CHAPTER 16 The Foreign Exchange Market and Exchange Rate Regimes

WHAT YOU WILL LEARN IN THIS CHAPTER

  • What the distinction is between spot and forward exchange rates and the role of currency swaps.
  • How foreign exchange is traded around the globe.
  • How spot and forward exchange rates are linked through interest rate differentials.
  • How the law of one price and purchasing power parity result in prices being the same across borders, allowing for the exchange rate, in the long run.
  • What is meant by the real exchange rate and its importance.
  • How a floating exchange regime works and how it frees up monetary policy to pursue inflation and output goals.
  • How a fixed exchange regime works and how it constrains monetary policy.
  • What is meant by dollarization, currency boards, and adjustable pegs.

BACKGROUND

Chances are you have traveled abroad. In doing so, you had to convert your home currency (dollars, if you are an American) for the local currency of the country you were visiting. You may have done this at an airport, at a currency exchange shop in the heart of a big city, or you may have gone to an automated teller machine (ATM). Is that how all foreign exchange transactions get done in this increasingly globalized world? Certainly, big commercial and financial transactions must be done differently. You may have heard politicians say that a strong dollar is good for America. Is this always true, or might a weaker dollar be of some benefit? The value of the U.S. dollar fluctuates ...

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