Learning Module 7
Capital Flows and the FX Market
Key Outcomes Summary & Practice Problems
What you must be able to do
Curriculum Year: 2026
Describe the foreign exchange market, including its functions and participants; distinguish between nominal and real exchange rates; calculate and interpret percentage change in a currency relative to another.
Describe exchange rate regimes and explain the effects of exchange rates on countries' international trade and capital flows.
Describe common objectives of capital restrictions imposed by governments.
1 · The Foreign Exchange Market
Market Size — Largest market; daily turnover ~USD6.6 trillion (2019). Operates 24 hours.
Participants — Sell side: large FX trading banks (e.g., Citi, UBS, Deutsche Bank). Buy side: corporate accounts, real money accounts (pension funds, mutual funds), leveraged accounts (hedge funds, CTAs), retail accounts, governments, central banks, sovereign wealth funds.
Instruments — Spot, outright forwards, FX swaps (largest volume), FX options.
Quoting Conventions — Price currency/base currency. Direct/indirect quotes. Two-sided prices (bid/offer).
Nominal vs Real Exchange Rates — Real exchange rate = Sd/f × (Pf / Pd). Reflects relative purchasing power.
Rd/f = Sd/f × (Pf / Pd)
An increase in R means domestic currency has depreciated in real terms.
2 · Exchange Rate Regimes
Adopting another currency (usually USD) as legal tender. No independent monetary policy.
Fixed parity with 100% foreign currency reserves backing the monetary base (e.g., Hong Kong SAR).
Exchange rate pegged to a single currency or basket; discretionary reserves; possible adjustments.
Fixed parity with wider intervention bands (±2%).
Exchange rate adjusted frequently (passive or active) to manage inflation or maintain competitiveness.
Market-determined but with occasional intervention ("dirty floating").
Market-determined; independent monetary policy (e.g., US, euro, yen).
Ideal Currency Regime — Credibly fixed rates + full convertibility + independent monetary policy — impossible (trilemma).
Trade Balance and Capital Flows — Trade deficit = capital account surplus; capital flows are primary determinant of short- to medium-term exchange rates.
3 · Capital Restrictions
Objectives — Protect against capital flight, maintain monetary independence, address macroeconomic crises, strategic/defense reasons.
Types — Taxes, quantity controls, price controls, outright prohibitions on international asset trade.
Effectiveness — Mixed results; can provide temporary relief but may distort markets and deter investment.