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THE THEORY AND PRACTICE OF

INTERNATIONAL FINANCIAL
MANAGEMENT

Dr. Yasser Alhenawi

Foreign Exchange Market Concepts

What is Exchange Rate?

An exchange rate is the price of the base currency expressed in terms
of the price currency.
Price/Base
USD/EUR = 1.3650 means that
You need $1.3650 to buy one euro
The price of the Euro is $1.3650
Think about it this way
The price of one bottle of milk is $1.3650
You need $1.3650 to buy one bottle of milk
Important note
This is the notation used in the CFA curriculum. Other sources might use
different notation (exact opposite). See note on page 10.
For example, www.finance.yahoo.com uses the opposite quoting
convention

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Types of Rate
Spot Rate
For settlement on the second business day T+2
At an exchange rate agreed on today
Two-Sided Price Quotation
Bid Price
The price, in price currency, at which the counterparty is willing to buy one unit of the
base currency.
So, this is how much you earn for selling the base currency if you decided to hit the
bid (Jargon)
Ask Price (Offer Price)
The price, in price currency, at which the counterparty is willing to sell one unit of the
base currency.
So, this is how much you pay to acquire the base currency if you decided to pay the
offer (Jargon)

BID < ASK

Types of Rate

Example
The following spot rate is quoted by ONB
USD/EUR exchange rate of 1.3648/1.3652
Bid Price is 1.3648
ONB is willing to buy one Euro for 1.3648 Dollar.

Ask Price (Offer Price) is 1.3652

ONB is willing to sell one Euro for 1.3652 Dollar.

BID < ASK

Types of Rate
Ask Bid = Spread
Compensation that the counterparty, i.e. the dealer, seeks
Interbank Market

Large Ask = 1.3651 Ask = 1.3652

global
network of 2 pips ONB 4 pips Customer
exchange
rate Bid = 1.3649
Bid = 1.3648
participants

Participants include, banks, governments, investors, portfolio managers,

etc.

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Types of Rate
Ask Bid Spread
Always positive
Always wider in the retail market
What determines the bid-offer spread? (Keep in mind that it is the dealers
profit)
Liquidity
High for major currencies narrower spread
High when major markets are open narrower spread
Low for volatile markets wider spread
Size of transaction
Spread is smaller for larger transactions
Relationship
Tighter spread is granted to frequent/large customers

Arbitrage
Definition
riskless opportunity to make profit
1. Interbank Market Arbitrage (Locational Arbitrage)
Dealers Bid cannot be higher than market Ask
Dealers Ask cannot be lower than market Bid

Imaging this hypothetical (non-realistic) situation

Large Ask = 1.3651 Ask = 1.3654

global
network of 2 pips ONB 2 pips Customer
exchange
rate Bid = 1.3649
Bid = 1.3652
participants

This situation cannot last for long because of arbitrage

Arbitrage
Visualization of Locational Arbitrage

Market
Bid Ask

Dealer Dealer
Bid Ask Bid Ask
Dealer Dealer
Bid Ask Bid Ask

Arbitrage is Arbitrage is Arbitrage is Arbitrage is

Possible NOT NOT Possible
Possible Possible

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Arbitrage
2. Cross Rate Arbitrage (Triangular Arbitrage)
Dealers Bid cannot be higher than implied cross-rate Ask
Dealers Ask cannot be lower than implied cross-rate Bid

What is a cross-rate?
Suppose the following is known i.e. we obtain the following quotes from the market:
USD/EUR is 1.3649/1.3651
JPY/USD is 76.64/76.66
Then, we know that the following must be true


=

= 76.64 1.3649 = 104.61


=

= 76.66 1.3651 = 104.65
Therefore,
the implied (or appropriate, or fair, or equilibrium) exchange rate JPY/EUR is
104.61/104.65
Keep in mind that it may be necessary to invert one of the quotes in order to
complete the calculation. The example on next slide illustrate this case.

Dealers Bid cannot be higher than 104.65

Dealers Ask cannot be lower than 104.61
If it happens, it will not last long because of arbitrage

Arbitrage
Visualization of Cross Rate Arbitrage (Triangular Arbitrage)

Cross-rate
Bid Ask

Dealer Dealer
Bid Ask Bid Ask
Dealer Dealer
Bid Ask Bid Ask

Arbitrage is Arbitrage is Arbitrage is Arbitrage is

Possible NOT NOT Possible
Possible Possible

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1, 2 ,3

2, 3 ,1

1, 3 ,2

Forward Markets
Spot Rate
For settlement on the second business day T+2
At an exchange rate agreed on today
Forward Rate
For settlement on a future date
At an exchange rate agreed on today
Why? Who uses them? Who needs them?
Hedge exposure to exchange rate risk
Avoid risk associated with exchange rate movements
Focus on your business and do not care about fluctuation
Speculate on future exchange rate movements
Make profit from anticipated exchange rate movements
Your business is to watch, analyze, and capitalize on fluctuation in currency exchange
Hedge
Hedge imports by locking in the rate at which they can obtain the foreign currency
needed in the future
Forward buy
Hedge against foreign currency appreciation
Hedge exports by locking in the rate at which they can sell the foreign currency
received in the future
Forward sell
Hedge against foreign currency depreciation

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Forward Markets
Quotation

Notes:
1
1. Forwards are quoted in points. Each point is of the spot rate.
10,000
Illustration:
If a market participant wants to sell the EUR forward against the USD and wishes to make
the settlement in three months.
15.9
He would receive 1.3549 + 10,000
= 1.35331 dollars
1.35331 is called all-in rate forward rate (i.e. incorporates both spot and forward points)
2. Bid < Ask (the Forward discounts also reflect this fact).
3. The absolute number of forward points is an increasing function of maturity
4. Only standard dates are quoted. However, this is an OTC market which means that
a client can negotiate any non-standard maturity (referred to as broken dates).
5. The quoted points are already annualized and, therefore, there no need for any
adjustment.

Forward Markets
What determines the bid-offer spread for forward contracts
The same three factors for the spread in spot rates
Liquidity
Size of transaction
Relationship with client
Additional forth factor
Longer maturity wider spread
Why?
Longer maturity less liquidity
Longer maturity more risk exposure (counterparty credit risk)
Longer maturity more risk exposure (interest rate risk)

Forward Markets
In Forward Contracts, we may conventionally use Foreign/Domestic
instead of Price/Base
Forward rate is a function of
Spot rate /
Risk-free interest rate in the home country
Risk-free interest rate in the foreign country
Forward rate is given by the Covered Interest Rate Parity

1 +
360
/ = /

1 + 360

Derivation is available on Page 18. Read it! It explains the intuition behind the
formula. I will not ask you to do the mathematical derivation in exam. However, I
may ask questions related to the intuition of the formula.
The difference between spot rate and forward rate is called Forward
Premium

360
/ / = / ( )

1 + 360

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Forward Markets
Marking to Market
Mark-to-market value reflects the profit (or loss) from closing out the position
at current market price
Mark-to-Market value equals zero when the contract is initiated
After that, mark-to-market value changes as a result of changes in:
Spot Rate /
Risk-free interest rate in the home country
Risk-free interest rate in the foreign country
Illustration
see next slide

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A Long-Term Framework for

Exchange Rates

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The Framework
Future outlook
Hedge exposure to exchange rate risk
Avoid risk associated with exchange rate movements in the future
Speculate on future exchange rate movements
Make profit from anticipated exchange rate movements in the future

Long-term Horizon
Parity Conditions
inter-relationships between key factors
Forward rates
Current spot Rates
Expected future spot rates
Interest rate differentials, and
Inflation differentials.

Basic Concepts
1. Long-run vs short-run
Longer-term equilibrium values act as an anchor for exchange rate movements
Short-term movements are random and almost impossible to predict
Parity conditions govern long-term equilibriums

Basic Concepts
2. Real vs. Nominal Interest Rates
Only nominal interest rates are observable and tradable
Nominal interest rates movements reflect
Real interest rate movements, AND
Inflation expectations
The factors that we discuss affect real, i.e. inflation-adjusted, rates NOT nominal
rate.
The distinction between the two is important
3. Expected vs. Unexpected Changes
Market prices move slowly to reflect slow changes in market participants'
expectations of future developments that result from current trends in key factors
(e.g. increasing/decreasing interest rate in a particular country).
Unexpected changes in any key factor can lead to immediate price adjustments.
Unexpected changes risk investor demand higher return (risk premium) higher
return lower prices
We do not consider unexpected changes
4. Relative Movements
The levels of key factors are much less important that the difference in these
factors across countries.
Increasing inflation in U.S. not much insight on USA/GBP without also knowing what is
happening with inflation in U.K.

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Word of Caution
There is no simple formula, model, or approach that will allow market
participants to precisely forecast exchange rates (or any other financial
prices) or to be able to make all trading decisions profitable.

We live in an imperfect world where exchange rates and other financial

prices can be highly erratic and hard to explain even after the fact, let alone
predict in advance.

Nonetheless, to operate in financial markets requires acceptance of these

imperfections. It also requires that market participants have a market view to
guide their decisions, even if this view requires significant revision as new
information becomes available.
Institute, CFA. 2015 CFA Level II
Volume 1 Ethical and Professional Standards, Quantitative Methods, and Economics.
And this is why Finance is so much FUN! And this is why financial analysts are
amongst the top highly respected and highly compensated professionals.
Yasser Alhenawi, Ph.D.

International Parity Conditions

1. covered interest rate parity;

2. uncovered interest rate parity;

3. forward exchange rates as unbiased predictors of future spot exchange

rates;

4. purchasing power parity;

5. the Fisher effect;

6. the international Fisher effect; and

7. real interest rate parity.

International Parity Conditions

Most empirical studies find that the key international parity conditions rarely
hold in either the short or medium term.

Why bother to study them at all if they do not work?

First, although the conditions are frequently violated, each reflects economic
forces that should not be ignored altogether.
Second, and perhaps even more importantly, international parity conditions truly
become interesting only when they fail to hold.
because it is only then that currency positions offer profitable opportunities.

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International Parity Conditions

1. covered interest rate parity;
We covered it when we discussed forward rates
Forward prices, for a certain maturity, should reflect the fact that investors can
invest at risk-free rates in both countries over the same time period.
Look at the formulas

1 + 360
/ = /

1 +
360

360
/ / = / ( )

1 +
360
Any disparity, i.e. deviation from the parity-determined price, would be quickly
arbitraged away by the actions of alert market participants.
Assumptions:
Zero transaction cost
Both currencies are identical in liquidity and default risk
Free flow of cash

International Parity Conditions

2. Uncovered interest rate parity
The change in spot rate, over a certain time horizon, should reflect the fact that
investors can invest at risk-free rates in both countries over the same horizon.
Notice the similarity between this definition and the one in the previous slide.
Therefore, forward exchange rate is an unbiased predictor of the future spot rate.
Formula:

%/ =

Note the e which stands for expected.

Derivation is available on Page 31. Read it! It explains the intuition behind the formula. I will
not ask you to do the mathematical derivation in exam. However, I may ask questions on
the intuition of the formula.

Any disparity, i.e. deviation from the parity-determined price, would be quickly
arbitraged away by the actions of alert market participants.
Assumptions:
Investors are risk-neutral
Zero transaction cost
Both currencies are identical in liquidity and default risk
Free flow of cash

International Parity Conditions

2. Uncovered interest rate parity
Implications
The country with the higher interest rate or money market yield is expected to see the
value of its currency depreciate.
It is this depreciation of the currency that offsets the higher yield.
Rules out the possibility of earning excess returns from going long a high-yield currency and
going short a low-yield currency.
Investors have no incentive to shift capital from one currency to another
Reality
uncovered interest rate works well over very long-term horizons.
Most studies find that it does NOT hold over short- and medium-term periods,
high-yield currencies have been found to strengthen, not weaken
Why?
Higher demand for fixed-income securities denominated in the foreign currency
high demand for the foreign currency.
This creates an opportunity called: FX Carry Trade. We will cover this in more details
later.

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International Parity Conditions

3. Spot and Forward Rates as Predictors of Future Spot Rates
If exchange rates follow a random walk, then current spot rate is a good predictor
of future spot rate.

/ = /
Given the similarity between the covered interest rate parity equation and the
uncovered interest rate parity equation, we conclude that forward rate is a good
predictor of future spot rate.

/ /
= %/
/

/ = /

Note the e which stands for expected.

Derivation is available on Page 32. Read it! It explains the intuition behind the formula. I will
not ask you to do the mathematical derivation in exam. However, I may ask questions on
the intuition of the formula.

Reality
Forward rates are poor predictors of future spot rates because spot exchange rates are
volatile and determined by a complex web of influences
Current spot rates are poor predictors of future spot rates because spot exchange rates
are volatile and determined by a complex web of influences

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International Parity Conditions

4. Purchasing Power Parity (PPP)
Law of one price (Absolute PPP)
Identical goods should trade at the same value across countries, therefore the price of good x in the
foreign country should be given as:

= /
Therefore,
/ = /
Relative PPP
Changes, not levels, in values of goods should be the same across countries and therefore the change in
spot rate equals the difference in inflation between the two countries

%/
Ex ante PPP

%/

Implications
The country with the higher expected inflation rate is expected to see the value of its currency
depreciate.
It is this depreciation of the currency that offsets the higher inflation.
Rules out the possibility of earning excess returns from buying in low-inflation county and selling in high-
inflation country
Investors have no incentive to trade based on inflation only
Reality
although over shorter horizons nominal exchange rate movements may appear haphazard, over longer
time horizons nominal exchange rates will tend to gravitate toward their long-run PPP equilibrium value.
See graphs on next slide

International Parity Conditions

5. The Fisher Effect and Real Interest Rate Parity
Fisher effect
one can break down the nominal interest rate ( i ) in a given country into two parts:
(1) the real interest rate in that particular country ( r ) and
(2) the expected inflation rate () in that country
Therefore,
= +
= +
More importantly, real interest rate parity states that real interest rates are identical across
countries
=
Hence the International Fisher Effect:
=
Reality
It works in long-run horizons

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International Parity Conditions

Summary

1+
1. Covered IRP: / = / or / /
1+

2. Uncovered IRP %/ = for a risk neutral investor
3.

Random walk / = /
/ /
If 1 and 2 hold = %/ or / = /
/

4. Ex ante PPP %/
5.
Fisher effect = + and = +
Real IRP =
International Fisher Effect =

How do they effect exchange rates?

1. They work together
2. They are interrelated
3. They hold in the long-run
See graph on next slide

International Parity Conditions

6. International Parity Conditions: Tying All the Pieces Together

,

%/ =

Real Interest Rate / /
Parity = ( )
/

International Parity Conditions

6. International Parity Conditions: Tying All the Pieces Together
Exhibit 4 shows that if all the key international parity conditions held at all times,
then the expected percentage change in the spot exchange rate would equal
the forward premium or discount (expressed in percentage terms);
the nominal yield spread between countries; and
the difference in expected national inflation rates.
More importantly,
if all these parity conditions held, it would be impossible for a global investor to earn
consistent profits on currency movements.
Reality
Parity conditions hold in the long-run but no in the short- and medium-run.

See exercise 6. (Important for exam!!!)

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Assessing an Exchange Rates Equilibrium Level

Tying It Together: A Model That Includes Long-Term

Equilibrium

Self-read

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The Carry Trade

Intro
Uncovered interest rate parity:
high-yield currencies are expected to depreciate in value
low-yield currencies are expected to appreciate in value
investors cannot profit from a strategy that undertakes long positions in baskets
of high-yield currencies and short positions in baskets of low-yield currencies.
Academic studies suggest that uncovered interest rate parity does NOT
hold over short- and medium-run time periods
Investors can potentially profit from FX Carry Trade Strategy.

How/why?
taking on
long positions (i.e. invest) in high-yield currencies and
Short positions (i.e. borrow) in low-yield currencies (the funding currencies)

It violates uncovered interest rate parity i.e. it assumes that currencies do NOT adjust in
the way described
It works in the short- and medium-term and generates positive returns

Why it exists?
Compensation for shifting investments to a more unstable economy
During turbulent periods
the realized returns on high-yield currency tend to decline dramatically
The realized returns on low-yield currency tend to rise just as dramatically
during periods of low volatility, carry trades tend to generate positive excess returns, but they are
prone to significant crash risk in turbulent times
It is a leveraged position (i.e. very little equity is required to open the position)
Inherently risky because investors in leverage positions are extremely sensitive to market
movements (i.e. they liquidate positions fast)
Volatile Risky more return
Interest rates are not completely influenced by market forces
A central bank might raise/lower rates abruptly for economic reasons (slow down/ boost
economic activities) and even non-economic reasons (e.g. lower interest rate in pre-election
season).

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Earn an Extra 2 Points

What to do?
Re-do the calculation above assuming that
The JPY did not change (i.e. future spot rate remains at todays level of 81.30)
The AUD has FULLY depreciated as the uncovered interest rate parity predicts (i.e. it
depreciated by 4.5% - 0.1% = 4.4%).

Rules
Use the same format above to show that when the AUD fully depreciates there will
be no (or very minimal) return of this Carry Trade strategy.
Submit next class on a single page following the same format presented above
I need to see the exact same steps with numbers
Do not forget to write your name

Earn an Extra 1 Points

What to do?
Re-do the calculation above assuming that
The JPY responded in a manner consistent with uncovered interest rate parity but the AUD did not
change.
Rules
Same as above

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The Impact of Balance of Payments

Flows

Current Account Imbalances and the

Determination of Exchange Rates

Definition
The current account balance of a country represents the sum of all recorded
transactions in traded goods, services, income, and net transfer payments in a
countrys overall balance of payments.

Influence on Exchange Rates

Countries that run persistent current account deficits (surpluses) often see their
currencies depreciate (appreciate) over time.

Mechanisms
1. The flow supply/demand channel
2. The portfolio balance channel
3. The debt sustainability channel

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Current Account Imbalances and the

Determination of Exchange Rates
1. The flow supply/demand channel
Mechanism
Purchases and sales of internationally traded goods and services require the exchange of
domestic and foreign currencies impact on the supply and demand of currencies

Current account deficit in U.K. implies that the demand for U.K.s goods has fallen
recently
But when demand for goods falls, this also means that the demand for falls
depreciates (short-run) U.K. goods now look cheaper to other countries improves
trade competitiveness eliminate deficit (long-run)

Current account surplus in U.K. implies that the demand for U.K.s goods has risen
recently
But when demand for goods rises, this also means that the demand for rises
appreciates (short-run) U.K. goods now look more expensive to other countries
deteriorates trade competitiveness eliminate surplus (long-run)

Current Account Imbalances and the

Determination of Exchange Rates
1. The flow supply/demand channel

The amount by which exchange rates must adjust to restore current accounts to
balanced positions depends on a number of factors:
1. The initial gap between imports and exports,
Reality:
If the gap is too large, changes in currency rates, alone, will not be sufficient to
correct the trade imbalance
2. The response of import and export prices to changes in the exchange rate
Reality:
Empirical studies find that changes in currency value do NOT drive proportional
change in prices
3. The response of import and export demand to the change in import and export prices.
Reality:
Empirical studies find that the response of demand is sluggish

Current Account Imbalances and the

Determination of Exchange Rates
2. The portfolio balance channel
Mechanism
This channel refers to the transfer of financial wealth among nations.
A surplus indicates that wealth is coming in
A deficit indicates that wealth is traveling out
Transfer of wealth takes place in the form of buying/selling financial assets (stocks and
bonds) denominated in the countrys currency exert a marked impact on the path of
exchange rates.

Current account deficit in U.K. implies that the demand for U.K.s securities has
fallen recently
But when demand for securities falls, this also means that the demand for falls
depreciates (short-run) U.K. securities look more attractive to other countries
(low price high return) eliminate deficit (long-run)

Current account surplus in UK implies that the demand for UKs securities has risen
recently
But when demand for securities rises, this also means that the demand for rises
appreciates (short-run) UK securities look less attractive to other countries
(high price low return) eliminate surplus (long-run)

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Current Account Imbalances and the

Determination of Exchange Rates
3. The debt sustainability channel
Mechanism
There should be some upper limit on the ability of countries to borrow from foreign
investors
If a countrys net external debt (as a percent of GDP) approached what investors
believe is an unsustainable level, they are likely to re-consider their position and
ultimately lower their investments in its debt assets (bonds) depreciation of
the deficit countrys currency

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Capital Flows and the Determination

of Exchange Rates
Global financial flows either caused or contributed to overshooting
exchange rates, interest rates, or asset price bubbles.
See examples in the book.
Emerging market policymakers have made a concerted effort in recent
years to:
Resist such inflows through the use of capital controls AND/OR
Prevent capital inflows from pushing currency values to overvalued levels (by
intervening heavily in the foreign exchange market)

We will look at three examples

1. Real Interest Rate Differentials, Capital Flows, and the Exchange Rate
2. Interest Rate Differentials, Carry Trades, and Exchange Rates
3. Equity Market Trends and Exchange Rates

Capital Flows and the Determination

of Exchange Rates
1. Real Interest Rate Differentials, Capital Flows, and the Exchange Rate
Consider the following relationship:

/ / =

/ = real exchange rate

/ = long-term equilibrium of real exchange rate
= real interest rate differential
= risk premium differential

What it says?
Movements in the real exchange rate / around its long-run equilibrium value / is
caused by:
Movements in real interest rate and
Movement in risk premia differentials
See graphs on next slides

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Capital Flows and the Determination

of Exchange Rates
1. Real Interest Rate Differentials, Capital Flows, and the Exchange Rate
The Turkish lira versus the US dollar over the 20022010 period
The lira attracted a lot of interest of global fund managers because of its attractive yield
levels of 1,000 basis points (i.e. 10%).
As capital flowed into Turkey, the Turkish authorities intervened in the foreign exchange
market in an attempt to keep the value of the lira broadly stable.
As a result, international investors were not able to reap much in terms of currency gains
over this period. Nevertheless, they were able to capture the high yields of a carry trade
position.

What would have happened if the Turkish government did not intervene?
Demand for Turkish securities would have drive the price of the lira up.
This would have eliminated much of the high return on the long run but created
tremendous opportunities for short-term currency traders
This would have increased volatility of lira prices which is not what any government likes
to see happening to its currency.

Capital Flows and the Determination

of Exchange Rates
2. Interest Rate Differentials, Carry Trades, and Exchange Rates
Consider the following relationship again:

/ / =

But this time let us replace real interest rate with nominal rate minus inflation

/ / =

What it says?
Movements in the real exchange rate / around its long-run equilibrium value / is
caused by:
Movements in nominal interest rate
Movement in expected inflation
Movements in risk premia differentials

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Capital Flows and the Determination

of Exchange Rates
2. Interest Rate Differentials, Carry Trades, and Exchange Rates
Application:

/ / =

If a foreign government wants to promote economic growth, they may increase

nominal rate to attract foreign investment in their currency.
An increase in nominal interest rate also implies an increase in expected inflation.
Combined with risk premium, these effect may drive the value of their currency
up.
Therefore, they must
Either stabilize the currency by direct intervention in the market AND/OR
Take other measures, beside interest rate increase, such as changing the investment
environment.

Capital Flows and the Determination

of Exchange Rates
3. Equity Market Trends and Exchange Rates
instability in correlation between exchange rates and equity markets makes it
difficult to form judgments on possible future currency moves based solely on
expected equity market performances

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Monetary and Fiscal Policies

Intro
Definitions
Monetary Policy
changing the interest rate and influencing the money supply
Lower interest rate more investment and spending boost the economy
Fiscal Policy
changing tax rates and levels of government spending to influence aggregate demand in
the economy
Lower taxes AND/OR more government spending increase output boost the
economy

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The MundellFleming Model

Monetary Policy
changing the interest rate and influencing the money supply
Lower interest rate more investment and spending boost the economy
But at the same time
Lower interest rate capital outflow (investors take their capital somewhere else) less
demand for domestic currency it exerts downward pressure on exchange rate

Fiscal Policy
changing tax rates and levels of government spending to influence aggregate
demand in the economy
Lower taxes AND/OR more government spending increase output boost the
economy
But at the same time
It increases budget deficits increase the need for financing it exerts upward pressure
on interest rates capital inflow (investors bring their capital in) upward pressure on
exchange rate

The MundellFleming Model

Insights:
1. Policymakers cannot achieve the following three objectives at the same time
(1)pursue independent monetary policies,
(2) permit capital to flow freely across national borders, and
(3) commit to defend fixed exchange rates
2. Policymakers should be aware that monetary and fiscal policies influence
capital flow
This is why emerging market economies often impose capital control while executing
monetary policies.
3. Policymakers should be aware that monetary and fiscal policies influence
exchange rates
Restrictive (expansionary) monetary policy local currency appreciates (depreciates)
Restrictive (expansionary) fiscal policy local currency depreciates (appreciates )

See graphs on next slides

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The MundellFleming Model

Keep in mind that the discussion so far has assumed that capital movement
is free. When capital mobility is low, the impact of monetary and fiscal
policies will differ

Homework,
Using the same logic above, explain the effects illustrated in the graph on the next slide.

The MundellFleming Model

Summary
Exhibit 7 is more relevant for the G10 countries because capital mobility tends to
be high in developed economies.
Exhibit 8 is more relevant for emerging market economies that restrict the
movement of capital.

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