International Monetary Economics - Assignment Example

MODULE Question Marshall Lerner condition is the factor that elaborates that the devaluation of the currency shall not immediatelyimprove the balance of payment of the country. When the currency devalues the cost of foreign goods increases as compared to the cost of the local goods and people shall prefer to purchase the local goods and thus more goods shall be exported and this lead to the improvement of the balance of payment as export shall be more than the import. However Marshall Lerner condition elaborates that along with the increased exports, due to the devaluation of the currency the imports shall be more costly to the country and thus the balance of payment shall show negative effect when imports shall be costing more. The condition stipulates that a devaluation or depreciation of its currency will improve a countrys trade balance only if the sum of the absolute values of a countrys import and export price elasticity is greater than one (Mohsen, Hanafiah and Scott). The foreign exchange market considers the valuation of the currency of the country. The value of the currency of a country is evaluated along with the comparison with the other currencies and thus the evaluation of the currency is done. In the flexible policy regime the state bank of the country shall interfere in the controlling the valuation of the currency by purchasing and/or selling the particular currency so as to control the demand and supply of that particular currency as thus controls the value of the its own currency. Whereas in the fixed rate the state bank shall fixes the amount to the exchange with the other particular currency and thus shall not be able to much control the evaluation of the currency. The FE curve elaborates that the balance of payment of the country shall be with in equilibrium in the foreign exchange market with incomes and the interest rates. In the flexible rate regime and the BOP is in deficit the state bank shall interfere with the supply and demand of the foreign currency by purchasing and selling thus affecting the equilibrium in the foreign exchange market causing shifts in the FE curve (Raphael and Gilberto). Question 2 With perfect capital mobility the increase in the tax rates of a small country, the investment shall be going out of the country and to those areas where the tax rates are less. Thus with such conditions the country’s income will increase with the reduction of money supply in the country as the money shall be leaving the country. The interest rate shall decrease as money supply is exporting from the country and the interest rate will increase, as the currency will face devaluation (De). The state bank shall interfere to control the currency value by purchasing or selling the foreign currency in floating rate regime and thus bringing back the BOP to equilibrium whereas in pegged rate regime this shall not be possible and the balance of payment of the country shall be deficit as the money is moving out from the country and the currency is losing its worth as in comparison with the foreign currency. The impact shall be similar with the large country as the circumstances shall be similar and the state bank shall be able to better control the demand and supply of the foreign currency. The reduction in the quantity of money will decrease the country income and shall decrease the money supply. The interest rates will decrease as the income shall be low and the exchange rate shall be low, as the currency shall appraise. In order to gather equilibrium in the floating rate the interference of the state bank with the supply and demand of the foreign currency y selling and purchasing will bring the balance of payment to equilibrium which shall not be possible in the case of pegged rate policy (Tarik). Whereas for the large country the impact shall be similar despite the fact that the bank shall be able to purchase and sell foreign currency at large and better control the demand and supply of the foreign currency and thus controlling the equilibrium in the balance of payment of the country. Question 3 For the equilibrium to pertain in the long run it is necessary that certain conditions in both the countries remains constant and if it change then the change should be accounted for in the other country accordingly or the change should be for a short period so as to get equilibrium in the long run. The currency valuation shall be same along with the supply of money in the country. The income of both the countries shall be similar and the exchange rate policy should be floating in both the countries. Considering these conditions the long run equilibrium can be ascertained in the international context. When the above condition are satisfied and followed the equilibrium in both the countries shall be leading to the equal purchasing power in both the countries. The valuation of the currencies of both the countries shall be similar and both the currency shall hold similar purchasing power, as the import and export of same quantity shall not be resulting in the changes in the balance of payment of both the countries. The long run equilibrium of both the countries is determined when the exchange rate is floating and the money supply is similar. However with the pegged exchange rate the long term equilibrium in the international context shall be lost as the demand and supply of the foreign currency cannot be controlled. The money supply in the economy determines the purchasing power in the country and when it is increased the purchasing power gets lower as due to inflation (Pender, O. Felix and Amon). With the increase in the money supply in the country whether small or large, inflation is increased thus decreasing the purchasing power of the currency and ultimately hitting the long run equilibrium in the international context. Thus when both the factors combined the pegged exchange rate and the increased money supply shall result in the loss of equilibrium in international context. Question 4 The interest parity condition elaborates that the difference in the interest rate of the two countries shall be equal to the difference between the forward exchange rate and the spot exchange rate. When the return upon investing a certain amount in the local currency and entering into the forward exchange rate as when the investment matures shall be equally beneficial to investing in the foreign currency and converting it into local currency when it matures. With the monetary expansion in the country the money supply increases and thus the rate of interest decreases. Along with the decrease in the rate of return the currency shall be devalued and thus the return from both the investments techniques shall be providing similar benefits when the interest parity condition exists. In case of temporary change in the money supply there shall be no change in the return from the investments as in the long run the benefits shall be similar. In case of permanent change the devaluation of the currency shall be impacting the indifferent return of the investors as the long-term effect of the change in the currency value cannot be ascertained and banks will contract forward at a bank favorable rate (Chin). The asset market equilibrium derived from the foreign exchange market shall be overriding the goods market equilibrium and thus providing super equilibrium. The conditions of the interest rate when prevailing in the foreign exchange market along shall be able to provide equilibrium, as the interest rate shall be equal and thus the asset market equilibrium. With the equality in the demand of the currency the purchasing power thus be providing goods market equilibrium. Works Cited Chin, C-C. "The long-run uncovered interest rate parity in view of a trading strategy." Strategic Direction 26.4 (2002): 15-25. De, Paoli, B. "Monetary policy and welfare in a small open economy." Journal of International Economics 77.1 (2009): 11-22. Mohsen, Bahmani, Harvey Hanafiah and W. Hegerty Scott. "Empirical tests of the Marshall-Lerner condition: a literature review." Journal of Economic Studies 40.3 (2013): 411-443. Pender, Gbenedio, Ayadi O. Felix and Okpala Amon. "MONEY SUPPLY VARIABILITY AND INTEREST RATE SPREAD IN DEVELOPING ECONOMIES: THE CASE OF NIGERIA." International Journal of Commerce and Management 9.1/2 (1999): 35-44. Raphael, Rocha Gouvêa and Tadeu Lima Gilberto. "Balance-of-payments-constrained growth in a multisectoral framework: A panel data investigation." Journal of Economic Studies 40.2 (2013): 240-254. Tarik, H. Alami. "Variance decomposition analysis of the demand for foreign money in Egypt." Journal of Economic Studies 28.2 (2001): 122-135. Read More