Chapter 2

The gold standard and the money supply. Under the gold standard all national governments promised
to follow the "rules of the game." This meant defending a fixed exchange rate. What did this promise
imply about a country's money supply?
Under the gold standard, the promise to follow the "rules of the game" and defend a fixed exchange rate
implied a direct relationship between a country’s money supply and its gold reserves. Specifically:
[Link] Supply Backed by Gold: A country's money supply was tied to the amount of gold it held.
Governments issued currency only to the extent that it could be backed by their gold reserves.
[Link] Exchange Rates: The value of a country's currency in terms of gold was fixed, ensuring stable
exchange rates between currencies of countries adhering to the gold standard.
[Link] Adjustments: Trade imbalances would automatically correct through gold flows:
1. A trade deficit would result in gold outflows (to pay for imports), reducing the money supply and
leading to lower prices and wages, making exports more competitive.
2. A trade surplus would result in gold inflows, increasing the money supply, leading to higher prices and
wages, and reducing competitiveness.
[Link] Monetary Policy: Governments had little to no flexibility to adjust their money supply
independently of their gold reserves. This constrained their ability to respond to domestic economic
conditions like unemployment or inflation.
[Link] Stability: The gold standard created a self-regulating system where gold flows-maintained balance-
of-payments equilibrium.
By adhering to these principles, governments ensured a stable and predictable monetary system, but at the
cost of reduced control over domestic economic policies.
If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the
fixed exchange rate to be devalued?

Causes of Devaluation in a Fixed Exchange Rate Regime

[Link] Trade Deficits: Prolonged trade deficits deplete foreign reserves, making it difficult to
maintain the fixed rate, leading to devaluation.
[Link] Foreign Exchange Reserves: Insufficient reserves caused by trade deficits or capital
outflows pressure the fixed rate, forcing devaluation.
[Link] Inflation: Higher domestic inflation than trading partners reduces competitiveness,
necessitating devaluation to restore balance.
[Link] Flight: Political or economic instability can trigger capital outflows, depleting reserves and
pressuring the fixed rate.
[Link] of Competitiveness: An overvalued currency due to productivity gaps or structural weaknesses
may need devaluation to regain export competitiveness.
[Link] Attacks: Speculative pressure can drain reserves, making devaluation unavoidable.
4. The Impossible Trinity
The Impossible Trinity states that a country cannot simultaneously achieve:
1.A fixed exchange rate.
[Link] capital mobility.
[Link] independent monetary policy.
It's impossible because, in practice, a country can only choose two of these three goals. For example, with free
capital flows and a fixed exchange rate, a country cannot control its own monetary policy.
5. Currency Board vs. Dollarization
•Currency Board: A system where a country's currency is pegged to a foreign currency, and reserves fully back
it (e.g., Hong Kong). The country still has its own currency but loses some monetary control.
•Dollarization: A country adopts a foreign currency (e.g., Ecuador using the US dollar), completely giving up
control over its monetary policy.
Difference: Currency boards retain domestic currency with a peg, while dollarization uses a foreign currency
exclusively.
6. Emerging Market Exchange Rate Regimes
•Free-Floating Regimes:
• Pros: Flexibility in monetary policy and exchange rate adjustments.
• Cons: Vulnerable to volatility and external shocks.
•Currency Board/Dollarization:
• Pros: Exchange rate stability, lower inflation, and increased investor confidence.
• Cons: Loss of independent monetary policy and vulnerability to foreign currency risk.
Emerging markets balance stability with flexibility in choosing between these regimes.
4. The Impossible Trinity
The Impossible Trinity (also known as the Trilemma) refers to the economic theory that a country cannot
simultaneously achieve all three of the following goals:
1.A fixed foreign exchange rate.
[Link] capital movement (i.e., no controls on capital flows).
[Link] independent monetary policy (the ability to control interest rates and money supply).
The trinity is considered impossible because, in practice, a country can only achieve two of these three
objectives at the same time. For example:
•If a country has a fixed exchange rate and free capital mobility, it cannot control its own monetary policy
because capital flows will influence interest rates and money supply.
•Similarly, if a country wants independent monetary policy and free capital mobility, it must allow its exchange
rate to float.
5. Currency Board vs. Dollarization
•Currency Board: A currency board is a fixed exchange rate regime where the domestic currency is directly
pegged to a foreign currency (e.g., Hong Kong’s peg to the US dollar). The central bank holds foreign currency
reserves to back the domestic currency 100%. The country gives up control over its monetary policy to maintain
the peg.
•Dollarization: In dollarized economies (e.g., Ecuador), a country adopts a foreign currency, usually the US
dollar, as its official currency. This eliminates the domestic currency altogether, meaning the country has no
control over its money supply or monetary policy.
Difference: The key difference is that in a currency board, the country still maintains its own currency but links it
to another currency, while in dollarization, the country completely adopts a foreign currency, giving up its
domestic monetary policy.
6. Emerging Market Exchange Rate Regimes
Emerging market nations face a dilemma between adopting free-floating regimes or currency
board/dollarization regimes due to high capital mobility.
•Free-Floating Regimes:
• Pros: Flexibility in adjusting the exchange rate to reflect economic conditions, ability to implement
an independent monetary policy, and automatic adjustment of trade balances through exchange
rate movements.
• Cons: Vulnerability to exchange rate volatility, speculative attacks, and capital flow instability.
•Currency Board/Dollarization:
• Pros: Stability in the exchange rate, lower inflation due to foreign currency discipline, and
increased investor confidence from a more predictable monetary environment.
• Cons: Loss of independent monetary policy, difficulty in responding to external shocks, and
potential exposure to foreign currency risks.
Emerging market countries often choose free-floating regimes to allow for economic flexibility but face
potential instability, while currency board/dollarization provides stability at the cost of giving up some
control over domestic economic policy.
7. Argentine Currency Board (1991-2002)
From 1991 to January 2002, Argentina implemented a currency board system, pegging the Argentine peso to the US
dollar at a fixed exchange rate of 1:1.
•Functioning: The Argentine central bank was required to hold reserves of US dollars equal to the amount of pesos
in circulation, limiting the government's ability to print money independently.
•Collapse: The currency board collapsed due to severe economic crises, including unsustainable debt, high
unemployment, and declining foreign reserves. This led to a loss of confidence in the peso and a default on external
debt in December 2001, forcing Argentina to abandon the peg and devalue its currency.
8. The Euro and its Effects on EMU Members
Three ways the euro affects EMU members:
[Link] of Exchange Rate Risk: Businesses and investors benefit from no exchange rate fluctuations within
the Eurozone, making trade and investment easier.
[Link] Policy Centralization: The European Central Bank (ECB) controls interest rates and inflation across the
EMU, reducing individual countries' ability to set their own monetary policies.
[Link] Price Transparency: Consumers can compare prices across Eurozone countries more easily,
promoting competition and market efficiency.
9. Motivations for Not Adopting the Euro
•United Kingdom: Prefers monetary independence to maintain control over its economy, particularly regarding
inflation and interest rates. The UK also values its ability to use the pound as a symbol of national sovereignty.
•Denmark: Chose to retain the krone due to a desire for economic flexibility and to avoid ceding control over
monetary policy to the European Central Bank (ECB).
•Sweden: Although a member of the EU, Sweden chose to keep the krona after a 2003 referendum where citizens
voted against adopting the euro, mainly due to concerns over losing economic autonomy.
10. International Monetary Fund (IMF) Objectives
The IMF was established by the Bretton Woods Agreement in 1944 with the following main
objectives:
[Link] International Monetary Cooperation: Facilitate balanced growth in international trade
and economic stability.
[Link] Exchange Rate Stability: Support fixed exchange rates and prevent competitive
devaluations.
Provide Financial Assistance: Lend to member countries facing balance-of-payments problems to
stabilize their economies.

11. Special Drawing Rights (SDRs)

Special Drawing Rights (SDRs) are an international reserve asset created by the IMF to
supplement its member countries' official reserves. SDRs are allocated to countries based on their
IMF quotas and can be exchanged for freely usable currencies in international markets. SDRs are
used by member countries to meet balance-of-payments needs or to strengthen their reserves.
13. Exchange rate regime classifications. The IMF classifies all exchange rate regimes into eight specific categories
that are summarized in this chapter. Under which exchange rate regime would you classify the following countries?
The IMF classifies exchange rate regimes into several categories. Based on the classification, the following
countries would fall under the specified regimes:
a. France
•Regime: Floating Exchange Rate
• France is a member of the Eurozone, so its currency, the euro (€), follows a floating exchange rate
system where its value is determined by market forces (supply and demand) relative to other
currencies.
b. The United States
•Regime: Floating Exchange Rate
• The US dollar (USD) follows a floating exchange rate regime where the value of the dollar is determined
by market forces in the foreign exchange market.
c. Japan
•Regime: Floating Exchange Rate
• The Japanese yen (JPY) operates under a floating exchange rate regime, where its value is determined by
supply and demand in the foreign exchange market.
d. Thailand
•Regime: Managed Float
• Thailand uses a managed float exchange rate regime, where the Thai baht (THB) generally floats
according to market forces, but the central bank occasionally intervenes to stabilize the currency when
necessary.
Chapter 4
a. Foreign Exchange Market (Forex Market)
The Foreign Exchange Market (also known as the Forex Market) is the global marketplace where
currencies are traded. It operates 24 hours a day and is the largest and most liquid financial market in
the world. The Forex market facilitates the exchange of one currency for another and is used by
businesses, governments, investors, and traders to buy, sell, and exchange currencies.

b. Foreign Exchange Transaction

A Foreign Exchange Transaction refers to the buying or selling of one currency for another, typically
conducted through a bank, forex broker, or other financial institutions. These transactions can occur in
the spot market (immediate exchange), forward market (future exchange), or through derivatives. The
aim is often to hedge risks, speculate on currency movements, or settle international trade payments.

c. Foreign Exchange
Foreign Exchange (Forex) refers to the process of converting one currency into another for various
purposes, including international trade, investment, tourism, or speculation. The term can also refer to
the actual currency being traded or held in reserves by governments and institutions. It encompasses all
aspects of trading, pricing, and managing currencies in the global financial system.
[Link] of the foreign exchange market. What are the three major functions of the foreign exchange
market?
The three major functions of the foreign exchange market are:
[Link] Conversion: The Forex market facilitates the conversion of one currency into another. This is essential
for international trade, investment, and travel, as it allows businesses and individuals to exchange currencies at
prevailing exchange rates.
[Link] and Risk Management: The Forex market provides a platform for businesses and investors to hedge
against currency risk. By using financial instruments like forward contracts, options, and futures, participants can
protect themselves from adverse fluctuations in exchange rates.
[Link] Discovery: The Forex market helps in determining the value of currencies based on supply and demand.
The exchange rates are influenced by various factors such as economic data, political stability, interest rates, and
market speculation, which help in setting the price of one currency relative to another.
3. Market Participants and Their Motives
•Commercial Banks: Provide currency conversion services for their clients and engage in trading to profit from exchange
rate fluctuations.
•Central Banks: Buy or sell foreign currencies to stabilize or influence the value of their own currency, ensuring
economic stability and managing monetary policy.
•Multinational Corporations: Buy or sell foreign exchange to conduct international business, pay for goods and
services, and hedge against currency risks.
•Hedge Funds and Speculators: Buy and sell foreign exchange to profit from short-term price fluctuations in the market.
•Governments: Exchange currencies to settle international payments, manage foreign reserves, or intervene in the
market to control exchange rates.
•Brokers: Facilitate transactions between buyers and sellers of foreign exchange, earning a commission or fee.
4. Foreign Exchange Transactions Types
•a. Spot Transaction: A spot transaction involves the immediate exchange of currencies, typically settled within two
business days. Example: Buying euros for US dollars at the current market rate.
•b. Outright Forward: A forward contract where currencies are bought or sold at a future date (more than two business
days) at a pre-agreed exchange rate. Example: A company agrees to buy 1 million euros in six months at a specific
exchange rate.
•c. Forward-Forward Swaps: A combination of two forward contracts with different settlement dates. One contract is
a spot (or near future) transaction, while the other is a forward contract. Example: A company enters into a contract to
buy a currency in the short term and sell it in the longer term.
•d. Non-Deliverable Forwards (NDFs): A forward contract where the currencies involved are not physically exchanged
at settlement. Instead, the difference between the agreed-upon exchange rate and the market rate is settled in cash.
Example: An NDF contract in which the difference in exchange rates is paid in USD rather than exchanging the actual
currencies.
6. Foreign Exchange Rate Quotations
•a. Bid Quote: The price at which a market participant is willing to buy a currency. Example: If the bid for EUR/USD is
1.1800, the trader is willing to buy euros for 1.1800 USD per euro.
•b. Ask Quote: The price at which a market participant is willing to sell a currency. Example: If the ask for EUR/USD is
1.1820, the trader is willing to sell euros for 1.1820 USD per euro.
7. Reciprocals
•a. Euro: €1.02/$ (Indirect Quote) → Direct Quote: $0.9804/€ (1 ÷ 1.02)
•b. Russia: Rub 30/$ (Indirect Quote) → Direct Quote: $0.0333/Rub (1 ÷ 30)
•c. Canada: $0.63/C$ (Direct Quote) → Indirect Quote: C$1.5873/$ (1 ÷ 0.63)
•d. Denmark: $0.1300/DKr (Direct Quote) → Indirect Quote: DKr7.6923/$ (1 ÷ 0.1300)
5. Foreign Exchange Market Characteristics (2001)
•a. Relative Size of Spot, Forwards, and Swaps:
• Swaps accounted for the largest share of foreign exchange turnover.
• Spot transactions were the second-largest.
• Forwards were the smallest in terms of turnover.
•b. Five Most Important Geographic Locations for Foreign Exchange Turnover:
• London
• New York
• Tokyo
• Hong Kong
• Singapore
•c. Three Most Important Currencies of Denomination:
• US Dollar (USD)
• Euro (EUR)
• Japanese Yen (JPY)
9. American and European Terms
•American Terms: Quotation of a foreign currency in terms of US dollars. Example: EUR/USD 1.1800 (1 euro = 1.18 USD).
•European Terms: Quotation of the US dollar in terms of a foreign currency. Example: USD/GBP 0.75 (1 USD = 0.75 British
pounds).
10. Direct and Indirect Quotes
•a. Direct Quote (US Dollar and Mexican Peso): A direct quote shows how many units of foreign currency are needed to
purchase one unit of domestic currency. Example: MXN 20.50/USD means it takes 20.50 pesos to buy 1 USD.
•b. Indirect Quote (Japanese Yen and Chinese Renminbi): An indirect quote shows how many units of domestic currency
are needed to buy one unit of foreign currency. Example: CNY 6.40/JPY means it takes 6.40 Chinese yuan to buy 1
Japanese yen.
8. Geographical Extent of the Foreign Exchange Market
•a. Geographical Location: The foreign exchange market is global, operating across financial
centers in major cities around the world (London, New York, Tokyo, etc.).
•b. Two Main Types of Trading Systems:
• Over-the-Counter (OTC): Decentralized trading between participants, typically done
electronically or by phone.
• Exchanges: Centralized platforms where currencies are traded, although this is less
common for Forex compared to stocks or commodities.
•c. How Are Markets Connected: Foreign exchange markets are connected via a network of
electronic platforms and communication systems that link participants globally for real-time
trading, including networks like Reuters and Bloomberg.