Foreign exchange market provides insurance against foreign exchange risks.

The indirect quotation method is defined as the price of domestic currency in terms of foreign currency. The direct quotation method is defined as the price of foreign currency in terms of domestic currency. The exchange rate applied by banks in foreign currency sales transactions is called ask rate. The exchange rate applied in purchase transactions is called as bid rate.

Nominal exchange rate is the value of one country’s currency in terms of another country’s currency. The real exchange rate is an exchange rate adjusted for changes in the prices of goods and services.

FD= (14.85-15)/15*360/120*100=-3%

The avoidance against foreign exchange risk in exchange market is called as hedging.

There is a home- currency depreciation and Turkish lira is said to depreciate against the dollar. That is why Türkiye’s currency causes its commodities to be cheaper for foreigners. Besides, a value of a good that is evaluated in US$ price level will be more expensive for Turkish buyers.

A country’s level of income is an important determinant of demand for imports. As income in a country increases, import demand increases. This would cause a rise in demand for foreign currency, increasing the supply of the country’s currency to purchase foreign currency.

There is not any limitation of trade on services. Other sections are criticized in theory.

Fundamental forces affecting exchange rate increases are an increase in income, an increase in the price level, a decrease in product availability, a decrease in interest rates and a decrease in trade barriers etc.

Stated differently, according to relative PPP, the change in exchange rates depends on changes in price levels, i.e., the rates of inflation, between the two countries.

A closed economy is assumed without trade and is not taken the purchase of goods and services made by foreigners (exports) and the purchase of foreign-made goods and services (imports) into account.

Economy is at not full employment in short run Keynesian model.

In a closed economy with a government; households use their after-tax income, disposable income for consumption spending.

Autonomous expenditure multiplier is a key concept that describes how changes in autonomous expenditure (spending) can have a larger effect on income.

Using the equilibrium condition:
Y = C + I + G, Y = a + bY_d + I₀ + G₀, Y = a + b (Y - T₀) + I₀ + G₀ ,Y = a + bY - bT₀ + I₀ + G₀
Y= 150+0.5(Y-50)+75+100
0.5Y=300, Y=600

The autonomous expenditure multiplier (k)= 1/1- Marginal propensity to comsume (MPC)
k=1/1-b, 1/1-0.5= 2
It implies that increase of 1 lira in, for example, government spending will cause income to increase by 2 liras. Multiplier gives the change in equilibrium income per unit change in one of the components of autonomous expenditure.

Imports are negatively associated with the real exchange rate and positively associated with income. As income rises, imports rise, and the positive slope of the import function is the marginal propensity to import.

In the Keynesian model, exports are taken as autonomous. It means that exports are independent on income level of the exporting country. Net export gives the difference between a country’s exports and imports of goods and services. Trade deficit means that export value is less than import value in a country. Conversely, Trade surplus means that import value is less than export value in a country.

According to the Marshall-Lerner Condition, depreciation of a country’s currency (an increase in the real exchange rate) will improve its trade balance if the combined price elasticity of demand for its exports and imports is greater than 1.

The higher the value of marginal propensity to import, the smaller the induced effect on demand for domestic goods and, hence, the smaller the change in domestic income (Y).

Payments outward from the country is named as debit. Exports of goods and services, interests, financial inflows etc. is called as credit. Imports of goods and services, interests, financial inflows etc. is also called as debits.

Disposal of non-produced assets is stated in the capital account. Export and import of goods and services, income payments and receipts, unilateral transfers, etc are in the current account category. Capital transfers, acquisition, and disposal of nonproduced, non-financial assets are called in The capital account. Purchase or sale of financial assets are indicated in the financial account.

The current account involves all trade-related economic transactions (exports and imports of goods and services), income payments and receipts from earlier investments from /to abroad, and net unilateral transfers. The current account balance has three main sub-categories called the trade, primary, and secondary income balances.
The capital account deals with wealth transfers between residents and non-residents in two forms: capital transfers and the acquisition/disposal of non-produced, non-financial assets, while the current account involves current flows in a given period.

In the financial account; sales in reserve assets are stated as credit. In capital account; payments in capital transfers are stated as debit. In the current account; export in trade balance is stated as credit.

Portfolio investment includes transactions in securities issued by private and public agents and shows less than 10 percent ownership of an enterprise in another country. Securities can be in two forms: equity and debt. Equities are typically the shares of corporations exchanged in stock markets, and debt securities are bonds and bills.

Central banks control the changes in reserve assets.

In open economy, private saving is amount of the disposal income after consumption.

If CA<0, it requires international borrowing and the financial account must be in surplus. Suppose this country is already in debt; the surplus needed in the financial account represents an increase in foreign indebtedness. However, if this country is already a net creditor, the surplus represents a decline in international lending. Therefore, when CA<0, a debtor country’s indebtedness increases, or the creditor country’s lending to foreigners reduces.

If imports exceed exports, it is called trade deficit.

The minus sign implies that the incurrence of liabilities exceeds the net acquisition of financial assets.

With the leading role played by the money market, the monetary approach emphasizes the financial flows side of the balance of payments (BOP) account more than the trade flows side.

Fixed Exchange rate: In a fixed exchange rate system, the monetary authorities officially set the country’s exchange rate at a predetermined value that is not allowed to change.

Floating (or Flexible) Exchange rate: In a freely floating exchange rate system, the exchange rate fluctuates without the central bank trying to control or prevent a change in its value. This system does not permit central bank intervention in the foreign exchange market.

Money supply or M1 equals the total stock of banknotes and coins issued by the central bank in circulation and the demand deposits held by the public.

The assets held by the central bank can be categorized into domestic assets (DR) and foreign assets (IR). Domestic assets (DR) include the domestic credit extended by the central bank to its institutions in the form of loans extended to the domestic banks and domestic government securities purchased. On the other hand, foreign assets refer to the central bank’s official international reserve holdings (IR). They may consist of the central bank’s holdings of foreign exchange, gold, or bonds. Foreign exchange intervention, that is, the central bank’s purchase or sale of foreign currency in the foreign exchange market, causes the official reserve holdings of the central bank to change.
The central bank’s liabilities can be grouped into currency in circulation (C) and bank reserves (BR). Currency in circulation (C) amounts to the coins and banknotes in the hands of the public (vault cash is excluded). Bank reserves (BR) consist of the deposits held by the banks at the central bank and vault cash (i.e., the coins and notes physically held in the banks’ vaults). The bank reserves can be grouped into required reserves and excess reserves. Required reserves refer to the officially obliged amount the banks have to hold in their deposit accounts with the central bank. The central bank sets the required reserve ratio against deposits.

The money demand increases when the:

1. price level (P) increases.
2. interest rate (i) decreases.
3. real income (Y) increases.
4. wealth increases.
5. inflation risk decreases.
6. payment technology deteriorates.
7. riskiness of other assets increases.
8. liquidity of other assets falls.

But then, how does an excess money stock create a BOP deficit? When the home country’s central bank engages in a monetary expansion, the people will find themselves with extra money balances they do not want to hold. As a result, they will try to reduce these excess balances by acquiring other physical or financial assets. In an open economy, some of this domestic expenditure will fall on foreign goods (i.e., imports) and financial assets (i.e., capital outflow). Thus, an excess money stock leads to a debit position in a country’s current and private capital accounts, leading to a BOP deficit. The home country’s purchase of imports and foreign assets increases its demand for foreign currency (i.e., US dollars). At the officially set exchange rate, this increase creates an excess demand for foreign exchange, and the home country’s central bank has to supply this excess demand from its official international reserve holdings (IR decreases). The fall in IR will, in turn, reduce the home country’s money supply. Hence, an outflow of official reserves will automatically correct the BOP deficit resulting from an excess money supply.

With flexible exchange rates, a BOP imbalance leads to and is corrected by an automatic adjustment in the exchange rate. For example, a potential BOP deficit that could result from an excess supply of money leads to a decrease in the value of the home currency against the foreign currency (i.e., the exchange rate increases). The excess money supply makes people spend part of their excess cash balances on foreign goods and services (imports increase) and financial assets (a capital outflow occurs). The demand for foreign exchange increases instantaneously due to the developments mentioned above. With flexible exchange rates, the home currency depreciates, and we move to point E´ in Figure 5.2. On the other hand, an excess money demand leading to a potential BOP surplus is automatically corrected by a fall in the exchange rate, which is an appreciation of the home currency against the foreign currency. The desire to hold more cash balances leads people to buy fewer foreign goods and services (imports decrease) and financial assets (capital outflow decreases). All these forces reduce the demand for foreign exchange and appreciate the home currency

According to monetary approach to the exchange rate, the bilateral exchange rate depends on the countries’ relative money supplies and the relative factors that determine their money demands.

All in all, a nation under fixed exchange rates cannot independently control its domestic money supply. The money supply must be regulated to correct the BOP disequilibrium. Hence, the policy implication is that a country cannot use discretionary monetary policy to stabilize its economy under fixed exchange rates (with capital allowed to move freely). These countries should either abandon the fixed exchange rate system, impose capital controls, or use fiscal policy to stabilize the economy.

The main purpose of economic policies is to attain internal and external economic balances simultaneously.

External balance is achieving a balance of payments equilibrium (i.e., a current account deficit is balanced by a capital and financial account surplus or a current account surplus is balanced by a capital and financial account deficit).

LM curve represents the money market equilibrium or the equality of real money supply and real money demand.

BP-curve: The BP curve shows the relationship between the interest rate and national income at the country’s balance of payments equilibrium. The BP curve may be horizontal, vertical, or positively sloped depending on the degree of capital mobility in the economy.

Fiscal policy in an open economy: The effect of fiscal policy on the external balance in an open economy is ambiguous. With the expansionary fiscal policy, imports increase when the national income increases, leading to a current account deficit. Capital flows into the country when the interest rate increases, leading to a capital and financial account surplus. Because of these two opposing effects, the net effect on the external balance is uncertain.

Mundell-Fleming Model: An approach that examines the effects of monetary and fiscal policies in fixed and flexible exchange rate systems under conditions of perfect capital mobility.

Suppose, while at equilibrium, the government applies the expansionary fiscal policy. In response, the IS curve shifts to the right from IS1 to IS2 . The new IS-LM equilibrium takes place at point E1 . This point shows that the national income and the interest rate increased with expansionary fiscal policy. Since the government increases aggregate demand in the economy by increasing public expenditures and/or reducing taxes, national income increases in the internal balance. However, with the increase in domestic income, real money demand increases, which leads to higher interest rates in the money markets. While the increase in national income has a negative effect on the foreign trade balance (current account) by encouraging an increase in imports, the increase in interest has a positive effect on the capital and financial account by encouraging capital inflows from abroad. Thus, there are two opposite effects on the balance of payments. However, in the case of perfect capital mobility, since the sensitivity of capital movements to interest is infinite, a significant capital inflow occurs in the face of an increase in the domestic interest rate. Thus, since the foreign exchange inflow in the form of short-term capital will exceed the foreign exchange outflow through imports, an external surplus occurs in the case of perfect capital mobility with expansionary fiscal policy. In the case of external surplus, since the foreign exchange supply exceeds the foreign exchange demand in the country, there is pressure to decrease the exchange rates (i.e., appreciation of domestic currency). However, the central bank does not allow it to change since the economy operates under a fixed exchange rate system. The central bank intervenes in the foreign exchange market by purchasing the excess foreign exchange from the market against the national currency. This increases the domestic money supply and lowers the interest rate to its original level. A rightward shift of the LM curve represents the increase in the domestic money supply. The new equilibrium in the economy is achieved at point E2 . As is seen, when the expansionary fiscal policy and the fixed exchange rate system are implemented together under perfect capital mobility, achieving the maximum national income increase is possible by maintaining the interest rate at the original level. Therefore, fiscal policy is fully effective in the fixed exchange rate system under perfect capital mobility assumption.

The increase in aggregate demand is reversed by currency appreciation and a deterioration in net exports. As a result, fiscal policy is proven ineffective in a flexible exchange rate system with perfect capital mobility.

The impossible trinity hypothesis was first developed by J. Frankel in 1999. According to this hypothesis, free capital mobility, independent monetary policy, and fixed exchange rate policy cannot be implemented simultaneously in an economy

Mundell’s Allocation Rule: It expresses the view that it is appropriate to follow a fiscal policy change for internal balance problems and a monetary policy change for external balance problems

Export indicates demand from the world for the goods and services produced in the country.
The answer is E.

If ZZ is greater than DD, NX>0 implies a trade surplus.
The answer is D.

If DD is greater than ZZ, NX<0 implies a trade deficit.
The answer is D.

Assuming that the Marshall-Lerner condition holds, a real depreciation will improve NX and shift the IS curve to the right.
The answer is B.

With real appreciation, the IS curve shifts to the left, assuming that NX deteriorates with real appreciation.
The answer is C.

In the case of perfect capital immobility, the BP curve is a line parallel to the vertical axis.
The answer is D.

the BP curve is positively sloped in the case of limited capital mobility.
The answer is D.

In the case of perfect capital mobility, the BP curve is parallel to the horizontal axis (Figure 6.6 Panel C). In this case, there are no impediments to capital inflows and outflows. Capital can freely move in and out of the country towards where the interest yield is high.
The answer is C.

According to this hypothesis, free capital mobility, independent monetary policy, and fixed exchange rate policy cannot be implemented simultaneously in an economy.
The answer is E.

In an economy, if there are inflation and external deficit problems, the fiscal policy should be contractionary and the monetary policy should be contractionary.
The answer is B.

The aggregate demand (AD) curve shows the relationship between the price level and national income (or output).

However, the money market will be affected because unless the monetary authority immediately increases the money supply, the real money supply will decrease, shifting the LM curve upward.

We need to distinguish between aggregate supply in the long and short run. Like that of a sector or of one firm, and for the same reason, the short-run aggregate supply curve, AS_SR, has an increasing slope. The marginal product of labor declines as output increases, so producers need higher prices to produce more. Prices have nothing to do with the long-run aggregate supply, AS_LR, since all prices are fully flexible in the long run.

In an open economy, in addition to equilibrium in the goods and money markets, one must consider the external balance represented by the BP curve.

Suppose prices increase to P1. Unless the monetary authority immediately adjusts the money supply accordingly, the real money supply will fall, requiring a higher interest rate for money market equilibrium. LM curve shifts to LM1. Also, higher prices will render domestic goods more expensive. This will increase imports and decrease exports which will worsen the trade balance. To achieve external balance, capital inflow must increase, requiring a higher interest rate, so the BP curve shifts to BP1.

The adjustment process is completely different, with flexible exchange rates. The LM curve has no role because the monetary authority is not involved. A potential deficit in the BoP would trigger a domestic currency depreciation, shifting the BP curve rightward back to its original position. The depreciating currency would trigger an improvement in the trade balance; thus, the IS curve would shift rightward to where it used to be.

What role does fiscal policy have to play with fixed exchange rates? What happens when the government changes its spending level or alters taxes? The impact of changes in government spending or taxes will be on the IS curve. Increases in government spending (taxes) will shift the IS curve to the right (left) and vice versa.

Why would any government undertake expansionary fiscal policy in a recession and risk inflation? The simple answer is that it takes too long to reach full employment level, YN, without intervention.

Could monetary policy bring the economy out of recession with flexible exchange rates? In contrast to fixed exchange rates, monetary policy is effective with flexible exchange rates.

The aggregate supply curve shows the relationship between the price level and the quantity of goods and services produced.

The essence of the system was the use of gold and silver in international payments. In this system, the exchange rates are based on the coins in which the amount of gold and silver they contain. The benefit of this system, as the supply of gold and silver was limited, and the value of each material was also determined by the limited amount available worldwide, was to keep the money supply under control.

As a result, the exchange parities between currencies created a stable IMS, while each currency was defined via their gold parity in relation to each other. Gold constituted the most reliable measurement of the IMS. With this fixed-exchange rate, international trade found the opportunity to flourish and expand further.

On August 5, 1971, the US declared the end of a system in which the exchange between the dollar and gold could no longer happen. Since the relationship between gold and the dollar collapsed, there was no need for the Bretton Woods system any longer.

The main advantages of a free-floating exchange rate regime:

• Low requirement for international reserves


• Monetary policy independence


• No need for intervention

The main disadvantages of a free-floating exchange rate regime:

• Exchange rate risk


• Uncertainty

How Do Central Banks Affect Exchange Rates?
A country’s currency should have a stable value. Central banks’ main role is to ensure the stability of the value their domestic currencies. With the foreign exchange market intervention, many central banks either increase or decrease the key interest rate or buy or sell foreign currencies.

1. The key interest rate movements

When the demand for money is high, a central bank decreases the interest rate, then the country’s currency appreciates. As a result, the demand for money lowers. When the demand for money is low, a central bank increases the interest rate, then the country’s currency devaluates. As a result, the demand for money rises.

2. Foreign currency movements

Central banks conduct foreign exchange market intervention, buying or selling domestic currencies in the foreign exchange market. For example, whenever any central bank buys the US dollar, it increases demand for the US dollar, thereby strengthening the value of the dollar against the domestic currency. When any central bank sells the US dollar, it increases the supply of the US dollar, thereby weakening the value of the dollar against domestic currency.

3. The currency peg

A currency peg is a policy in which a national government or central bank sets a fixed exchange rate for its currency with a foreign currency. For example, the central bank of China follows this strategy

The Federal Reserve Bank (FED), established in 1913 by the Federal Reserve Act, is the central banking system of the United States.

Every country has an institution responsible for the country’s monetary policy, which is called a central bank. A central bank manages the country’s currency and regulates the money supply. The key objective of a central bank is to maintain price stability in the country.

There are four types of independence for central banks; goal independence, functional independence, financial independence and institutional independence. Goal independence for the central bank means that the central bank will be independent in choosing targets and policies. Functional independence for the central banks means they will be independent in selecting their policy instruments to reach their targets and policies. Financial independence means that the central banks are independent in determining their budget and financial resources. Central banks are institutionally independent of pressures and free from all political parties.

Apart from Steinberg and Walter (2013), many other studies were also conducted in the central bank independence literature. In their study, Alesina and Summers (1993) also showed that when central banks act independently like the Bundesbank, they score lower inflation and higher output levels. Acemoglu et al. (2008) used the case of the CBI to illustrate independent central banks with currency reforms. Fraccaroli, Sowerbutts & Whitworth (2020) conducted an empirical study and found that the benefits of central bank independence for economies are far more than we can account to list.

What are the Risks of Foreign Exchange Intervention?
If a central bank intervenes in the economy, it can increase the market risk factor. The reasons for this risk are; reversal of capital flows, speculative attacks, loss of independence, hoarding and capital controls.

1. Reversal of capital flows

A central bank buying a currency could lead to a devaluation.

2. Loss of independence

If government decisions influence a central bank’s actions, the central bank may lose credibility.

3. Hoarding

Domestic currency may be subject to hoarding if a central bank buys foreign currencies in large volumes.

4. Speculative attacks

If the actions of a central bank are viewed as inconsistent more speculative attacks can be experienced.

5. Capital controls

It is easy to violate capital controls when a central bank buys large volumes of foreign currencies.