International Finance and Exchange Rates: Parity, Regimes, and Adjustment
Balance of payments
A double-entry record with three parts: the current account (goods, services, income, unilateral transfers), the financial/capital account (direct investment, portfolio flows, bank flows), and official reserves. A current-account deficit is matched by net capital inflow or reserve loss. The accounts always balance in an accounting sense; the question is which component adjusts.
Exchange rates
An exchange rate is the price of one currency in another. Appreciation makes exports dearer and imports cheaper, hurting exporters and helping importers. Quoting conventions matter: in a direct quote (dollars per euro), a rising number means the euro appreciates.
Parity conditions
Purchasing power parity holds that exchange rates adjust so identical baskets cost the same; it works better long run than short run. Interest rate parity: the forward premium or discount equals the interest differential, so covered arbitrage yields no riskless profit. Nominal interest differentials also reflect expected inflation differentials.
Regimes and adjustment
Floating rates clear through supply and demand. Fixed rates require the central bank to buy or sell reserves to defend the peg, which subordinates monetary policy - the impossible trinity says a country can have only two of a fixed rate, free capital flows, and independent monetary policy. A currency board fixes the rate by holding foreign reserves equal to the monetary base, surrendering monetary independence entirely. Devaluation is a deliberate fixed-rate change; depreciation is market-driven. The J-curve says a devaluation worsens the trade balance at first, then improves it if the Marshall–Lerner condition holds (import plus export elasticities exceed 1).
Worked example
US rates are 5%, euro rates 2%, spot is $1.10/€. Covered parity implies a forward rate of 1.10 × (1.05/1.02) ≈ $1.1324/€ - the euro trades at a forward premium because the dollar interest rate is higher.
Traps
Assuming a stronger dollar always helps the economy; confusing devaluation with depreciation; expecting PPP to hold month to month; reversing the direction of the forward premium.