Naked Economics Notes Chapter 11 and 12

Topics: Foreign exchange market, United States dollar, Exchange rate Pages: 3 (734 words) Published: March 16, 2014
NAKED ECONOMICS Chapters 11 and 12
ERM: Exchange Rate Mechanism
This agreement was designed to manage large fluctuations in the exchange rate between European nations The ERM created targets for the exchange rates among the participating countries Each government was obligated to pursue policies that kept its currency trading on international currency markets within a narrow band around this target Currencies are no different than any other good; the exchange rate, or the “price” of one currency relative to another, is determined by supply relative to demand Two tools for propping up the value of the currency in the face of market pressure pushing it down: The government could use its reserves of other foreign currencies to buy their currency- directly boosting demand for the currency The government could use monetary policy to raise real interest rates which makes the country’s bonds (and the currency necessary to buy them) more attractive to global investors and attracts capital Capital flows across international border for the same reason it flows anywhere else: Investors are looking for the highest levels of return (at any given risk) Individuals, firms, and governments borrow funds from abroad because it is the cheapest way to “rent” capital that is necessary to make important investments or to pay the bills International transactions have a higher level of complexity when compared to domestic trading since different countries have different currencies and have different institutions for managing and creating these currencies When people trade across borders, it must be exchanged at an exchange rate A yen has value because it can be used to purchase things, a dollar has value for the same reason. In theory we ought to be willing to exchange $1 for however many yen would purchase roughly the same amount of stuff in the relevant country. This is the theory of PPP (purchasing power parity)

If one country buys less...
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