Structural Framework of International Finance - Research Paper Example

INTERNATIONAL FINANCE School A flexible exchange rate regime stimulates the adjustment of the Current Account in case of either a deficit or surplus. A flexible exchange rate system is an exchange rate regime or monetary system that is influenced by the forces of demand and supply of its currency in relation to other currencies of the world. Figure showing equilibrium exchange rate MS The nominal exchange rate e1 is determined by the supply and demand for money as illustrated above. Any change in the nominal exchange rate depends on shifts in money demand or money supply (Rogoff, 2004). In a flexible exchange rate regime, an increase in foreign price levels results to a decrease in the exchange rate. This causes the domestic currency to appreciate. In addition, under this regime, an increase in international real interest rates increases domestic output, decreases exchange rates and domestic price level on condition that money demand is more elastic to changes in the real income than the real interest rates. An increase in domestic money supply causes a proportional increase in the price levels. The current account model is given by CA = Y –C –G In this model, the income of a consumer is assumed to be exogenous. The consumer is also assumed to be living in both the present and future periods. The consumer can also borrow and lend regardless of the prevailing world interests rates. The model also assumes that there is no investment made and the current and future government expenditure (G and G’ respectively) is exogenous. A Current Account Surplus implies that a particular country saves more than it invests. It is reflected by an excess of domestic savings over domestic investments and an increase in a country’s net foreign assets evidenced by positive sales abroad. The model suggests a positive relationship between the current account surplus and the current income. As the current income increases, the current account surplus also rises due to an increase in current consumption and government expenditure. The current account surplus experiences an inverse relationship with anticipated future income. As the future income is expected to rise, the current account surplus is expected to reduce as a result of reduction in savings. When the current account surplus is zero, the country’s savings equals the investments. Capital controls refer to prohibitions enforced by the government or Central Bank of a country to restrict the flow of foreign capital in the domestic economy. Capital controls could be exchange controls, taxes, legislation, volume restrictions and reduction in foreign remittances which reduce foreign trade. Capital controls are intended to manage a country’s capital account transactions. Capital controls can be imposed to control the foreign direct investments or movement of portfolio (De Gregorio, Edwards and Valdes, 2000). In case of anticipated increase in future total factor productivity and in the absence of capital controls, firms expect a future increase in the return on investments. This causes firms to increase their demand for investment goods. Also, a consumer expects a future increase in income and therefore increases the current consumption. The increase in current consumption and investment demand causes a decrease in the current account balance. The current account balance also decreases because the supply for domestic goods equals its demand and thus the output is in equilibrium. A further decrease in the current account balance causes a deficit in the current account balance. Similarly, when the future total factor productivity is expected to increase, the level of income of a country is expected to increase. The anticipated future increase in total productivity shifts the real national income, Y’, outwards and to the right. The output demand curve also shifts to the right while the output supply curve does not change. Output thus does not change. Firms are also likely to increase their optimal investments. This is represented by a shift of the investment schedule curve outwards and to the right. An increase in investments interferes with the current account balance by causing a deficit in the current account. In an economy without capital controls, the national output will not be affected. The domestic income will not change and therefore the individual consumption and savings will not change. There will be no effect on the domestic real interest rates or the nominal exchange rates and the price level. The current account will be a deficit. This is because the absorption will increase. What will be the equilibrium effects on the economy in the event of anticipated increase in future total factor productivity? An increase in total factor productivity is likely to increase the output of an economy. The equilibrium aggregate output and domestic real interest rate is determined by the interaction of the output supply and demand curve. An increase in the total factor productivity causes the output supply curve to shift outwards and to the right. This causes a decrease in international interest rates. Figure showing the effect of an increase in total factor productivity on international interest rates Real Rate of interest, r Yd Ys1 Ys2 Y1 Y2 Current Income, Y In the event of a Real Shock to the domestic economy caused by factors such as decrease in international interest rates, the real output of the domestic economy decreases. The output in the foreign countries increases and thus they reduce imports from the domestic economy. The current account balance of the domestic economy reduces and the output demand curve shifts to the left. Decrease in domestic real output results to decrease in money demand. The money demand curve shifts to the upwards and to the left and the nominal exchange rate rises. The domestic price level increases as the nominal exchange rate increases. Thus the effect of an increase in total factor productivity leads to a reduction in international interest rates. A decrease in international interest rates leads to an increase in exchange rate and an increase in domestic price level. The Central Bank of the domestic country can stabilize the price level by reducing the money supply in response to a shock from the decrease in money demand. In the case where the government dislikes current account deficits and imposes capital controls in an attempt to reduce current account deficit, the national output increases. The output demand curve shifts to the right. The output supply curve also shifts to the right by an equal amount so that the output demand and the output supply are equal. This is also facilitated by increasing domestic real interest rates as a result of the domestic output and absorption remaining equal. The increase in the real interest rate causes an increase in investments spending but the increase will be smaller than in the case of an absence of capital controls. Do the capital controls have the desired effect on the current account deficit? Capital controls are intended to control the capital account transactions. Capital controls prevent further current account deficits. Capital controls reduce capital flight and stabilize the depreciation of the domestic currency. Current account deficits depend on capital inflow to fund the deficit (Edward, S. 2007). Capital controls dampen the effects of external shock. Capital controls increase the national output through its effect on investment spending. It increases output but at a less than proportion than in the absence of capital controls. Capital controls stabilize the depreciation of the domestic currency and decreases the exchange rate by reducing extreme movements in the interest rates. Capital controls tend to dampen the effects of real shock to the domestic economy. They reduce extreme fluctuations in aggregate output, current account surplus and nominal exchange rate. Empirical studies differ in opinion on the effect of capital controls on the economy. Capital controls are shown to have a reduction effect on exchange rate volatility (Frankel, 1996; Frenkel et al., 2002). Other studies suggest that capital controls increase the exchange rate (Glick and Hutchinson, 2005). Capital controls tend to solve the problem of fluctuating nominal interest rate under the flexible exchange rate regime. However, the capital controls produce an economic inefficiency. In the absence of capital controls, the domestic economy experiences a lower real interest rate in the event of a change in the total factor productivity. Borrowers of funds would benefit from lower borrowing rates while lenders for example commercial banks would lose because of lower lending rates. In economic sense, this reflects a general improvement in economic welfare. In emerging economies, abrupt stops in capital inflow are highly disturbing to the economy because it results in huge adjustments of the current account and causes large decline in economic growth (Dornbusch, Goldfajn and Valdes, 1995). Capital controls are ineffective policies and have several traditional shortcomings. They are heavily criticized as ineffective policies in resolving financial crises. Capital controls inhibit the imminent growth of the economy. They are incompetent in stabilizing the exchange rates and domestic price level. They also reduce economic welfare. In addition, most participants in financial markets have huge inducement to elude the capital controls. It is relatively easy for investors to avoid them. The International Monetary Fund discourages countries from employing the use of capital controls except in dire situations where need be. Under the flexible exchange rate regime, the exchange rate depends on market forces of supply and demand of money. Money supply is assumed to be exogenous and is determined by the Central Bank. Thus the money supply curve is perfectly inelastic. In a condition where the Central Bank increases the money supply, the money supply curve shifts outwards and to the right. Figure showing effects of increase in money supply on equilibrium exchange rate Ms This causes the nominal exchange rate to increase. The increase in nominal exchange rate has no effect on the real output, real international interest rates, consumption, investment or the current account balance. However, an increase in nominal exchange rate causes the prices of foreign currencies to become more expensive compared to the domestic currency. This causes depreciation of the domestic currency and causes an increase in domestic price level. In this case, money is neutral because an increase in money supply by the Central Bank has no real effect on the economy. Capital controls usually have four main goals to achieve in the economy. Capital controls are meant to slow down the volume of capital inflow into the country while altering the portfolio into long term maturities. Capital controls also lessen the volatility of nominal and real exchange rates. They are meant to delay decrease in the real exchange rate that arises from capital inflow. In addition, they allow the government to maintain high domestic interest rates by implementing effective monetary policies through the Central Bank (De Gregorio et al 2000, Massad 1998). In the absence of capital controls, monetary policy for example increase in monetary supply responds by allowing nominal exchange rate depreciation and an increase in the domestic nominal interest rates. The current account adjusts due to a drop in domestic spending. Capital controls smoothen out the responses in the economy to monetary policy by stabilizing the depreciating domestic currency, increasing the domestic interest rates and reversing the drop in consumption (Gali, Jordi and Tommaso Monacelli, 2005). Capital controls however, will not have any effect on the exchange rate depreciation in case the government imposes capital controls before increasing money supply. The exchange rate depreciation is independent of the existence of capital controls. Report The relationship that exists between current account and exchange rate dynamics still remains a challenge in the conceptual framework of open-economy macro-economics. A surplus current account implies that the currency is very weak. Under this condition, a country with a flexible exchange rate will experience appreciation in exchange rate. The exports of the surplus country will be cheaper in the international market. The surplus country will export more goods and services to deficit countries. Similarly, the goods and services of the deficit country will be considered more expensive by the citizens of the surplus country thus; they will import less of the items of trade from the deficit country. The overall effect is that the exports exceed the imports (Madura, 2011, pp56-98). Temporary shocks in an open economy have no effect on the real exchange rate in the long-run. But the temporary shocks have some effect on the real nominal exchange in the short-run (Sercu, 2011, pp 124-143) The global shocks also have no effect on the current accounts and the real exchange rates. It is only the shocks of a particular country which can impact on these two variables. The above assumptions are in line with the open macroeconomic models. For instance, the real exchange rate is treated as to be constant in the Obstfelt and Rogoff model of 1995 on the assumption of differences in the purchasing power of the consumers. On the other hand, in the Betts and models in 2000, reveals that monetary shocks cause real exchange fluctuations in the short run. When there is a permanent shock in an open economy, normally interpreted as technological innovation, the real exchange rate appreciates permanently (Sercu, 2011, pp 124-143) This would lead to an insignificant seeable impact on the current account based on the economic statistics. Moreover, a temporary shock, usually associated with monetary innovations always causes a temporary depreciation of the real exchange rate and simultaneous improvement in the current account. Naturally, the temporary shocks in an open economy are interpreted as the monetary shocks and the permanent shocks on the other hand, are understood as productivity shocks. The consumption basket an economy consists of both tradable and non-tradable items. The version introduced by Obstfeld and Rogoff, gives us a simple outlay that permits an economic analysis on how the real exchange rate can be determined (Sercu, 2011, pp 124-143). The real exchange rate is achieved at a point where the productivity level together with the monetary factors has no effect on the economy at all. This point reflects the flexibility of the prices of tradable and non-tradable of the economic commodity basket. The real exchange rate appreciates really at this point (Madura, 2011, pp56-98). Horizon life-cycle consumers, the monetary shocks will have long term effects, as the amount of foreign assets adjusts in response to the price rigidities. Ultimately, the long-run effect that the monetary shocks will have on the net foreign assets will be even smaller. Since the supply of domestic tradable is assumed to be constant, the short-run current account balance equals the change in the short-run consumption. The short-run current account response is dependent on several parameter values, the balance between the inter-temporal and the intra-temporal elasticity’s of substitutes in an economy (Madura, 2011, pp56-98). If money supply is permanently increased, the long-term change in real exchange rate is written down as short-run changes in consumption. The long-term real exchange rate therefore, becomes a fraction of change in the net foreign assets that cannot be greater than the change in money supply (Madura, 2011, pp56-98). When the elasticity’s of tradable and non-tradable are equal to 1, then, the effect of the long-run real exchange rate of monetary shocks cannot exceed the real interest rate of the original shock. By the fact that the short-run current account a fraction of the monetary shock itself, the actual real exchange rate will be much smaller (Sercu, 2011, pp 124-143). Even though productivity has a huge long-term effect, the effect of productivity somehow differs from the solutions achievable under the assumption that the prices are fully flexible. The effect of long-term real exchange e rate of productivity can be collaborated with short-term changes in consumption (Desai, 2006, pp24-78). When a country has a deficit current account, the current account will improve given the actual experience of the temporary shock associated with money shocks, and the level of real exchange rate immediately depreciates and eventually levels off to zero effect. However, when there is a permanent shock in the economy, that is, anticipation of increased level of productivity, the real rate of exchange will gradually and continuously appreciate until equilibrium is reached (Sercu, 2011, pp 124-143). The money shock often leads to depreciation of the currency with greater magnitudes resulting in the improvement of the current account over a shorter period of time normally within one to three quarters. Surprisingly, the effect that money shock has on the current account takes a long period of time to clear up before the rate of exchange effect disappears at equilibrium. Commonly, all countries of the economic world have the same experience of the permanent shocks that will always cause their real exchange rates to appreciate. And as the real exchange rates appreciate, the current account also improves (Desai, 2006, pp24-78). This implies a positive correlation between current accounts and the real exchange rates in an open economy which does not fit the predictions in a single-sector economic model. An increase in total productivity as anticipated by the country is a form of a permanent shock. The exchange rates will respond by appreciating in value. This will take a relatively longer period to be realized in the economy. As a result of appreciation of the domestic currency, the country’s export will be more expensive in the international markets. Also, the locally produced commodities will also be more expensive compared to the cheap imports. The overall effect is that the citizens of the surplus country will prefer imports to locally produced items. Similarly, there will a general tendency of consumption of imports. This will cause surplus the surplus country to import more than it exports. As the imports continues to exceed exports, the surplus in the current account of the surplus country fades away (Madura, 2011, pp56-98) This tendency will gradually and continuously until equilibrium real rate of exchange is established as dictated by the market forces of demand and supply of the foreign currency (Desai, 2006, pp24-78). Appreciation of domestic currency causes less demand for foreign currency to pay for imports, while at the same time; there is excess supply of foreign currency hence the foreign currency becomes depreciated in relation to the domestic currency. Equilibrium will be determined at the point where the demand and supply of the foreign required for export-import trade will be equal. In addition, as the exchange rates appreciate, the domestic currency appreciates making imports cheaper than locally produced products leading to more imports than exports. This leads to current account deficit. Capita controls are the restrictions imposed by the government on the asset’s trade across the international borders (Sercu, 2011, pp 124-143) The imposition of capital controls by the government can just help in lengthening the maturity of inflows, and allowing the autonomy of the monetary autonomy to a greater extent on temporary basis. But capital controls are less effective in discouraging the inflows of capital or easing the pressure on appreciation of the currency. The application of capital controls is appropriate in a strong economy with relatively high rates of interest. There will be deficit current account, a factor attributable to the total factor productivity as anticipated by the consumers and the firms (Madura, 2011, pp56-98) The capital controls if imposed by the government, alter the manner in which the domestic responds to temporary or a permanent shock (Desai, 2006, pp24-78). If a country is concerned with the effects of fluctuations in the nominal exchange rate under a flexible rate regime, the government tends to use capital controls to solve this problem in cases where the main source of shock is temporary changes in total factor productivity. Under such circumstances, the solution is very expensive because it produces an economic inefficiency. The equilibrium allocation of the available resources is at pareto in the absence of capital controls. With no capital controls, real interest rate is lowered after the total factor productivity shock. This implies that the lenders would be worse off and the borrowers better off (Sercu, 2011, pp 124-143) . Productivity causes appreciation of the rates of exchange. This in turn makes imports cheaper than exports, thus, the current account deficit remains uncorrected. Capital controls have less effect on the current account’s deficit (Shailaja, 2008,pp 112-138). Capital controls tend to dampen the fluctuations that result from some shocks to the economy. However, they are unfavorable to the economy since they reduce the efficiency with which the economy operates. When a temporary negative shock is injected to domestic total factor productivity, the output increases given that initially, the current account had a zero surplus. The real interest rate increases given the additional nominal supply of money. In the case of a temporary in domestic factor productivity, supply decreases. This coupled with no capital controls in existence, the current account surplus fall. The demand for factors declines, real output falls, and consumption also falls due to a fall in income (Shailaja, 2008,pp 112-138). The nominal money demand declines. The exchange rates depreciate while the nominal rate of exchange increases. The capital controls tend to aggregate fluctuations in output, current account surplus, and the exchange rate from shocks in the economy. Increasing money supply by central bank constitutes a temporary shock. The effect is decrease in the nominal exchange rate. If this comes after the government had imposed capital controls, the money supply will still affect the exchange rates (Sercu, 2011, pp 124-143). The supply of domestic currency increases causing the domestic currency to depreciate. This causes the nominal exchange rate to depreciate as the domestic currency loses value. Increased supply of money increases the demand for goods and services that is, ’too much many facing so few goods’. As a result, the prices of goods and services sky rocket causing the general increase in prices of the commodities. The nominal interest rates increases in a bid to discourage borrowing. The supply of goods and services increases as prices are at peak as per dictated by the law of demand and supply (Shailaja, 2008, pp112-138). Bibliography Shailaja, G. (2008). International finance. Hyderabad, India, University Press (India). Desai, M. A. (2006). International finance: a casebook. Hoboken, N.J., Wiley. Sercu, P. (2011). International Finance Theory into Practice. Princeton, Princeton University Press. Madura, J. (2009). International financial management. Mason, OH, South-Western/Cengage Learning. Madura, J. (2009). International financial management. 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Rogoff, K. S. (2004). Evolution and performance of exchange rate regimes. Washington, DC: International Monetary Fund. Read More