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Questions and Answers
What is the nominal exchange rate, and how does it differ from the real exchange rate?
What is the nominal exchange rate, and how does it differ from the real exchange rate?
The nominal exchange rate is the actual market exchange rate, whereas the real exchange rate is the nominal exchange rate adjusted for inflation differences between countries.
How do higher interest rates in a country affect the value of its currency?
How do higher interest rates in a country affect the value of its currency?
Higher interest rates in a country can attract foreign investment, increasing demand for the currency and appreciating its value.
What is the main difference between a fixed exchange rate system and a floating exchange rate system?
What is the main difference between a fixed exchange rate system and a floating exchange rate system?
In a fixed exchange rate system, the government fixes the exchange rate, whereas in a floating exchange rate system, the exchange rate is determined by market forces.
What is the balance of payments, and what are its main components?
What is the balance of payments, and what are its main components?
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What is the relationship between the current account balance and the capital and financial account balance?
What is the relationship between the current account balance and the capital and financial account balance?
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What is foreign direct investment, and how is it recorded in the balance of payments?
What is foreign direct investment, and how is it recorded in the balance of payments?
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What is the effect of higher inflation in a country on its exchange rate?
What is the effect of higher inflation in a country on its exchange rate?
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What determines the exchange rate of a currency in a floating exchange rate system?
What determines the exchange rate of a currency in a floating exchange rate system?
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A fixed exchange rate system is one where the value of the currency is determined by the government.
A fixed exchange rate system is one where the value of the currency is determined by the government.
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Foreign direct investment is a type of portfolio investment.
Foreign direct investment is a type of portfolio investment.
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The balance of payments is a record of a country's international transactions over a specific period of time.
The balance of payments is a record of a country's international transactions over a specific period of time.
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Higher inflation in a country will lead to an appreciation of its currency.
Higher inflation in a country will lead to an appreciation of its currency.
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The current account and capital and financial account balances must add up to zero.
The current account and capital and financial account balances must add up to zero.
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Study Notes
Exchange Rate
- Definition: The price of one country's currency in terms of another country's currency.
-
Types:
- Nominal Exchange Rate: The actual market exchange rate.
- Real Exchange Rate: The nominal exchange rate adjusted for inflation differences between countries.
-
Exchange Rate Determination:
- Supply and Demand: The intersection of the supply and demand curves for a currency determines its exchange rate.
- Interest Rates: Higher interest rates in a country can attract foreign investment, increasing demand for the currency and appreciating its value.
- Inflation: Higher inflation in a country can decrease the value of its currency.
-
Exchange Rate Systems:
- Fixed Exchange Rate System: The government fixes the exchange rate, often pegging it to a strong currency.
- Floating Exchange Rate System: The exchange rate is determined by market forces.
Balance of Payments
- Definition: A record of a country's international transactions, including trade in goods and services, income, and financial claims.
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Components:
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Current Account:
- Trade in Goods: Exports and imports of goods.
- Trade in Services: Exports and imports of services.
- Income: Income earned by residents abroad and income paid to non-residents.
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Capital and Financial Account:
- Foreign Direct Investment: Investment in businesses and real estate abroad.
- Portfolio Investment: Investment in foreign stocks and bonds.
- Reserve Assets: Changes in a country's official reserves.
-
Current Account:
-
Balance of Payments Identity:
- Current Account Balance + Capital and Financial Account Balance = 0
- A surplus in the current account is offset by a deficit in the capital and financial account, and vice versa.
Exchange Rate
- Definition: Price of one country's currency in terms of another country's currency.
- Types:
- Nominal Exchange Rate: Actual market exchange rate.
- Real Exchange Rate: Nominal exchange rate adjusted for inflation differences between countries.
Exchange Rate Determination
- Supply and Demand: Intersection of supply and demand curves determines exchange rate.
- Interest Rates: Higher interest rates attract foreign investment, increasing demand and appreciating currency value.
- Inflation: Higher inflation decreases currency value.
Exchange Rate Systems
- Fixed Exchange Rate System: Government fixes exchange rate, often pegging to a strong currency.
- Floating Exchange Rate System: Exchange rate determined by market forces.
Balance of Payments
- Definition: Record of a country's international transactions, including trade in goods and services, income, and financial claims.
Components of Balance of Payments
- Current Account:
- Trade in Goods: Exports and imports of goods.
- Trade in Services: Exports and imports of services.
- Income: Income earned by residents abroad and income paid to non-residents.
- Capital and Financial Account:
- Foreign Direct Investment: Investment in businesses and real estate abroad.
- Portfolio Investment: Investment in foreign stocks and bonds.
- Reserve Assets: Changes in a country's official reserves.
Balance of Payments Identity
- Current Account Balance + Capital and Financial Account Balance = 0
- A surplus in the current account is offset by a deficit in the capital and financial account, and vice versa.
Exchange Rate
- Definition: Price of one country's currency in terms of another country's currency.
-
Two main types:
- Nominal Exchange Rate: Actual market exchange rate.
- Real Exchange Rate: Nominal exchange rate adjusted for inflation differences between countries.
-
Determinants:
- Supply and Demand: Intersection of supply and demand curves determines exchange rate.
- Interest Rates: Higher interest rates attract foreign investment, increasing demand and appreciating currency value.
- Inflation: Higher inflation decreases currency value.
-
Exchange Rate Systems:
- Fixed Exchange Rate System: Government fixes exchange rate, often pegging to a strong currency.
- Floating Exchange Rate System: Exchange rate determined by market forces.
Balance of Payments
- Definition: Record of a country's international transactions, including trade, income, and financial claims.
-
Components:
-
Current Account:
- Trade in Goods: Exports and imports of goods.
- Trade in Services: Exports and imports of services.
- Income: Income earned by residents abroad and income paid to non-residents.
-
Capital and Financial Account:
- Foreign Direct Investment: Investment in businesses and real estate abroad.
- Portfolio Investment: Investment in foreign stocks and bonds.
- Reserve Assets: Changes in a country's official reserves.
-
Current Account:
-
Balance of Payments Identity:
- Current Account Balance + Capital and Financial Account Balance = 0
- Surplus in Current Account is offset by deficit in Capital and Financial Account, and vice versa.
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Description
Test your knowledge about exchange rates, including types and determination, such as nominal and real exchange rates, and how supply and demand, and interest rates affect exchange rates.
