 nominal interest rates nominal effective exchange exchange rate and, 61–65 rates (NEER), 30 factor in exchange rate determination, nominal exchange rate (exchange rate). 14–15 See also MBOP infl ation and, 274 absolutes and falsehoods, 20 nominal money supply applying relative price to, 22–23 central bank control of, 93–94 appreciation, 28–30 classical–neoclassical school of appreciation (revaluation), 13 economics (long-run analysis of bid–ask spread, 35–37 economics), 94 calculating cross rates, 34–35 Keynesian school of economics (short- combined MBOP, 113–114 run analysis of economics), 95–96 in commodity standard system, 196 short- and long-run effects of increase defi ned, 12 in, 97–98 depreciation, 28–30 nominal shocks depreciation (devaluation), 13 applying to MBOP, 120–126 determining, 14 effects of, 128–131 determining through demand–supply nontradables, 164–165 framework, 76–78 North Korea, 263 effective, 12, 25–26 Norway, 206 Euro-zone, 19 exchange rate regimes, 66–68 • O • in fi at money system, 197 fl oating (fl exible) exchange rate regime, OCA (optimum currency area) theory, 12–13 19, 256–257 importance of, 13 OECD (Organization of Economic infl ation rates and, 58 Cooperation and Development), 287 interest rates and, 61–65 Onex Corporation, 42 international monetary systems, 18–19 open economy, 202 nominal, 23 optimum currency area (OCA) theory, output and, 55–57 19, 256–257 overview, 21 options pegged exchange rate regime, 12–13 American-type, 180 percent change, calculating, 27–28 call, 179, 181–184 percent change, defi ned, 15 European-type, 179–180 as price of currencies, 22 expiration (maturity) date, 179 as price of domestic currency, 33–34 FX derivatives, 170 as price of foreign currency, 32–33 holder, 179 random walk model, 152 option premium, 180–181 real, 12, 23–25 overview, 168 short-term volatility, 15–16 put, 179, 184–187 type of money and, 16–18 strike (exercise) price, 179 visual approach to, 52–54 writer, 179

226_9781118523896-bindex.indd6_9781118523896-bindex.indd 306306 33/26/13/26/13 33:01:01 PMPM Index 307

Organization of Economic Cooperation rupiah–dollar exchange rate, 58–60, and Development (OECD), 287 64–65 output (real GDP) yen-dollar exchange rate, 56, 58 comparing demand-supply model and perfectly elastic curve, money supply, MBOP approaches to exchange rate 93–94 determination, 133 perfectly inelastic curve, money supply, Eurozone, increase in, 118–120 93–94 exchange rate and, 55–57 peso problem effect, 289–290 growth rate, 80 Pharmaceutical Business Review, 40 U.S., increase in, 116–117 Philip Morris Products (PMP), 40–41 overshooting pips, 180 comparing MBOP with and without, PMP (Philip Morris Products), 40–41 125–126 Poland, 263 defi ned, 120–121 political risk, 153 effect on exchange rate, 281 portfolio investment, 239, 241 short- and long-run effects of nominal Portugal shock, 121–124 in European Union, 263 overvaluation, currency, interest rates, 268 163–164, 236–237 post–Bretton Woods monetary systems. See also unilaterally pegged • P • exchange rates comparing alternative international Paris Treaty of 1951, 256 monetary systems, 246–253 parity, 196. See also gold parity; IRP fl oating (fl exible) exchange rates, parity curve (expected real returns), 227–232 102–105 IMF and currency crisis, 241–246 pegged exchange rate regime. See also PPP (purchasing power parity) unilaterally pegged exchange rates absolute PPP, 157, 161–164 advantages and disadvantages, 252–253 application of, 160 in developing countries, 17–19 Big Mac standard, 161–164 government role in, 12–13, 66–67 defi ned, 15 stability and, 283 derivation of, 158–159 unilateral currency pegs, hard pegs, linking to MBOP, IRP, and IFE, 156 197, 232–235 overview, 155–156 unilateral currency pegs, IMF and, relative PPP, 157–158 242–244 short-term deviations, 290 unilateral currency pegs, overview, 232 pre–Bretton Woods monetary systems unilateral currency pegs, soft pegs, bimetallic era, 204–206 232, 235–241 gold standard of pre-WWI era, 206–207 percent change, exchange rate. See also interwar years, 207–210 IRP; PPP overview, 203–204 calculating, 27–28 predictable excess, exchange rate defi ned, 15 disconnect puzzle, 289

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prediction rules, exchange rate • Q • determination, 14–15 premium, option, 180–181 quantity present value (PV), 141 demand–supply framework, 72–75 price dollar market, 76–77 demand–supply framework, 72–75 Quantity Theory of Money dollar market, 76–77 defi ned, 98, 120 Law of One Price, 157, 161, 163, 280 effects of nominal shock with relative, 22–24, 273 overshooting, 123–124 sticky, 95–96, 281 effects of nominal shock without price factor, metallic standard internal overshooting, 121 balance, 198–199 quota system, IMF, 219, 245–246 price stability. See stability price–specie–fl ow mechanism, • R • 200, 207, 249 Prussian War, 206 random walk model, exchange rates, 152 purchasing power parity (PPP) real exchange rate (RER) absolute PPP, 157, 161–164 defi ned, 12 application of, 160 overview, 23–25 Big Mac standard, 161–164 purchasing power puzzle, 290 defi ned, 15 real GDP (real gross domestic product) derivation of, 158–159 comparing demand-supply model and linking to MBOP, IRP, and IFE, 156 MBOP approaches to exchange rate overview, 155–156 determination, 133 relative PPP, 157–158 Eurozone, increase in, 118–120 short-term deviations, 290 exchange rate and, 55–57 purchasing power puzzle, 290–291 growth rate, 80 pure commodity standard, 192–194 U.S., increase in, 116–117 put options real interest rates defi ned, 179 comparing demand-supply model and exercising, 185–186 MBOP approaches to exchange rate overview, 184–185 determination, 132 selling, 186–187 demand–supply framework, 81–82 puzzles, international fi nance dollar–euro exchange rate, 84–85 consumption correlation puzzle, 288 exchange rate and, 61–65 exchange rate disconnect puzzle, MBOP and, 89 288–290 real money supply, 93–94 explanations related to market real returns, MBOP and, 89 imperfections, 291–292 real shocks Feldstein–Horioka puzzle, 287 applying to MBOP, 115–120 home bias in portfolio puzzle, 286–287 effects on MBOP, 126–128 home bias in trade puzzle, 285–286 recidivism, IMF quota system, 245–246 purchasing power puzzle, 290–291 reconstruction efforts, war-torn PV (present value), 141 countries, 216

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relative PPP percent change and consumer price empirical evidence on, 164–165 index in Indonesia, 58–60 overview, 157–158 percent change and nominal and real relative price discount rates in Indonesia, 64–65 applying to exchange rate, 22–23 percent change and real discount rate barter economy, 22 in Indonesia, 64 defi ned, 273 percent change and real GDP growth nominal exchange rate, 23 rates, 56–57 real exchange rate, 23–24 T-bill rate in Indonesia, 63 reparation payments, Germany, 213 RER (real exchange rate) • S • defi ned, 12 overview, 23–25 San Marino, 263 purchasing power puzzle, 290 Scandinavian Monetary Union, 206–207 reserve currency system (Bretton SDR (Special Drawing Rights), 223 Woods system) seignorage, 234 collapse of, 223–225 selling defi ned, 196 call options, 183–184 deterioration of, 221–223 currency in spot (derivative) markets, dollar shortage and Marshall Plan, 46–47 220–221 put options, 186–187 established at Bretton Woods SGP (Stability and Growth Pact) of 1997, conference, 217–218 260, 270 gold parity in, 247 short-run analysis of economics London Gold Pool, 222 (Keynesian school of economics) overview, 211–212 defi ned, 95–96, 214 Special Drawing Rights, 223 nominal shocks, 120 revaluation (appreciation) short-run effects defi ned, 13 Australian contractionary monetary euro, 264 policy, 130–131 exchange rate, 28–32 of nominal shock with overshooting, risk, foreign exchange 123–124 domestic fi rms, foreign subsidiary of nominal shock without overshooting, setting, 46 121–123 exporting fi rms, 44–45 short-run rigidities (sticky prices), importing fi rms, 45 95–96, 281 speculation, 46–50 short-term liquidity facility (SLF), 245 Romania, 263 short-term volatility, exchange rate, Rome Treaty of 1957, 256 15–16, 281 rupiah–dollar exchange rate SLF (short-term liquidity facility), 245 1970-2011, 54 Slovakia, 263 pegged exchange rate regime, 67–68 Slovenia, 263

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small economy, 202 fl oating exchange rates, 250–251 Smithsonian Agreement, 225 IMF and, 244–246 Smoot–Hawley tariff, 210 metallic standard and, 283 SNB (Swiss National Bank), 229–231 pegged exchange rates and, 283 soft pegs (crawling pegs) Stability and Growth Pact (SGP) of 1997, attracting foreign investors with, 260, 270 238–241 sterilized direct interventions, 230, 282 defi ned, 232 sticky prices (short-run rigidities), general discussion, 235–238 95–96, 281 South Africa, 249 strike (exercise) price, options, 179 sovereign debt crisis surpluses creating European Financial Stability current account, U.S., 221 Facility, 268 trade, American plan for managing, euro and, 268 215–216 intra-Euro-zone relationships, 269–270 trade, British plan for managing, 215 utilizing European Financial Stability Sweden, 206, 263 Facility, 268–269 Swiss National Bank (SNB), 229–231 Soviet Union Switzerland and, 214 London Gold Pool, 222 détente (easing of strained monetary agreement, 206 relations), 224 Syria, 263 gold standard and, 218 Spain, 263 • T • Special Drawing Rights (SDR), 223 specie, defi ned, 204–205 T-bill (Treasury bill) rate, 61–63 speculation, with exchange rates, 46–50 trade restrictions speculative attack, currency, 241 demand–supply framework, 82–83 speculators lessons learned from, 213 defi ned, 170 in response to current account defi cits, foreign exchange markets, 42–43 221–222 spot (derivative) markets trade-weighted index, 25–26 buying and selling currency in, 46–47 transparency, ECB, 262 call options, 182–184 Treasury bill (T-bill) rate, 61–63 covered versus uncovered interest treaties arbitrage, 146–147 Maastricht Treaty of 1992, forward contracts, 171–175 256, 259–260, 270, 277 put options, 184–186 Paris Treaty of 1951, 256 spread, interest rate, 268 Rome Treaty of 1957, 256 stability Treaty on European Union, 260–261 European Central Bank (ECB), 260–261 Treaty on European Union, 260–261 fi xed exchange rates, 247–249 Triffi n’s dilemma, 222

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trilemma détente (easing of strained under fi xed exchange rate regime, relations), 224 202–203 holding gold standard, 209–210 IMF restrictions due to, 219–220 increase in output, 116–117 Turkey London Gold Pool, 222 currency overvaluation, 236–237 money market–related variables, 109 European Recovery Program, 221 proposal at Bretton Woods Conference, 215–216 • U • role in collapse of Bretton Woods system, 223–225 U.K. (United Kingdom). See also Britain unsterilized direct interventions, 230 in European Union, 263 London Gold Pool, 222 • V • uncovered interest arbitrage, 145 undervaluation, currency, 163–164, Vatican City, 263 237–238 volatility unilaterally pegged exchange rates fl oating exchange rates, 228–229, 251 hard pegs, 197, 232–235 FX derivatives, 276, 279 IMF and, 242–244 short-term, 15–16, 281 overview, 232 soft pegs, 232, 235–241 • W • United Kingdom (U.K.). See also Britain in European Union, 263 Washington Post, 41 London Gold Pool, 222 welfare state, 214 United Nations Monetary and Financial West Germany, 256 Conference in Bretton Woods White, Harry Dexter, 214, 215–216 (Bretton Woods Conference) White plan, 215–216 American plan, 215–216 Wilmar International, 41 avoiding past mistakes, 213 World Trade Organization (WTO), 216 British plan, 215 writer, option, 179 ideological views, 214 WTO (World Trade Organization), 216 International Monetary Fund, 17, 219–220 • Y • overview, 212–213 setting reserve currency system, yen-dollar exchange rate 217–218 1970-2011, 52–53 United States general trend over 40 years, 52 bimetallic era monetary system, growth rates in Japan’s real GDP, 55–56 204–205 nominal and real effective exchange Civil War, 204–205 rate index, 53 current account defi cits, 221–222 pegged exchange rate regime, 67 current account surpluses, 221

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yen-dollar exchange rate (continued) yen–euro exchange rate, 265 percent change and consumer price yuan–dollar exchange rate index, 58 pegged exchange rate regime, 68 percent change and real GDP growth percent change, 31–32 rates, 56 Yugoslavia, 247 T-bill rate in Japan, 62–63

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