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International Finance

Topic 1- National Income Accounting & BOP

National Income Identity
gross domestic product is given by consum­ption expend­itures, plus investment expend­itures, plus government expend­itures, plus exports, minus imports
National Savings
the amount of output that is not devoted to private consum­ption and government spending
S= Y-C(Y-T)-G or S= Sp+Sg or S=I+CA
Balance of Payments
records a country's intern­ational transa­ctions with the rest of the world in a given time period- records its payments and recepits from foreigners and shows demand and supply of a country's currency in FEM
*every intern­ational transa­ction enters the BOP accounts twice, once as a credit and once as debit
Credit Entry
any transa­ction resulting in receiving payments from foreigners
exports of goods, services, assets
Debit Entry
any transa­ction resulting in making payments
imports of goods services, assets
Components of BOP Accounts
Current Account, Financial Account, Capital Account
CA+KAn­on+­Cap­ita­lAcc= -ORT
Current Account
shows the difference b/w exports and imports of goods and services plus net unilateral transfer
CA= EX-IM+ Net Unilateral Transfer
Financial Account
difference b/w sales & purchases of assets to foreigners
KA= KAnonr­es+ORT
Non-re­serve Portion
the purchases & sales of assets by the private sector
Reserve Portion
the purchases & sales of foreign assets by the country's monetary authority
foreig­n-c­urrency denomi­nated assets held by central banks

Topic 4- Price Levels & Exchange Rate in LR

Purchasing Power Parity
explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels
Absolute PPP
identical basket of goods should be sold for same amount of money in diff countries when expressed in same currency
E= P/P*
Relative PPP
% Δ in exchange rate between 2 currencies over many period equals to the inflation rate differ­entials between 2 countries
Ee-E/E= π-π*
Monetary Approach to Exchange Rate
shows factors that affect MS and MD will play a role in determ­ining exchange rate
PPP holds, LR Model, shocks are permanent
Equili­brium exchange rate
E= (MS/MS)(L(Y,R)/(L(R,Y)
Domestic MS Increases
Exchange rate increases
DC deprec­iates
Foreign MS Increases
Exchange rate decreases
DC apprec­iates
Domestic Interest Rate increases
Exchange rate increases
DC deprec­iates
Foreign Interest Rate increases
Exchange rate decreases
DC apprec­iates
Domestic Output increases
Exchange rate decreases
DC apprec­iates
Foreign Output Increases
Exchange rate increases
DC deprec­iates

Topic 2- Asset Approach to Exchange Rate

Exchange Rate
the price of one currency in terms of anothe­r(D­C/FC)
Forward exchange rates
the exchange rate that is contracted today for the exchange of currencies at a specified date in the future
R= R*+Ee-E/E
Interest Parity Condition
the condition that the expected returns on deposits of any two currencies are equal when measured in the same currency
Covered interest Rate Parity
agents can lock in the future exchange rate by getting a forward contract & elimin­ating uncert­ainty
R= R*+ F-E/E
Real Rate of Return
the rate at which its value expressed in terms of a repres­ent­ative output basket is expected to rise
Expected ate of return
the rate at which the value of an investment in the asset is expected to rise over time
the process of buying a currency cheap and selling it dear
Asset Approach
IPR holds & deals with financial capitals
Focused on money mkt shocks and impacts on exchange rate (SR & LR)
R, domestic interest rate
return on DC deposits
annualized percentage change in the DC/FC exchange rate
expecting DC return on FC deposits
Increase in Domestic Interest
R curve shifts right, invest in DC Deposit
Capital inflows & DC apprec­iates
Increase in Foreign Interest
R* curve shifts right, invest in FC deposit
Capital outflows & DC deprec­iates
Expected Deprec­iation of DC
R* curve shifts right, invest in FC deposit
Capital outflows & DC deprec­iates
Forward Trading
parties agree to exchange currencies on some future date at a pre-ne­got­iated exchange rate
Spot Trading
trades are settled immedi­ately

Genera­lized Approach (real exchange rate, q)

Real exchange rate, q
measures the purchasing power of a country's currency relative to another country's currency
shows how many baskets of domestic goods are needed to exchange one basket of foreign goods q= E(P/P*)
If q increases
real deprec­iation of DC
If q decreases
real apprec­iation of DC
Absolute PPP
q= E(P/P*)
Relative PPP
If AD increa­ses­-do­mestic
domestic goods are more valuable
PPP of DC increases and real apprec­iation of DC
If AD* increa­ses­-fo­reign
domestic goods are less valuable
PPP of DC decreases and real deprec­iation of DC
Genera­lized Approach
considers how changes in both monetary and real sides of the economy affect LR exchange rate
in the LR changes in q, changes in P and P* lead to a change in E

Topic 3- Money, Interest Rate & Exchange Rate

Money Supply
the total amount of currency and checking deposits held by households and firms
Currency in circul­ati­on+­Demand Deposit
Aggregate Money Demand
the toal demand for money by all households and firms in the economy
Md= L(R,Y)
liquidity function
nominal interest rate
opport­unity cost of holding money
real income= real GDP
when income increases, consum­ption increases, volume of transa­ction increases
Interest rate- fisher
R= r+Π
Money market equili­brium
MS/P= L(R,Y)
R adjusts to ensure the money market is in equili­brium in SR
If MS increases
Pressure for R to fall to initial level
If real income Y increases
Consum­ption increases and we hold more money
L(R,Y) increases and R increases
In the long run
P= MS/L(R,Y)
P= MS/L(R,Y*)
Quantity Theory of Money
%Δ MS+%ΔV= %ΔP+%ΔY
Level change in MS doesn't impact %Δ in MS
no change in MS means no change in Π
Exchange Rate Oversh­ooting
immediate response to a distur­bance is greater than its long-run response
Exchange Rate Unders­hooting
the immediate deprec­iation of a currency to a shock is greater than its long run response


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