International Finance - Essay Example

? International finance Table of Contents  International finance Table of Contents 2 Answer to Question 3 Answer to Question 2 4 Answer to Question 3 6 Answer to Question 4 7 Answer to Question 5 9 Answer to Question 6 10 References 11 Answer to Question 1 The International Monetary and Financial Conference of the United and Associated Nations, commonly known as the Bretton-Woods Conference after the name of the location where it was held, had been summoned during July, 1944. The primary objective of the conference had been to incorporate robustness into the world financial system. Most of the nations around the world had been victimised at that time by the aftermath of World War and needed a structured financial system to help them stand upright. In fact, the creation of International Bank for Reconstruction and Development (IBRD) as well as the International Monetary Fund (IMF), had both been the consequences of the conference. The innate characteristics of the conference had been – Firstly, the conference stressed upon the fixation of upper and lower limits for the exchange rates of any domestic currency. Such a system would help in reducing possibilities of financial distress owing to fluctuations in the rate of exchange. The upper and lower limits of the rate of exchange are on the other hand, made the domain of the national government with regard to their respective current account positions. To be precise, the domestic governments were allowed to make adjustments to up to 10% below or above the pegged rates of exchange. The domestic currency of any nation was made completely convertible with any other currency to ease foreign trade. Lastly, all nations were made members to the International Monetary Fund so as to make the latter’s task easier to conduct at times when a financial crisis takes place. The system collapsed during 1970s, though that did not mean that the whole world converted itself into a system of floating exchange rates. For instance, the nations underlying European Union follow a fixed exchange rate regime where they maintain a fixed rate of exchange with the Euro as well as between themselves (Alderman, 2011, ‘Europe’s Challenge: Fostering Growth Amid Austerity’). Answer to Question 2 According to the concept of uncovered interest rate parity (UIP), the difference between the rates of returns on domestic and foreign bonds must be equal to the expected change in the rate of exchange between the two concerned currencies. Technical representation indicates, RD – RF = E(ed) Where, RD = Rate of interest from domestic bonds. RF = Rate of interest from foreign bonds and E(ed) = Expected change in the rate of exchange. In case that the difference exceeds the expected change in the rate of exchange, there arises scope for reaping profit through arbitraging. As soon as any channel for making profit arises, investors try to make full use of the same, till the point when any further scope of reaping profits get exhausted. Hence, it could easily be said that even if there exists differences in the rate of returns from domestic and foreign bonds, it is only a short run phenomenon. In the long run however, the differences arising out of this avenue is depleted which is why it is often said that the foreign and domestic bonds are perfect substitutes of each other. During the long run thus, E(ed) equals ‘0’ though during short run fluctuations, they might be positive or negative. When the difference is positive, investors are more attracted towards investing in domestic bonds until the rate of interest offered falls to equate with those offered in the foreign bonds. According to the portfolio balance model, the equilibrium rate of exchange is determined by the demand and supply schedule characterising the domestic and foreign bonds. The diagram alongside depicts the mechanism defining the portfolio balance model framework. However, if this particular assumption is relaxed, the responsibility that the rate of exchange is entitled to attract investment in a nation gets exhausted. On the other hand, rate of interest then has the utmost responsibility of attracting investors to invest in domestic resources. In such cases hence, monetary authorities implement expansionary policies through enhancing the rate of interest rather than depreciating the rate of exchange. Answer to Question 3 Economies which follow a system of making up their current account deficits by means of borrowing from abroad are likely to end up in debt traps which ultimately lead them towards a fatal collapse. Since 1982, the economy of USA had been continuing with such a regime and today it has ended up with a large current account deficit. However, the nation is likely to end up in a situation of debt trap if such a mechanism is followed for a prolonged period. Normally, the borrower nations have to make hefty interest payments to their creditor nations which take a toll upon their financial positions. The amount that the former pays as interest depends upon its credibility that again depends upon the current account position. Portugal and Spain are two examples of nations which had been entangled into debt traps through ruthless borrowing activities to cover up their current account deficit. On the other hand, the government of Japan is regarded to be one that has the largest debt volume in the world (BBC News, 2010, ‘Japan agrees record 92.4 trillion yen draft budget’). However, the difference between USA and Japan is that while the latter compensates its debts through national savings, USA does not make any attempt to do the same. Hence, the economy of USA is regarded to be in a potentially threatening position. Answer to Question 4 Mundell-Fleming model is the modified version of the IS-LM model, incorporating for the global economy as well. While the latter accounts only for the determinants of aggregate demand in the domestic environment, the former includes the demand arising in the foreign markets as well. Implementation of monetary and fiscal policies in this model is found to throw different impact upon the economies depending upon their exchange rate regime. Fixed Exchange Rate An expansionary fiscal policy in the form of a rise in government expenditures would lead to a rightward shift in the IS curve to represent a rise in the aggregate production. However, that would mean a rise in the domestic rate of interest thus facilitating the inflow of foreign funds. While accumulation of foreign reserves serves in strengthening the exchange value of the currency, it actually leads to a fall in the volume of exports thus reducing the amount of net exports. But, as the exchange rate is fixed so the monetary authorities control the supply of domestic money through buying them against foreign reserves. Such a measure pushes the LM curve to the right as well so that rate of exchange is restored. However, in the process, the volume of domestic production rises. Monetary policies taken amidst fixed exchange rate regime do not create much impact upon the economy. Any expansionary or recessionary monetary policy creates an impact over the domestic supply of money. This is when the national authorities adjust the volume of domestic currency at the expense of foreign currencies so that there is no final impact upon the economy. This is the macroeconomic trilemma facing economic policy makers which impose that a combination of fixed exchange rate, free capital movement and an independent monetary policy cannot be combined together. Flexible Exchange Rate Expansionary fiscal policies in this case pushes the IS curve to the right thus leading to a rise in the local rate of interest. The mechanism is almost similar to that in the case of fixed exchange rate. The only difference lies in the fact that there is no urgency on part of the government authorities to purchase domestic currencies. Instead, there is a rise in volume of net exports given that the rate of exchange is depleted. Expansionary monetary policy on the other hand, leads to a rightward shift in the LM curve instigating the IS curve to shift as well. Hence, the rate of exchange is depreciated and thus, there is a rise in net export volume as well. Answer to Question 5 The financial crisis of 1997 had been a devastating experience for most of the East Asian countries. It had occurred at a time when these very nations had been experiencing a height of economic growth. In fact, these economies were at that point of time featured by high output growth, low inflation and low budget deficits which would lead anyone to presume their considerably robust financial and economic position. However, the global vision crashed down as the economies collapsed following the depreciation of Thai Baht. When Thailand submerged under the debt burden from the USA, the government authorities decided to remove its peg with USD which aggravated the problem of the nation as the domestic currency further depreciated in value. The devaluation of currency negatively affected expectations of international investors towards East Asian nations and led to a massive capital flight from the region. Absence of ample funds for investment led to a fall in aggregate production, i.e., GDP. Demand for financial assets belonging to these regions dipped drastically and hence, supply increased for the same. This is why, foreign reserve stock of these nations depleted which led towards exchange rate depreciation. The nations had been drained out of their resources with which to invest and hence, were in a fix. However, the domestic governments framed sound fiscal policies to support their respective systems. Furthermore, IMF granted an aid of US$ 40 billion to retrieve those nations out of the impending crisis (The New York Times, 1997, ‘BUSINESS DIGEST’). Apart from the measures being adopted by the IMF to bail out the region from the clutches of recession, the national authorities also initiated steps to ease the recessionary impact that the crisis had over the economy. Some of the nations adopted a low rate of interest regime in order to repel savings and encourage more investment in the nation. Many economists around the world had expressed misgivings about the success of such a strategy assuming that such a step might engage the region in a low growth trap. However, all expect Indonesia revived to their previous forms by 1998, after such a monetary policy was adopted. Answer to Question 6 Purchasing Power Parity exchange rate or simply the Real exchange failed on account of following reasons: a) Presence of tariffs and other barriers often creates a wedge between prices of the same goods prevailing in different markets. In such a case the ‘Law of One Price’ does not hold and the concept of PPP measurement fails. b) Permanent shifts in the terms of trade between the traded goods may take place. c) Even if the traded goods are identical in both the countries, CPI indices include traded goods as well as non traded goods, which cannot be arbitraged internationally-thus the ‘Law of One Price’ ceases to hold. Any empirical study of PPP actually shows a high variability in real exchange rate at least in the short run. The standard deviation of the real pound/dollar rate was 26% over the period 1973-2000, although in the Bretton-Woods system, i.e. over the period 1945-72 it was only 9%. But while comparing national income or GDP between the developed and the less developed nations, the indispensability of PPP is beyond doubt. Per capita GNP comparisons between developed and less developed countries are often exaggerated by the use of official nominal exchange rate while converting the LDCs GNP figures into the currencies of Developed Countries. This conversion fails to measure the relative domestic purchasing power of different countries. GNP of a poor country quoted in US dollar may appear very low, but it should also be kept in mind that the purchasing power of $1 in that poor country is also very high compared to US. Since the PPP exchange rate includes the relative prices of currencies as well as a measure of purchasing power, it reveals the real extent of income gaps and thus differences in living standards between a rich and a poor nation. For example, China’s 1997 per capita GNP was only 2.7% of that of US using the nominal exchange rate conversion-but it rose to 12.5% when converted by the PPP. References Alderman, L. (January 6, 2011). “Europe’s Challenge: Fostering Growth amid Austerity” The New York Times. Available at http://www.nytimes.com/2011/01/17/business/global/17euro.html?src=busln (Accessed: January 17, 2011). BBC News. (December 24, 2010). “Japan agrees record 92.4 trillion yen draft budget” BBC News. Available at http://www.bbc.co.uk/news/business-12074304 (Accessed: January 17, 2011). Melvin, M. (2008). International Money and Finance (7th ed.). New York, USA: Pearson. The New York Times. (November 22, 1997). “BUSINESS DIGEST”. Available at http://select.nytimes.com/gst/abstract.html?res=F30916F9385F0C718EDDA80994DF494D81 (Accessed: January 17, 2011). Read More