Chapter 29 – Exchange Rates and International Capital Flows
Most countries have their own currencies, and international transactions require converting one currency into another. The foreign exchange market — trading $6.6 trillion per day — is the largest market in the world. This chapter examines how exchange rates are determined, what causes them to shift, and the policy trade-offs governments face when managing their currencies.
Table of Contents
1. How the Foreign Exchange Market Works
1.1 The Foreign Exchange Market
The foreign exchange market is where people and firms use one currency to purchase another currency. Exchange rates are prices — the price of one currency expressed in units of another — and are determined by supply and demand.
Scale: A 2019 Bank of International Settlements survey found that $5.3 trillion per day was traded in foreign exchange markets — dwarfing the entire annual U.S. GDP of $21.4 trillion. Most transactions involve portfolio investment (short-term capital flows) and interbank dealer activity, not tourism or trade.
| Currency | % Daily Share (Sep 2019) |
|---|---|
| U.S. dollar | 88.3% |
| Euro | 32.3% |
| Japanese yen | 16.8% |
| British pound | 12.8% |
| Australian dollar | 6.8% |
| Canadian dollar | 5.0% |
| Swiss franc | 5.0% |
| Chinese yuan | 4.3% |
Note: Shares total more than 100% because each transaction involves two currencies.
Dollarization: Some countries use another nation’s currency. Ecuador, El Salvador, and Panama use the U.S. dollar. Seventeen European nations replaced their currencies with the euro starting in 1999.
1.2 Four Groups of Market Participants
| Group | Role | Example |
|---|---|---|
| International trade firms | Earn foreign currency from exports, need home currency for costs | Chinese exporter earns dollars, needs yuan |
| Tourists | Supply home currency, demand destination currency | American tourist in China supplies dollars, demands yuan |
| Foreign Direct Investment (FDI) | Buy ≥10% of a foreign firm or start an enterprise; long-term, involves management | InBev (Belgium) buying Anheuser-Busch for $52 billion |
| Portfolio investment | Purely financial (<10% ownership); short-term, no management role | U.S. investor buying UK government bonds |
- Foreign Direct Investment (FDI): Purchasing at least 10% of a firm in another country or starting a new enterprise abroad. Involves management responsibility and is long-term.
- Portfolio investment: A purely financial investment in another country with no management role. Can be withdrawn quickly with a phone call or click.
1.3 Hedging
Hedging means using a financial transaction to protect yourself against currency risk. A U.S. firm expecting €1 million in a year can sign a contract locking in today’s exchange rate — eliminating uncertainty about what the euros will be worth in dollars. The firm pays a fee but is protected if the euro weakens.
1.4 The Interbank Market
About 2,000 firms are foreign exchange dealers worldwide. In the U.S., fewer than 100 dealers operate, but the largest 12 handle more than half of all transactions. There is no central physical location — dealers monitor each other electronically at all times.
1.5 Appreciating vs. Depreciating
- Appreciating / strengthening: A currency rises in value, exchanging for more of other currencies
- Depreciating / weakening: A currency falls in value, exchanging for less of other currencies
- These are mirror images: if Currency A appreciates against Currency B, then B must depreciate against A
1.6 Who Benefits from a Stronger vs. Weaker Currency?
| Actor | Stronger Home Currency | Weaker Home Currency |
|---|---|---|
| Domestic exporters | ❌ Hurt — foreign revenue converts to fewer home dollars | ✅ Benefit — exports become cheaper abroad |
| Foreign exporters (importers) | ✅ Benefit — their earnings buy more home currency | ❌ Hurt — imports become more expensive |
| Domestic tourists abroad | ✅ Benefit — their money goes further overseas | ❌ Hurt — travel costs more |
| Foreign tourists visiting | ❌ Hurt — their currency buys less | ✅ Benefit — the trip is cheaper |
| Domestic investors abroad | ❌ Hurt — foreign returns convert to fewer home dollars | ✅ Benefit — foreign returns buy more |
| Foreign investors in home economy | ✅ Benefit — returns convert to more foreign currency | ❌ Hurt — returns buy less |
Common misconception: A “stronger” currency is NOT necessarily better. It helps importers and tourists going abroad but hurts exporters and the tourism industry at home. The effect depends on who you are.
2. Demand and Supply Shifts in Foreign Exchange Markets
Exchange rates are prices — they shift when demand or supply for a currency changes. Three main factors drive these shifts:
2.1 Expectations About Future Exchange Rates
If investors expect a currency to appreciate, they:
- Buy it now (demand shifts right)
- Hold it rather than sell (supply shifts left)
- Both shifts cause immediate appreciation — expectations become self-fulfilling
Self-reinforcing cycles: A currency’s appreciation leads other investors to expect further appreciation → even more buying → further appreciation. The same works in reverse with depreciation. This is why exchange rates can move dramatically in short periods.
Unusual feature of forex markets: Unlike most markets where supply and demand move independently, in the foreign exchange market supply and demand typically both move at the same time in response to news. Both shifts push the exchange rate in the same direction, but have opposing effects on quantity traded.
2.2 Differences in Rates of Return
Higher interest rates or returns in a country → more foreign investment → increased demand for that currency → appreciation.
Example: If U.S. interest rates rise relative to Mexico, investors demand more dollars (to buy U.S. bonds) and supply fewer dollars (preferring to hold them). The dollar appreciates from 10 pesos/dollar to, say, 9 pesos/dollar. Since a central bank controls interest rates via monetary policy, it can indirectly influence exchange rates.
2.3 Relative Inflation
Higher inflation in a country → currency’s purchasing power erodes → investors and traders flee the currency → depreciation.
Mexico 1986–87: Inflation exceeded 200%. The peso’s exchange rate plummeted from $2.50/peso to $0.50/peso as demand for pesos collapsed and supply surged.
2.4 Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is the exchange rate that equalizes the prices of internationally traded goods across countries. Over the long run, exchange rates tend to gravitate toward PPP, enforced by arbitrage — buying goods where they’re cheap and selling where they’re expensive.
The PPP exchange rate and the real exchange rate are captured by these key formulas:
\[e_{PPP} = \frac{P_{domestic}}{P_{foreign}}\] \[RER = e \times \frac{P_{foreign}}{P_{domestic}}\]Where:
- $e_{PPP}$ = PPP-implied exchange rate (domestic currency per unit of foreign currency)
- $e$ = nominal (market) exchange rate
- $RER$ = real exchange rate (measures competitiveness)
- $P_{domestic}$, $P_{foreign}$ = price levels in each country
Worked Example — Real Exchange Rate:
A Big Mac costs $5.58 in the U.S. and ¥450 in Japan. The market exchange rate is ¥140/$.
PPP exchange rate: $e_{PPP} = \frac{450}{5.58} = 80.6$ ¥/$
Real exchange rate: $RER = 140 \times \frac{5.58}{450} = 140 \times 0.0124 = 1.74$
Interpretation:
- The market rate (¥140/$) is much higher than the PPP rate (¥80.6/$), suggesting the yen is undervalued (or the dollar is overvalued) by $\frac{140 - 80.6}{80.6} \times 100 = 73.7\%$.
- $RER > 1$ means U.S. goods are relatively expensive — the U.S. is less competitive at this exchange rate.
- Over time, the market rate should move toward PPP — the dollar should depreciate against the yen.
Arbitrage is the process of buying and selling goods or currencies across international borders at a profit due to price differences. Over time, arbitrage forces prices (and exchange rates) to converge.
Two functions of PPP:
- International comparisons: Economists use PPP exchange rates to compare GDP across countries, because market exchange rates fluctuate too much for reliable year-to-year comparisons
- Long-run anchor: While exchange rates deviate from PPP in the short and medium run, they tend to converge toward PPP over many years
2.5 Summary: Time Horizons
| Time Frame | Primary Driver |
|---|---|
| Extreme short run (minutes to weeks) | Speculation and expectations |
| Short run (months) | Differences in rates of return (interest rates) |
| Medium run (months to years) | Relative inflation rates |
| Long run (many years) | Purchasing power parity |
3. Macroeconomic Effects of Exchange Rates
Central banks care about exchange rates for three reasons:
3.1 Exchange Rates and Aggregate Demand
- Weaker home currency → exports cheaper, imports more expensive → net exports ↑ → AD shifts right
- Stronger home currency → exports more expensive, imports cheaper → net exports ↓ → AD shifts left
Euro/Dollar example: A French firm with €10M in costs sells products in the U.S. for $10M.
- At $1.06/€ (1999): converts $10M → €9.4M → loss
- At $1.37/€ (2013): converts $10M → €7.3M → even larger loss
- A strong euro discourages eurozone exports; a weak dollar encourages U.S. exports
3.2 Exchange Rates and the Banking System
The most destructive effect: In many developing countries, banks borrow in foreign currencies (e.g., U.S. dollars) but lend in the domestic currency. If the domestic currency suddenly depreciates, banks cannot repay their foreign-currency debts — even if domestic borrowers repay on time.
Thailand example: A bank borrows $1M and converts at 40 baht/dollar → lends 40M baht. The borrower repays 40M baht. But if the baht weakens to 50 baht/dollar, the bank now needs 50M baht to repay its dollar loan — a 10M baht shortfall.
Real-world crises:
- 1997–98 Asian Financial Crisis: Thailand, Korea, Malaysia, Indonesia saw currencies depreciate 50%+, banking systems collapsed
- 2002 Argentina: Peso depreciation bankrupted banks that had borrowed in dollars
3.3 Policy Tension
Every nation wants stable exchange rates for international trade, but may also want:
- A weaker currency to stimulate exports and AD during recession
- A stronger currency to fight inflation
These goals can conflict, and rapid movements in either direction create risks.
4. Exchange Rate Policies
Exchange rate policies form a spectrum from most flexible to most rigid:
Floating → Soft Peg → Hard Peg → Merged Currency
4.1 Floating Exchange Rate
A floating exchange rate lets the foreign exchange market determine the currency’s value. About 40% of countries use this approach, including the United States.
Advantages:
- Monetary policy stays free to target inflation and unemployment
- Exchange rate adjusts naturally to economic fundamentals
- No need to hold foreign exchange reserves
Disadvantages:
- Exchange rates can swing 30%+ over a few years (e.g., yen/dollar)
- Creates uncertainty for exporters, importers, and banks
4.2 Soft Peg
A soft peg allows the market to set the exchange rate most of the time, but the central bank intervenes when rapid movements occur. About one-third of countries used this approach in the mid-2000s.
Two intervention methods:
- Monetary policy: Lower interest rates to weaken currency; raise rates to strengthen it
- Direct market intervention: Create domestic currency and buy foreign currencies (to weaken), or sell foreign reserves and buy domestic currency (to strengthen)
Risk: Dealers trade on rumors of when/how the government will intervene, potentially increasing volatility instead of reducing it.
4.3 Hard Peg
A hard peg sets a fixed, unchanging exchange rate. The central bank commits to maintaining this rate at all times. About one-quarter of countries used this approach in the mid-2000s.
Trade-off: Eliminates exchange rate fluctuations but surrenders domestic monetary policy entirely — the central bank cannot fight recessions or inflation independently because it must keep rates aligned with the peg.
4.4 Merged Currency
A merged currency (or dollarization) occurs when a nation adopts another country’s currency or shares a currency. Ecuador uses the U.S. dollar; 17+ European nations use the euro.
Trade-off: Eliminates exchange rate risk entirely but a nation gives up monetary policy completely. When Ecuador uses the dollar, it has no voice in Fed decisions. When Portugal uses the euro, ECB policy may not suit Portugal’s specific needs.
4.5 Summary of Policy Trade-offs
| Feature | Floating | Soft Peg | Hard Peg | Merged |
|---|---|---|---|---|
| Short-run exchange rate fluctuations | Often considerable | Maybe less | None | None |
| Long-run fluctuations | Can happen | Can happen | Cannot (unless peg changes) | Cannot |
| Monetary policy independence | Full | Partial (conflicts possible) | Very little | None |
| Need for foreign reserves | None | Moderate | Large | None |
| Risk of trade imbalance | Adjusts often | Adjusts over medium term | May diverge far from market | Cannot adjust |
4.6 Tobin Taxes
Tobin taxes (named after Nobel laureate James Tobin, 1972) are taxes on international capital flows designed to reduce short-term speculation and exchange rate volatility. Countries like Chile and Malaysia have experimented with them.
Practical problem: If one country imposes a Tobin tax, transactions simply move offshore (e.g., Grand Cayman Islands). In a globalized economy where goods flow across borders, payments must follow — it’s nearly impossible to allow trade while blocking capital flows.
5. Key Takeaways
- The foreign exchange market is the world’s largest market ($6.6 trillion/day), dominated by portfolio investment and dealer activity
- Four groups demand/supply currencies: international traders, tourists, FDI investors, and portfolio investors
- A currency appreciates (strengthens) when it buys more of other currencies; depreciates (weakens) when it buys less
- A stronger currency is not inherently better — it helps importers/tourists abroad but hurts exporters/tourism industry
- Exchange rate shifts are driven by expectations (short run), interest rate differentials (short-medium), relative inflation (medium), and PPP (long run)
- Arbitrage pushes prices and exchange rates toward equality across borders over time
- Exchange rate movements affect aggregate demand through the trade balance and can destabilize banking systems when banks borrow in foreign currencies
- Policy options range from floating rates (full monetary independence, volatile exchange rates) to merged currencies (zero volatility, zero monetary independence)
- Soft pegs try to balance flexibility and stability but may increase volatility through speculation about government intervention
- There is no consensus on which exchange rate policy is best — the choice depends on the nation’s economic goals and institutional capacity
6. Practice Questions
Q1. A U.S. dollar currently trades for 110 Japanese yen. If the exchange rate changes to 100 yen per dollar, has the dollar appreciated or depreciated? Who benefits and who is hurt?
Answer
The dollar has **depreciated** (weakened) — it now buys fewer yen (100 instead of 110). Equivalently, the yen has **appreciated** (strengthened). **Beneficiaries:** U.S. exporters (their products are cheaper in Japan), Japanese tourists visiting the U.S. **Hurt:** U.S. tourists in Japan (everything costs more in dollar terms), U.S. importers of Japanese goods (prices rise), Japanese exporters to the U.S.Q2. Explain the difference between foreign direct investment and portfolio investment. Why does this distinction matter for exchange rate stability?
Answer
**FDI** involves buying ≥10% of a foreign firm or starting an enterprise abroad; it's long-term and involves management responsibility. **Portfolio investment** is purely financial (<10% ownership), short-term, and can be withdrawn with a mouse click. This matters because portfolio investment can flow in and out of a country rapidly, causing large exchange rate swings. FDI is "sticky" — selling a factory takes months — so it doesn't contribute to sudden capital flight the way portfolio investment does.Q3. If interest rates rise in the U.S. relative to Mexico, what happens to the peso/dollar exchange rate? Trace through the demand and supply shifts.
Answer
Higher U.S. returns attract foreign investment. **Demand for dollars shifts right** (investors want dollars to buy U.S. bonds). **Supply of dollars shifts left** (U.S. investors keep money at home rather than investing in Mexico). Both shifts cause the dollar to **appreciate** (the peso depreciates). For example, the rate might move from 10 pesos/dollar to 9 pesos/dollar — each dollar buys fewer pesos, but this means each peso is worth more dollars... wait, no: 9 pesos/dollar means each dollar buys *fewer* pesos. Actually, dollar strengthening means the price of a dollar *rises* in pesos, so it would move from 10 to, say, 12 pesos/dollar.Q4. A car costs $20,000 in the U.S. and C$28,000 in Canada. The exchange rate is $1 = C$1.30. Is arbitrage possible? In which direction?
Answer
At $1 = C$1.30, the U.S. car costs $20,000 × 1.30 = **C$26,000** in Canadian dollar terms. Since the same car costs C$28,000 in Canada, an arbitrageur could **buy in the U.S. for C$26,000 equivalent and sell in Canada for C$28,000**, pocketing C$2,000 (minus transaction costs). This arbitrage activity would increase demand for U.S. dollars (to buy U.S. cars), pushing the exchange rate toward purchasing power parity where the prices equalize.Q5. During the 1997–98 Asian Financial Crisis, the Thai baht depreciated from 25 baht/dollar to 50 baht/dollar. A Thai bank had borrowed $10 million and lent 250 million baht domestically. Even if all domestic loans are repaid in full, what happens to the bank?
Answer
The bank receives 250 million baht from its domestic borrowers. At the new exchange rate of 50 baht/dollar, it needs 50 × $10M = **500 million baht** to repay its dollar loan. But it only has 250 million baht — a **shortfall of 250 million baht**. The bank is **effectively bankrupt** even though none of its domestic borrowers defaulted. This is why currency mismatch (borrowing in foreign currencies and lending domestically) is so dangerous.Q6. Why is a “soft peg” sometimes described as the “worst of both worlds”?
Answer
A soft peg creates the **illusion of stability** — firms and banks may behave as if the exchange rate is fixed, failing to hedge against currency risk. When the peg is eventually adjusted or abandoned, the effects are devastating because no one prepared. Additionally, dealers and investors constantly speculate about *when and how* the government will intervene, which can **increase** short-term volatility rather than reduce it. The country also partially sacrifices monetary independence without gaining the full credibility of a hard peg.Q7. If a country experiences hyperinflation (200%+ per year), what happens to its exchange rate? Use supply and demand analysis.
Answer
Hyperinflation erodes the currency's purchasing power dramatically. **Demand shifts left** — foreign investors and traders don't want to hold a rapidly depreciating currency. **Supply shifts right** — domestic holders rush to convert to more stable currencies. Both shifts cause the currency to **depreciate sharply**. Mexico experienced this in 1986–87: with inflation over 200%, the peso fell from $2.50/peso to $0.50/peso — an 80% depreciation.Q8. Ecuador uses the U.S. dollar as its currency. What are the advantages and disadvantages of this arrangement?
Answer
**Advantages:** No exchange rate risk with the U.S. (Ecuador's largest trading partner); eliminates speculation and currency crises; provides immediate credibility against inflation (tied to the Fed's reputation). **Disadvantages:** Ecuador has **zero monetary policy independence** — it cannot lower interest rates during a recession or raise them during inflation. If the U.S. economy diverges from Ecuador's (e.g., the Fed tightens while Ecuador needs stimulus), Ecuador has no tools to respond. It also cannot act as a lender of last resort in dollars.Q9. Explain why, in the foreign exchange market, supply and demand curves often shift at the same time and in the same direction. How is this different from typical goods markets?
Answer
In a typical goods market, a supply shift and a demand shift usually have independent causes. In the foreign exchange market, the same event (e.g., the expectation that a currency will strengthen) affects both sides: investors **demand** the currency (expecting profits) AND are **less willing to supply** it (holding on for anticipated gains). Both shifts push the exchange rate in the same direction (appreciation). They have **opposing effects on quantity**, however — higher demand increases quantity while lower supply decreases it — so the net effect on volume depends on the relative magnitude of the shifts.Q10. A developing country wants to attract foreign investment but is afraid of capital flight. What exchange rate policy should it consider, and what are the trade-offs?
Answer
Options include: **(1) Floating rate** — attracts investment since investors can exit freely, but leaves the country vulnerable to sudden capital outflows and exchange rate volatility. **(2) Soft peg** — provides some stability but may create false confidence and devastating adjustments. **(3) Tobin taxes** — tax short-term capital flows to reduce speculation while allowing long-term FDI, but firms can easily relocate transactions offshore. **Best practical approach:** A floating rate with strong macroeconomic fundamentals (low inflation, stable fiscal policy) and transparent regulations. This attracts investment through good governance rather than exchange rate manipulation.Q11. Country A has a price level of $P_A = 150$ and Country B has $P_B = 200$. The market exchange rate is 1.50 A-currency per 1 B-currency.
(a) Calculate the PPP exchange rate. Is A’s currency overvalued or undervalued?
(b) Calculate the real exchange rate. Is Country A more or less competitive than Country B?
(c) If inflation in A is 8% per year and inflation in B is 2% per year, predict what will happen to the market exchange rate over time.
Answer
**(a)** $e_{PPP} = \frac{P_A}{P_B} = \frac{150}{200} = 0.75$ A per B. The market rate (1.50) is much higher than PPP (0.75), meaning A's currency is **undervalued** — each B-currency buys more A-currency than PPP suggests it should. **(b)** $RER = e \times \frac{P_B}{P_A} = 1.50 \times \frac{200}{150} = 1.50 \times 1.33 = 2.0$. Since $RER > 1$, Country A's goods are relatively **cheap** in international markets — Country A is **more competitive** (this is consistent with the undervalued currency). **(c)** With A's inflation (8%) much higher than B's (2%), A's price level rises faster. Over time: $e_{PPP}$ increases ($\frac{P_A}{P_B}$ grows as $P_A$ rises faster). The market exchange rate should **rise** (A's currency depreciates against B's) — A-currency buys less of B-currency. The competitiveness advantage erodes as inflation eats into it.Q12. In 2022, the U.S. Federal Reserve raised interest rates aggressively from 0.25% to 4.5%, while the European Central Bank raised rates more slowly from 0% to 2.5%. The euro fell from $1.14 to $0.99 (briefly below parity).
(a) Use the interest rate differential framework to explain the euro’s depreciation.
(b) How did this exchange rate movement affect European exporters vs. American exporters?
(c) Calculate: if a German manufacturer has €10M in costs and sells products for $12M, what is their profit in euros at the $1.14/€ rate vs. the $0.99/€ rate?
Answer
**(a)** Higher U.S. rates (Δ = 4.25%) vs. European rates (Δ = 2.5%) created a **2% interest rate differential** favoring the U.S. Investors moved capital from Europe to the U.S. (higher returns): - Demand for dollars ↑ (to buy U.S. bonds) - Supply of dollars ↓ (U.S. investors keep money home) - Demand for euros ↓ + Supply of euros ↑ - Result: Dollar appreciates, euro depreciates from $1.14 to $0.99 **(b)** **European exporters benefited** — their euro-denominated costs bought more dollars, making their products cheaper in U.S. markets. **American exporters were hurt** — their dollar-denominated products became more expensive in Europe. **(c)** At $1.14/€: Revenue = $12M ÷ 1.14 = €10.53M. Profit = €10.53M − €10M = **€0.53M**. At $0.99/€: Revenue = $12M ÷ 0.99 = €12.12M. Profit = €12.12M − €10M = **€2.12M**. The euro's depreciation **quadrupled** the manufacturer's profit (from €0.53M to €2.12M) — a dramatic example of why exporters benefit from a weaker home currency.Q13. Case Study — The Impossible Trinity (Trilemma):
The impossible trinity states that a country can have at most two of the following three:
- Free capital flows
- Fixed exchange rate
- Independent monetary policy
(a) Explain why China in the 2000s chose options 2 and 3 (fixed rate + independent monetary policy) and had to restrict capital flows.
(b) The Eurozone chose options 1 and 2 (free capital flows + fixed rates among members). Why did this create problems for Greece during the 2010 debt crisis?
(c) The U.S. chose options 1 and 3 (free capital flows + independent monetary policy). What is the trade-off?
Answer
**(a)** China pegged the yuan to the dollar at an undervalued rate to boost exports (“fixed rate”). It simultaneously ran independent monetary policy to manage domestic growth (“independent monetary policy”). To maintain both, China had to impose **capital controls** — restricting how much money could flow in/out. Without controls, arbitrageurs would exploit the interest rate/exchange rate mismatch, breaking either the peg or the independent policy. **(b)** Greece shared the euro (fixed exchange rate) with free capital flows within the EU. When Greece's debt crisis hit in 2010, it needed expansionary monetary policy (lower rates, weaker currency), but the ECB set rates for the entire Eurozone. Greece **couldn't devalue** its currency to boost exports, couldn't set its own interest rates, and couldn't restrict capital outflows. The only tool left was **fiscal austerity** — cutting spending and raising taxes during a depression, which worsened the downturn. GDP fell 25% from 2008–2013. **(c)** The U.S. has full monetary independence (Fed sets rates freely) and free capital flows (anyone can invest in U.S. assets). The trade-off is a **floating exchange rate** that can swing dramatically — the dollar can appreciate 20%+ in a few years (as in 2014–2016 and 2021–2022), hurting exporters and creating uncertainty. But the U.S. accepts this volatility because monetary independence (ability to fight recessions and inflation) is more valuable than exchange rate stability.7. Glossary
| Term | Definition |
|---|---|
| Appreciating (strengthening) | A currency rises in value, exchanging for more of other currencies |
| Arbitrage | Buying and selling goods or currencies across borders to profit from price differences |
| Depreciating (weakening) | A currency falls in value, exchanging for less of other currencies |
| Dollarize | A country adopts the U.S. dollar (or another nation’s currency) as its own |
| Floating exchange rate | The foreign exchange market determines the currency’s value without government intervention |
| Foreign direct investment (FDI) | Purchasing ≥10% of a foreign firm or starting a new enterprise abroad; involves management |
| Foreign exchange market | The market where people and firms use one currency to purchase another |
| Hard peg | The central bank fixes the exchange rate at an unchanging value |
| Hedging | Using a financial contract to protect against currency risk |
| Interbank market | The market where banks and dealers trade foreign exchange with each other |
| International capital flows | Financial capital flowing across national boundaries as portfolio or direct investment |
| Merged currency | A nation adopts another nation’s currency or shares a common currency (e.g., euro) |
| Portfolio investment | A purely financial investment in another country (<10% ownership, no management role) |
| Purchasing power parity (PPP) | The exchange rate that equalizes prices of internationally traded goods across countries |
| Soft peg | The government usually lets the market set the rate but intervenes during rapid movements |
| Tobin tax | A tax on international capital flows designed to reduce short-term speculation |