Currency Exchange and IMF Classification System

• There isn't a single governing body for global currency exchange.
• The IMF has established a classification system for currency regimes.
• The IMF helps countries with their money and economy.
• An exchange rate is the price of one country's money compared to another.
• A currency regime refers to a country's rules regarding how its money value changes.
• The IMF analyzes how countries manage money to decide for itself instead of directly asking them.
• De facto describes how countries' money really behaves, based on IMF observation.
• De jure is what a government claims its money rules are.

IMF De Facto System

• Category 1: Hard pegs
• Category 2: Soft pegs
• Category 3: Floating arrangements
• Category 4: Residual

Hard Pegs

• Some countries relinquish control of their money to maintain stability.
• Some use another country's currency.
• A currency board only prints money equal to foreign reserves.
• Currency boards prevent inflation and keep prices stable.
• They can result in a loss of control over money policies.

Soft Pegs

• Soft pegs are fixed exchange rates.
• Subcategories differ based on what the currency is fixed to, whether the fix can change, the types and frequency of intervention allowed, and the degree of variance around the fixed rate.

Floating Arrangements

• The market determines currency value.
• Can be fully free or have some government control if needed.

Residual

• Applies to currencies that don't fit in other categories.
• Countries in this category change their money policies often.

Global Eclectic

• The world's monetary system uses a mix of currency rules.
• There is not a "one size fits all" approach.

Fixed vs. Flexible Exchange Rates

• A nation's choice reflects and can be changed based on priorities like inflation, unemployment, interest rates, trade balances, and economic growth.

Fixed Exchange Rates

• Allow for stability in international prices for trade.
• Help control inflation but require strict money policies, such as limited government spending and borrowing.
• Central banks must hold gold or strong foreign currencies to keep the exchange rate stable.
• Can become unstable if the fixed rate doesn't match the economic reality.

The Impossible Trinity

• Exchange rate stability maintains a steady currency value.
• Monetary independence means a country controls its own interest rates and money supply.
• Free capital flow allows money to move easily in and out of the country.

Free Floating Exchange Rate

• Changes are based on what people are willing to pay for it.
• A currency board ties a country's money to another country's money, making it easily changeable.
• Dollarization involves a country using another country's money instead of its own.

Single Currency for Europe: The Euro

• A convergence criteria was laid out to prepare for the EMU.
• Each member country was responsible for managing nominal inflation rates, long-term interest rates, fiscal deficits, and government debt to a specific level.

Benefits of the Euro

• Cheaper transaction costs in the eurozone
• Reduced currency risks and costs related to uncertainty
• Price transparency and increased price-based competition for consumers and businesses in and outside the eurozone

Currency Boards

• Exists when a country's central bank backs its money supply entirely with foreign reserves.
• A unit of domestic currency cannot be introduced without first obtaining an additional unit of foreign exchange reserves.

Dollarization

• Disadvantages of dollarization include loss of sovereignty over monetary policy, the ability to profit from printing money, and the central bank's ability to act as a lender of last resort.

Balance of Payments

• A record that tracks money coming in and out of a country from trade, investments, and loans.
• Components include GDP (how much a country produced), employment (how many people got jobs), exchange rates (how much a country's money compares to others), and interest rates (how much it costs to borrow money).
• For multinational enterprises (MNE), balance of payments data from both the home and host countries is important.
• Indicators include foreign exchange pressure, which indicates potential troubles with a country's money value, payment controls, which show limits on paying dividends, and market potential.

BOP Accounting

• Credit is recorded when exporting.
• Debit is recorded when importing.
• Current transactions involve cash flows completed within one year, such as for import or export of goods and services.
• Capital and financial transactions involve financial accounts.

Balance of Payment Accounting

• Current, capital, and financial account entries are recorded independently.
• Discrepancies will exist between debits and credits.
• The balance sheet shows a snapshot of a country's assets and liabilities.
• The BOP tracks money flow in and out over time.

Two Economic Activity

• Current transactions are completed within one year, involving export and import of goods.
• Capital and financial transactions involve investors acquiring a foreign asset, such as a company or portfolio investment.
• The BOP has three major sub-accounts: the current account, the capital account, and the financial account.

Current Account Components

• Goods trades (export and import of goods).
• Services trades (export and import of services).
• Income (money earned from past investments or wages paid to foreign workers).
• Current transfers (one-way payments like gifts or aid from one country to another).

Capital and Financial Accounts

• They measure all international economic transactions of financial assets.
• They are made of transfers of financial assets.

Financial account

• Direct investment involves money flowing in and out of a country for control of assets (owning at least 10% of a company).
• Portfolio investment involves money flowing in and out of a country for investment in assets without controlling them (owning less than 10%).
• In a fixed exchange rate system, the government ensures the balance of payments is close to zero.
• If the current and capital accounts don't balance, the government intervenes.
• The government will either buy or sell foreign money to fix the imbalance and maintain a stable exchange rate.
• A company's interest rates compared to other countries affect its financial account balance.
• Low interest rates may cause investors to move money to countries with higher rates, causing capital outflow.

Raising Interest Rates

• Attracts capital (money) from other countries, increasing demand for its currency and helping balance the current account deficit.
• Higher interest rates can make borrowing more expensive for businesses, hurting the local economy.

The U.S. Case

• Despite low interest rates and a current account deficit, the U.S. attracts investment due to its strong economy, growth, and political stability.
• This has allowed the U.S. to maintain low interest rates and manage its large fiscal deficit.
• Financial inflows are slowing down, and the current account deficit is worsening.

Balance of Payments and Inflation

• Imports can lower inflation by bringing in cheaper goods, which limits what local companies can charge. If cheaper imports replace local goods, it can lower the Gross Domestic Product (GDP) and hurt employment in the country.

Foreign Exchange Market (Forex)

• Where money is traded between different countries.

• It determines how much one country's money is worth compared to another and where the trades happen.

• A foreign exchange involves a buyer and seller agreeing to exchange a set amount of one country's money for another at a specific price.

• Foreign exchange is the money of a foreign country, including currency bank balances, banknotes, checks, and drafts.

• Transferring purchasing power involves moving money from one country to another, often by importers, exporters, investors, and tourists.

• Financing goods in transit involves money paying for goods being shipped between countries.

• Hedging protects against currency changes, used by importers, exporters, and creditors/debtors.

• A global trading day means the foreign exchange market spans the globe, with currencies trading somewhere every hour.

• Market participants include liquidity seekers and profit seekers.

• Foreign exchange dealers are mainly banks that buy and sell foreign money in large amounts and resell it to customers for a small profit.

Foreign Exchange Brokers

• Middlemen who connect dealers, keep their identities secret until after the deal, and quickly compare prices to find the best deal.
• Importers and exporters: businesses that buy and sell goods across countries.
• Direct foreign investment companies: companies that invest directly in businesses in other countries.
• Securities investors: people buying or selling stocks or bonds in foreign markets.
• A spot transaction is completed within the next business day for banks.
• An outright forward transaction exchanges currencies at a set date in the future, with the exchange rate locked in today.
• Spot against forward: A dealer buys a currency in the spot market and simultaneously sells the same amount back to the same bank in forward market.
• A swap is when two people buy and sell the same amount of money, but for different dates.
• Spot against forward involves a mix of buying now and later.
• Forward-forward swaps involve buying and selling at two future dates.
• Nondeliverable forwards (NDFs) involve agreeing to a deal without exchanging foreign money; the difference is paid in U.S. dollars instead.
• Currency composition refers to which types of money are used in trades around the world.
• The U.S. dollar has become more common in global trades.
• The Japanese yen and European euro have become less common.
• The Chinese renminbi (money from China) is still small but increasing quickly.

Forward Quotations

• Spot rates show the current exchange rate with all digits listed.
• Forward rates are often shown in points or pips (small changes in exchange rates).
• Types of Forward Rates: Cash Rates (for deals lasting a year or less), Swap Rates (for deals lasting more than a year).

Law of One Price

• The same product or services should have the same price in both markets.
• Even with different currencies, prices should be the same when converted.
• Limited due to transportation costs, taxes, trade restrictions, and currency differences.

International Parity Conditions

• Economic theories that link exchange rates, price levels, and interest rates.
• They form the core of the financial theory that is unique to international finance.
• Purchasing power parity and the law of one price: Comparing prices of goods in different places can help to understand their relationship.

Absolute Purchasing Power Parity

• The exchange rate between two currencies is based on how much similar goods cost in each country.

The Big Mac Index

• Compares the prices of Big Macs in different countries to see if a currency is overvalued or undervalued.
• It measures PPP between currencies, offering a simple way to check if the law of one price applies.

International Parity Conditions

• Products should be identical in every market.
• Product prices should mainly come from local materials and costs, not imports that depend on exchange rates.
• The index has limitations, as Big Macs cannot be traded across borders.

Relative PPP

• If prices rise faster in one country, its money will become weaker; the exchange rate adjusts to match inflation differences.
• Empirical tests of PPP show it works well long-term.
• It performs better in countries with high inflation and less developed financial markets.

Exchange Rate Indices

• They compare the value of one country's money to others.
• Index Example: A nominal effective exchange index measures currency value changes over time.

Exchange Rate Pass Through

• Measures how much imported and exported goods' prices change when the exchange rate changes.
• Complete pass-through: price change matches exactly with the exchange rate change.
• Partial pass-through: price change is only part of the exchange rate change.
• Emerging markets used to control currency, now allow more capital flow, increasing their importance as it affects prices.

International Fisher Effect

• If one country has a higher interest rate, the exchange rate will change in the opposite direction.
• Real return on investments should be the same in different countries.

Interest Rate Parity

• The difference in interest rates between two countries should match the difference in their forward exchange rates, adjusting for transaction cost

Covered Interest Arbitrage

• When investors profit by using the interest rate differences between currencies while avoiding exchange rate risk.

Arbitrate Rule of Thumb

• Invest in the currency with higher interest rates, if the interest rate difference is bigger than the forward premium.
• Invest in the currency with lower interest rates, if the interest rate difference is smaller than the forward premium.

Uncovered Interest Arbitrage

• Investors borrow money in countries with low interest rates, and they convert it into currencies with higher interest rates.
• It's uncovered because the exchange rate isn't locked in, so they risk it changing when they convert back later

Equilibrium Between Interest Rates and Exchange Rates

• Normally, interest rates and exchange rates should balance out, but disqualification imbalances can happen due to transaction costs or political risk.
• The forward rate is considered an "unbiased predictor'' of the future spot rate.

Forward Rate as an Unbiased Predictor

• An average, the forward rate will sometimes overestimate and sometimes underestimate the future rate, but both will happen equally often.
• All important information is quickly reflected in both the spot and forward exchange markets.
• Transaction costs (like fees) are low.
• Financial instruments in different currencies are perfect substitutes for each other.

Explore the role of the IMF in classifying currency regimes. Understand the difference between de facto and de jure systems. Learn about hard pegs, currency boards, and their impact on stability and inflation.