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Foreign Exchange Market

The market in which the currencies of different countries are bought and sold.

Exchange Rate Appreciation

increase of value of currency related to the value of another- means that imports are less expensive than exports

Exchange Rate Depreciation

decrease of value of currency in relation to other currency- imports are more expensive than exports

Exchange Rate devaluation

an exchange rate is adjusted by purchasing foreign assets so domestic monetary assets increase and domestic interest rates fall leading to a fall of the rates of return

exchange rate revaluation

occurs when a government changes their pegged exchange rate to give it a higher or lower value in relation to other currencies

Equilibrium exchange rate

the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied

Fixed exchange rate

This occurs when the value of a currency is matched to another currency or other value, such as gold.

Flexible exchange rate

rate determined in foreign exchange markets by the forces fo demand and supply without government intervention

Balance of Payments

a system of recording all of a country's economic transactions with the rest of the world over a period of one year

Current Account

that part of the balance of payments recording a nation's exports and imports of goods and services and transfer payments

Financial Account

shows public and private investment and lending activities; includes direct investments, portfolio investments, and other financial items

Official Reserves

foreign currencies owned by the central bank of a nation

Balance of payments adjustment under a fixed regime

government regime applys capital controls and adjusts the prices within the country and can apply laws against foreign investments to control the int'l money supply

Balance of payments adjustment under a flexible regime

occurs through a change of exchange rates by controlling the amount of currency in the int'l market via buying or selling importing or exporting to deal with imbalances

Balance of payments crisis

occurs when a central bank does not have enough official int'l reserves to maintain a fixed exchange rate, results in capital flight and currency devaluation

Sterilization policy of the central bank


Sterilized intervention

a way for a country to alter its debt composition without affecting its monetary base. It is used to counter undesirable exchange-rate movements

Bimetallic standard

a monetary standard in which the value of the monetary unit can be expressed as a certain amount of gold or as a certain amount of silver; the ratio between the two metals is fixed by law.

Fiat money

money that the government declares to be legal tender although it cannot be converted into standard specie

Fiduciary system

backing of domestic monetary liabilities with gold, under which a fixed amount of those liabilities are not collateralized

Fractional reserve banking

system that keeps only a small proportion of funds on hand and lends out the remainder

Gold Standard

a monetary standard under which the basic unit of currency is defined by a stated quantity of gold; Used by the U.S. until FDR removed it in 1933

Network externalities

the situation where the usefulness of a product increases with the number of consumers who use it

Price specie flow mechanism

(David Hume) the adjustment of prices as gold flows into/out of a county causing an adjustment in the flow of goods

Gold exchange standard

an exchange-rate system in which each nation fixes the value of its currency in terms of gold, but buys and sells the US dollar rather than gold to maintain fixed exchange rates.

Beggar-thy-neighbor devaluation

exchange rate devaluation of one country in which country A compresses its need for imports and thus negatively effects its trading partner B, leaving them worse off.


severe and prolonged inflation that results in the value of money losing its acceptability as a medium of exchange

IMF Conditionality

an agreement to loan IMF funds on the condition that certain government policies are adopted

Gresham's Law

states that bad money drives good money out of circulation

Bretton Woods System

The international monetary system developed after the Second World War in which adjustable pegs were employed, the International Monetary Fund helped stabilize foreign exchange rates, and gold and the dollar were used as international monetary reserves.

Capital Controls

legal restrictions on the ability of a nation's residents to hold and trade assets denominated in foreign currencies

Capital Flight

When residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency, usually taking place when domestic currency is depreciating rapidly or a counry is facing dim economic prospects


difference between the face value of money and the cost of supplying it; the "profit" from issuing money

Currency Convertibility

the ability for a currency to become freely exchangeable for foreign currencies

The Triffin Dilemma

occurs when a national currency also serves as an international reserve currency, there are fundamental conflicts of interest between short-term domestic and long-term international economic objectives.(the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency to fulfill world demand for foreign exchange reserves.)

Special drawing rights

international reserve assets in the International Monetary Fund holding basket of 4 key international currencies that can be readily exchanged and are freely usable

Dollar Glut

accumulation of a country's money out side of that country


Dollar-denominated deposits issued by foreign branches of banks outside the United States. The market in which these exist is less regulated than the domestic market, so the perceived riskiness is greater.

Capital liberalization

a result of globalization and trade liberalization, refers to the relaxation of government restrictions in the market.

Mudell-Fleming Trilemma

says that states can't simultaneously maintain open capital markets, stable exchange rates, and monetary/fiscal autonomy (when states refuse to close capital markets their currencies float and then exchange rates must be stabilized, the need to do this causes a loss in monetary/fiscal autonomy_

Monetary policy autonomy

central banks are able to influence the domestic money supply, interest rates and inflation with no import of inflation/deflation from abroad


characterized by high unemployment and high inflation. Combination of inflation and economic stagnation occuring uncheck for a sig. period.

Intermediate Regimes

characterized by a soft "crawling peg" with a tightly managed exchange rate float

Currency Board

A country's currency authority that holds reserves of foreign currency equal at the fixed exchange rate to at least 100 percent of the domestic currency issued in order to keep inflation down. (all currencies are 100% backed and can only issue enough currency as can be backed by foreign assets)


when a poorer country ties the value of its currency to that of a wealthier country, or when it abandons its currency and adopts the wealthier country's currency as its own

Monetary union

An agreement between many European countries to integrate their monetary systems including using a single currency.

European Economic Community

An economic organization established in 1957 to reduce tariff barriers and promote trade among the countries of Belgium, Luxembourg, the Netherlands, France, Italy, and West Germany. These countries became the original members of the European Community in 1965.

European snake arrangement

Named for the founding countires of the EEC: Belgium, Luxembourg, the Netherlands, France, Italy, and West Germany.

European Monetary Cooperation Fund

established to monitor the European monetary policies and authorize realignments of monetary policies

European Monetary System

a system of pegged but adjustable currencies established by the members of the EC in 1979

Target zone

a zone beyond which an exchange rate is prevented from fluctuating by intervention of authority in the foreign exchange market/policy alteration to maintain fluctuation within the set limits- seen in EU


system used in EU for banking and repayment of loans, not international trade

Single European Act

Adopted by members of the European Community in 1987, this act committed member countries to establish a single market by the end of 1992

Delors Report

1989 Jaques Delors: 1: Removal of capital controls 2: granting independence to central bank and conform domestic laws to treaty of Maastricht 3: monetary unification

European Monetary union

he agreement among the participating member states of the European Union to adopt a single hard currency and monetary system.


the basic currency shared by the countries of the European Union since 1999

European Central Bank

The European Central Bank is the de facto successor of the European Monetary Institute (EMI) The primary objective of the ECB is to maintain price stability within the Eurozone Governing Council defined price stability as inflation at 2%. The key tasks of the ECB are to define and implement the monetary policy for the Eurozone, to conduct foreign exchange operations, to take care of the foreign reserves

Stability and Growth Pact

allows for financial penalties on countries with excessive deficits or debt to preserve fiscal stability

Optimum currency area

an area that is highly economically integrated has free flows of goods and services, free flows of financial and physical capital, and high labor mobility (the EU is not considered this)

Maastricht Treaty

The Maastricht Treaty was signed in 1992 by the twelve members of the European Community and most of the members of the European free Trade Association. The treaty eliminated national barriers to the movement of goods and services. Also known as the Treaty on European Union.

Distributional consequences of exchange rates


Electoral model of exchange rate policy

Voters reward a government that has delivered good economic conditions and punish a government that has delivered poor economic conditions/results

partisan model of exchange rate policy

Phillips curve with trade off b/t unemployment and inflation with left parties appealing to working class and wealth distribution(flexible exchange rates) and right parties appealing to businesses, financial sector and middle class (fixed exchange rates)

sectoral model of exchange rate policy

exchange rate policies are determined by societal grouping e.g: export oriented=fixed, import competing= flexible, non tradable services=flexible and banking/financial services=ambiguous

The Plaza Accord (1985)

agreement by the group of 5 to devalue the USD against the yen and german marc by 10-12% (most recent attempt to control exchange rate fluctuations by group of 5)

The Louvre Accord (1987)

agreement between group of 7 to create target zones +/- 5% around which an exchange rate is allowed to fluctuate

Exchange rate volatility

short term movements in currency appreciation by 1 or 2% in one month and then depreciation by the same percentage the next month

exchange rate misalignment (misaligned currency)

large or persistent gaps between the equilibrium exchange rate and the actual or market determined exchange rate


over borrowing, crisis and adjustment

default on loan

when a borrower fails to repay a on schedule according to loan contract without the agreement of the lender

debt crisis

country lacks sufficient foreign debt exchange to repay sovereign (government) or private sector.

banking crisis

bankruptcies and other problems for private sector banks brought on by loan defaults and lack of capital inflows to repay other debts.

debt-service ratio

the percentage of a country's export earnings that must be devoted to payments of interest and principal on foreign debt. a high _____ means that a large share of the country's total export revenues must be used to make debt repayments.

london club

a private association established and run by the large commercial banks engaged in international lending. (developing countries that want to reschedule their commercial bank debt must work out terms with this entity)

macroeconomic stabilization

correction through various policy programs of macroeconomic imbalances that are producing high/rising inflation. most of these programs involve reduction of government budget deficit and tight monetary policy. (like IMF conditionality)

structural adjustment

development strategy that stresses integration into global markets, privatization, and so on. Supported by the World Bank, IMF, and other major northern financial institutions

the washington consensus

collection of policy reforms advocated by US officials and by IMF and world bank staff as a solution to economic problems faced by developing countries. emphasizes stabilization, structural adjustment, privatization and market liberalization.

diversification of assets

investing in several financial assets (bonds, stocks, bank deposits) with unrelated or independent risks to lower the total risks of loss.

mutual fund

An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.

commercial bank

A profit-seeking organization that receives deposits from individuals and corporations in the form of checking and savings accounts and then uses some of these funds to make loans.

savings and loan association

a thrift institution that is required by law to make a certain percentage of its loans as home mortgages

mutual savings bank

a state-chartered savings bank owned by its depositors and managed by a board of trustees

credit union

nonprofit service cooperative that accepts deposits, makes loans, and provides other financial services

bank based financial system

close relationship between an enterprise and its banks is the key to financing (long term development strategy)

market based financial system

capital markets channel finance to enterprises with emphasis on shareholder dividends in the short term

corporate governance

set of mechanisms governing the relationship between stakeholders of a firm and the management of the firm with banks holding the role of an outside monitor.

central bank

a government monetary authority that issues currency, regulates the supply of credit, holds the reserves of other banks and sells new issues of securities for the government

monetary base

money supply narrowly defined generally comprising cash, bankers deposits with the central bank and short term monetary assets

discount rate

rate charged by Fed when a member bank not meeting reserve requirements pays to borrow from the fed

open market operations

reduction/increase of monetary base by central bank buying or selling government debt from or to banks

reserve ratio

a minimum reserve ratio of assets to liabilities as is required by the Fed

reserve requirements

portion of assets which must remain on hand at a bank

federal funds rate

interest rate banks charge each other for loans

prime rate

best or lowest interest rate commercial banks charge their most credit worthy customers

expansionary vs restrictive monetary policy


inflation targeting

when central bank announces its policy intentions and targets inflation to not fluctuate over 2% in either direction.

time inconsistency

politicians have an incentive to announce low inflation policies and then renege on that promise to promote economic growth and employment after election

independent central bank

solution to time inconsistency of monetary policies by insulating monetary policy from direct control of politicians

asymmetric information

a condition that occurs when borrowers have some information about their opportunities or activities that they do not disclose to lenders, creditors, or insurers.

moral hazard behavior of banks

arises when banks believe the government will bail them out if they suffer large losses on loans. this causes banks to have more incentive to make riskier loans for higher profits but raises likeliness loan defaulting and consequently of banking crisis

deposit insurance

ensures depositors against losses up to $250,000 and prevents bank panics due to a lack of info- but creates moral hazard

lender of last resort

in U.S, the fed may lend to banks facing massive deposit outflows to prevent banking panics/crises

too big to fail

occurs when financial regulators are reluctant to allow big financial institutions to fail and cause losses o its depositors and creditors

prudential supervision

overseeing who operates financial institutions and how they are operated includes chartering of financial institutions, regulator on site, sanctioning in case of non-compliance and crisis management

offshore banking

much riskier form of banking due to lack of asset restrictions and capital requirements/regulation and supervision, no lender of last resort, no deposit insurance

stand by arrangement

IMF procedure adopted 1952 that allows a country to negotiate in advance its access to fund resources up to specific limits without being subject to review of its position at the time of drawing

the baker plan

(1985) designed to resolve the developing country debt crisis through a combination of economic adjustment and additional lending linking access to financial assistance from IMF, world bank and private lenders to the willingness of debtor governments to adopt structural adjustment programs

the brady plan

(1989) designed to bring developing country debt crisis to a close by encouraging commercial banks to negotiate debt reduction agreements with debtor governments. to make the proposal attractive to commercial banks advanced countries and multilateral financial institutions advanced 30 billion to guarantee the bonds granted.

IMF conditionality

an agreement to loan IMF funds on the condition that certain government policies are adopted

the tobin tax

tax on foreign exchange market transactions high enough to discourage short term capital flows but not so high to discourage long term capital flows or international trade. grants countries a degree of microeconomic policy autonomy.

subprime mortgage

mortgages from borrowers who do not qualify for market interest rates because of income level, credit history, size of down payment, and employment prospects

Paris Club

an informal group composed of 19 permanent members all of which are governments that hold large claims on other governments. its primary role is to negotiate the rescheduling of debts.

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