The Euro in Crisis: Decision Time at the European Central Bank - Assignment Example

International Economics Assessment – 1 Name (s) 1._______________________________________________________________________ 2.________________________________________________________________________ 3.________________________________________________________________________ Student ID 1._____________________________ 2._____________________________ 3._____________________________ Assessment 1 1. The following excerpt is from the case study “The Euro in crisis: Decision Time at the European Central Bank”. “……a bailout for Greece would send a signal to other indebted member states that the ECB would step in if private lenders become nervous.” a. When ECB went out for bail out then what was expected to happen to the interest rate in Greece? The interest rate in Greece was expected to decline. This is because the bailout increased the money demand hence Greece money supply. Notice that in this case money supply is an exogenous variable determined by the European bank through its monetary policy. This is illustrated in the diagram below The increase in money supply from MS1 to MS2 necessitated by an increase in money demanded causes a decrease in interest rate from r1 to r2. A decrease in money supply leads to an increase in the rate of interest (International Monetary Fund, 2010). However, the increase in money supply will cause a decline in interest rate up to a certain level upon which further increase in money supply will not influence a reduction in the level of interest. This is called the liquidity trap of interest. Therefore, the bailout is expected to cause a decline in interest rate up to a certain level. b. Comment on the expected outcome of this policy on behalf of ECB. Provide diagram and detailed explanation on output and prices. As noted in FSB (2012), a lower interest rate encourages investment goods and since investment is a component of output, the general output increases. In addition, a decline in interest rate tends to expand the economy by depreciating the currency and raising the net exports. The movement of price level downwards causes a rightward movement of China along the aggregate demand curve. In addition, this policy prevents depreciation of Euro. According to Pratt (2010), a high exchange rate of Euro will discourage import by Euro zone hence increasing the net export. This increases the output of Greece. c. If government of Greece also increases (assume) the expenditure (expansionary fiscal policy) then what do you think can potentially happen to prices? A rise in government expenditure causes a rise in real GDP (Block & Hirt, 2008). In the short run unit cost increases and price level also increases. This is illustrated by the diagram below Increase in government expenditure causes real output to increase from Q1 to Q2. The increased output causes an increase in unit costs. Firms react to increased unit costs by increasing prices hence resulting to an overall increase in price level from P1 to P2. d. Overall do you think that bail out of Greece is healthy policy from the perspective of ECB? The bail out of Greece is a healthy policy from the perspective of ECB. Failure to bailout Greece will expose it to risk of recession. Furthermore, the uncertainty in financial market and the financial system of Greece will cause it to face more difficulties in raising the funds required to clear its debt. This will be compounded by the high inflation rate that will be occasioned by decline in output. This means that the country will be faced with the risk of higher levels of interest rate. The bailout of Greece will send a good signal to investors of the ability of Greece to service its debt (Brummer, 2011). A lower interest rate will attract investment, which will lead to increase in aggregate output. Furthermore, the bailout prevents the pressure of depreciating the Euro against other countries. Currency depreciation encourages importation from other countries. This disrupts production in Euro zone economy. e. Explain why a group of economist thinks that a common currency like Euro for the region is not a good idea. A common currency is more likely to have a pronounced foreign currency crisis. This is the case when a major trading partner with the common currency zone countries cannot maintain a fixed exchange rate that is above the equilibrium. Therefore, the government of this country through its Central Bank is forced to devalue its domestic currency, for instance against the Euro. If for example, the U.S change the exchange to a lower fixed rate from a higher fixed rate, the Euro zone exports will decline while its imports from the U.S. increases. Therefore, the Euro zone countries will have a trade deficit with the U.S. The Europeans will purchase goods from the U.S. at even lower prices. This will cause the Europeans tastes to change for goods from the U.S. the resultant effect of the rapidly growing trade with the U.S. is disruption of production in the Euro zone economy. This will have a multiplicative effect since there will be a wide-spread unemployment in Euro zone countries. The diagram below shows that undervalued U.S. Dollar can create Euro zone trade deficit. Before the undervaluation of the U.S. Dollar, the equilibrium exchange rate was P1 and the quantity of the U.S Dollars demanded was Q1. However, after the U.S. Dollar was fixed at a lower value P2, its demand increased to Q2. This is because the U.S exports have become cheaper and the Europeans will demand more U.S Dollars in order to import goods from the U.S. (Paterson, 2006). Assuming that the U.S. maintains a fixed exchange rate regime it will overcome the market forces of appreciating its currency due to the increased demand from Euro zone countries by selling its domestic currency. If this situation continues for a prolonged period, the Euro zone will become dependent on the U.S. hence a common currency like the Euro is not necessarily a good idea. Assessment 2 1. The following information is from International Business Times (April 4, 2012) “China has reacted to U.S. QE in the past by expressing dismay, primarily given the overweight U.S. dollar position in their foreign currency reserves.” (Source: http://www.ibtimes.com/exnet/chinese-reaction-fed-qe3-not-happy-797141 ) Explain the dismay of Chinese government due to quantitative easing (QE) using the FOREX market model discussed in the class. Make sure that you consider the undervalued exchange rate of China while answering the question. When the exchange rate of Chinese Yuan is undervalued, Chinese exports will become cheaper and there will be increased demand for Yuan. Due to the low exchange rate price of Chinese Yuan is low. Therefore, Chinese goods are cheaper to Americans hence the Americans will buy more Chinese goods. This causes the quantity of Yuan demanded to increase. Since you can only use Yuan to buy goods from china. This is illustrated by the diagram below P1 is the equilibrium value of Yuan if the exchange rate between the U.S Dollar and the Chinese Yuan was left to be determined by the forces of demand and supply (market forces). However, the China government intervenes in the foreign exchange market and sets the official price of Yuan at P2. Clearly, P2 is less than P1. P2 is the price of the undervalued Chinese Yuan which has been brought about by the government intervention in the official price of its domestic currency in terms of a foreign currency. Therefore, the increase in china’s exports to U.S will increase the demand for Chinese Yuan from Q1 to Q2. A drop in the price of the Yuan moves the U.S rightward along the demand curve for Yuan. The real GDP for the U.S increases and the relative price level increase. The American taste shift towards Chinese goods and its interest rate declines. The net effect is anticipated appreciation of the Yuan (Ang, Hodrick, Xing & Zhang, 2009). This means that the Chinese Yuan need to be undervalued further. 2. Let’s assume the following information for an economy. C=10000+0.6Y I=2000 G=5000 X=600 M=400 a. Find the size of the multiplier in this economy. Y = C + I + G + (X-M) Y=α+βY+ I + G + (X-M) Y- βY = α+ I + G + (X-M) Y(1-β)= α+ I + G + (X-M) Therefore, multiplier = b. Find the short run equilibrium output. Equilibrium output = The equilibrium output will be the output multiplied by the multiplier. Therefore, short-run equilibrium output = 43,000 * 2.5 = 107,500 3. The following news was issued in Bloomberg. “Thailand’s baht fell for a second week to reach the lowest level since 2010 and the benchmark stock index led losses in Southeast Asia on concern worsening political unrest will spur further capital outflows”. (“http://www.bloomberg.com/news/2013-12-27/baht-falls-a-second-week-on-concern-protests-to-spur-outflows.html”) a. Why do you think that there is going to be capital outflow? According to Sloman and Jones (2011), currency depreciation is inflationary since it raises net exports and therefore increased aggregate demand. The presence of too much money supply in the economy will cause the interest rate to decline. A fall in domestic interest rate leads to capital outflows. This is because investors will lose confidence in the ability of Thailand to service its debts hence will disinvest from Thailand and channel their resources to other promising economies. In addition, there is going to be an international capital outflow (the purchases and sales of financial assets across national borders). Investors from Thailand will purchase financial assets from foreign countries with higher interest rates. This leads to more capital outflow from Thailand. b. If indeed there is going to be huge capital flight, what should be the policy taken up by Bank of Thailand to avoid a free fall of their exchange rate and how they can achieve it. In order to avoid a free fall of its exchange rate the bank of Thailand should reduce the amount of money in circulation. Brickley, Smith & Zimmerman (2009) observe that this can be achieved through its participation in open market operations. This is where the bank of Thailand purchases and sells government securities in the open market. For it to reduce money in circulation, it will sell government securities in the open market. The buyers use cheques to drawn on their accounts with the commercial bank to pay the bank of Thailand. The bank of Thailand will then debit commercial banks’ accounts thereby reducing their cash reserves. The result is commercial banks limiting credit amount they can extend to borrowers hence reducing the amount of money in circulation. The lack of credit will mean that Thailand investors will not have the ability to purchase financial assets from other countries hence the bank of Thailand will have succeeded in preventing capital flight. The government of Thailand can also intervene through bank of Thailand by using a fixed rate of exchange. The bank of Thailand intervenes in the market by maintaining the chosen exchange rate. When it wants to avoid a free fall of its country’s exchange rate, it will buy its own currency. Denis & McConnell (2003) point out that this usually happens when the exchange rate is above equilibrium. In such a case, there is excess supply of domestic currency and the bank of Thailand will intervene in the market by buying its own currency. This overcomes the market forces of demand and supply to depreciate the country’s currency. This is illustrated in the diagram below. At point A, the demand and supply curves show that the equilibrium rate of exchange is Pe per Baht. When Bank of Thailand fixes the exchange rate at P* per Baht, there will be excess supply of Baht (B C) which is equal to (Q2 – Q1). Therefore, the Bank of Thailand must buy (Q2 – Q1) in order to keep the Baht from depreciating. References Ang, A., Hodrick, R. J., Xing, Y., & Zhang, X. 2009. High idiosyncratic volatility and low returns: International and further U.S. evidence. Journal of Financial Economics, 91 (1),1-23. Block, S. B., & Hirt, G. A. 2008. Foundations of financial management (12th ed.). Boston, MA: McGraw-Hill/Irwin. Brickley, J., Smith, C., & Zimmerman, J. 2009. Managerial economics and organizational architecture (5th ed.). New York: McGraw Hill/Irwin. Brummer, C., 2011. Soft Law and the Global Financial System: Rule Making in the 21st Century. Cambridge: Cambridge University Press. Denis, D.K. & McConnell, J. J., 2003. International Corporate Governance. Journal of Financial and Quantitative Analysis, 38 (1), pp.1-36. FSB, 2012. Meeting of the financial stability bond in Hong Kong. Press release, 30 May 2012. International Monetary Fund, 2010. Australia: Report on the Observance of Standards and Codes-Data Module. Sydney: International Monetary Fund. Paterson, M., 2006. Consumption and Everyday Life. Abingdon: Rutledge. Pratt, J., 2010. Financial Accounting in an Economic Context. New York: John Wiley and Sons. Sloman, J. and Jones, E., 2011. Economics and the Business Environment (3rd ed.). Harlow: FT Prentice Hall. Read More