Money and Banking: Interest Rates and the BOP Factors - Essay Example

Money and Banking 1A When we suppose that, there are differences in interest rates between countries and prices are comparatively close then we expect exchange rates to change because of the BOP inequality. Interest rate parity supposes that the asset markets have more effect on exchange rates than the goods market. Interest rates fluctuate because of macroeconomic shocks like fiscal policy and monetary policy, because monetary policy is only a tool for economies with floating exchange rates. For economies with a fixed exchange rate, monetary policy is only used to support the fixed exchange rate or offset changes of the interest rate because of fiscal policy. One of the shortcomings of an economy with a fixed exchange rate is that monetary policy cannot be utilized to stimulate the economy, although an economy with a floating exchange rate like the U.S. can employ monetary policy to stimulate economic growth. The macroeconomic shock, interest rates in the domestic economy fluctuate with respect to foreign interest rates. For instance, when there is an expansionary monetary policy, it will cause interest rate to decline in the domestic economy, as a result, domestic investors will have an opportunity to invest in the foreign market that will cause a capital account deficit and cause the exchange rate to decrease. The monetary growth causes a raise in domestic income that in turn causes an increase in imports and a current account deficit. When the domestic money supply increases in the foreign market because of an increase in imports and net capital outflows, it leads to depreciation of the domestic currency due to the weak association between supply and demand. The decline in the exchange rate will cause domestic capital to be attractive for foreign investors and the domestic economy will start to draw foreign investment as the exchange rate declines until the BOP equals zero that lead to interest rate parity. 1b The BOP factors that affect the supply for domestic currency in the foreign economies are a raise in imports and an increase in capital outflows in search of higher rates of return. These factors lead to a BOP deficit in the domestic economy and are frequently affected by expansionary monetary policy that causes a decrease in the domestic interest rate. 1C Increase in exports and an increase in capital inflows where foreign investors are in search of higher rates of return in the domestic economy are factors that affect the demand for domestic currency in the foreign economies. In addition, if the domestic economy cause an increase of exports, it indicate that domestic goods are relatively less expensive compared to foreign goods. Consequently, foreigners will demand more domestic currency as they import compared to domestic exports. When, the domestic rate of returns is more in respect to foreign economies, there will be a raise in demand for the domestic currency, as foreign investors will require domestic currency to buy domestic capital. 2A Based on flexible exchange rates and relatively responsive capital flows, we can establish that any fluctuate in the capital financial account will be greater in magnitude than fluctuate in the capital account. Thus, the EE curve will be flat compared to the LM curve. A fiscal expansion causes IS curve to shifts up and to the right that lead to increase of interest rates and output (y) .The increase in interest rates lead to increase of inflow of KA and a demand for domestic currency in magnitude than the CA deficit affected by increase in revenues that in turn increases imports relative to exports. This causes a BOP surplus that causes the exchange rate to appreciate and lead to shift of the EE curve up and to the left. The exchange rate will appreciate to the point where the BOP comes back to equilibrium. When exchange rate appreciates, the rate of return on domestic capital gets smaller due to diminishing marginal returns, which will reduce the rate of capital inflows to the domestic economy and will lead to depreciation of the exchange rate until the BOP is back to equilibrium. 2B A down and rightward shift of the LM curve is caused by monetary expansion that results to a decrease in interest rates and fiscal expansion causes increase in interest rate. As result, the increase in money supply will cause interest rates to reduce and the exchange rate to depreciate. Thus, if monetary expansion is used to pay for the fiscal expansion, there is no need for the exchange rate to change and the market will go back to equilibrium via due to two policies that counteract each other. 3A IS curve represents money demand because it represents the goods market equilibrium. Thus, the demand for goods and services directly affect the demand for money because for one to purchase goods and services money is the required. The equilibrium condition of Y = C+I+ (G-T) + (EX-IM) is that leakages equal injections, S+T+IM = I+G+EX. 3B The interest rate represent opportunity cost of money because it consist the income from holding money. Incase there is increase in interest rate and the opportunity cost, it will open opportunity for investors and consumers to deposit more money in banks at a low risk or opt to invest in other investment with low risk returns. Acquiring of capital assets and communities becomes high when as due to an increase of interest rates. This will cause reduction of the expected profits to be made off the initial investment in capital. Therefore, if interest rates decreases the price of commodities decreases as well as the cost of acquiring capital at a low interest rate. It results to higher profits and expected rates of returns on the investment in capital when interest rates decrease, so does the opportunity cost of holding money. Therefore, households have an opportunity to invest in financial assets that are more risky, but have the potential for higher rates of return than to maintain the money in a savings account with a low interest rate. Meanwhile, the lower interest rate leads to a raise of consumption due to relatively cheaper commodities because of the decrease in interest rate. 4B When the foreign money supply rises relative to the U.S. domestic money supply, it will cause the spot exchange rate to increase due to an increase in the foreign money supply. Consequently, it depreciates the foreign currency relative to the U.S. dollar that will enhance dollar and increase its demand relative to the foreign currency in the spot market. Meanwhile, when the foreign money supply starts to increase, it indicates that the foreign economy is investing in domestic assets in search for higher rates of return. As result, there is a higher demand for the dollar and upward pressure on the spot exchange rate. The higher spot exchange rate will have the reverse cause on the forward exchange rate and the forward exchange rate will decrease. Although foreign investors will ultimately want to generate the benefits from their investment, they will demand more of their currency in the forward market when they sell their assets and want to convert the proceeds from their investment in dollars to their own currency. As result, it causes an increase in supply of the dollar and decrease exchange rate. The forward market is used to hedge against risk because foreign investors that want a strong dollar during the exchange of dollar to their own currency because it will take more foreign currency to purchase the dollar. 5A Initial BOP surplus is caused by a monetary contraction because LM curve shifts up and to the left. Meanwhile, it moves the LM curve up along the IS curve that slopes downward. A monetary contraction reduces the money supply and causes interest rates to increase, but lead to decrease in income. The net inflow of capital and a capital account surplus are caused by increase in interest rate. However, decrease in imports, an increase in exports, and a current account surplus are because of decrease in income. Thus, these are unmistakably outcomes of the BOP surplus. 5B The IS curve would shift up and to the right due to fiscal expansion. In case, government expenditure increases, taxes reduces, or both, the interest rate will raise and income will increase. The net capital inflows and a capital account surplus are caused by raise in interest rates. Meanwhile, the increase in income will offer consumers more money for imports and result to current account deficit. Under fixed exchange rates, monetary contraction is expected to occur when capital flows are unresponsive that would generate the change in the current account that are greater in magnitude than the change in the capital account. Thus, a current account deficit is caused by BOP deficit that would have downward pressure on the exchange rate. Given that exchange rate is fixed, decreasing the money supply via monetary contraction must occur to offset the outcome and reduce the downward pressure on the exchange rate. 6A The moral hazard and adverse selection availability cause the expected nominal rate of return demanded by investors so that to compensate for the uncertainties and risks related with moral hazard and adverse selection. Moral hazard was established after a contract has been signed where the beneficiary, for instance an insurance policy holder, no longer has an incentive to act morally after the contract has been signed. Meanwhile, someone with car insurance may not drive as sensibly because he or she is secured by an amount agreed upon in the contract. On the other hand, someone without insurance has the incentive to be more careful when he or she drive because of unavailability of funds required paying for damages if an accident occurs. Thus, an insurance company must include this moral hazard risk when underwriting an insurance policy. Adverse selection indicates an information weakness where the investor cannot gather all relevant information required to reduce risk. When there is less information available about the risk there will be higher nominal rate of return demanded by investors. Meanwhile, more information about the risk decreases the nominal rate of return demanded by investors because the risk is low. Read More