The State, The Financial System and Economic Modernization - Assignment Example

Economics Assignment College: Name: Students ID: Date: Course Name: Unit Code: Time: Instructor: 1. Since the required reserve and discount rate policies are not very effective in controlling money supply in practice, what are the purposes of maintaining the above two policies? Explain. The reserve requirements are vault cash and deposits made by each bank to the Federal Reserve. By changing the reserve requirements, the Federal Reserve is able to control bank lending rates by affecting the deposit multiplier and consequently money supply. Therefore the reserve requirement act as a safeguard to public deposits and gives the Federal Reserve a powerful tool to perform its role. With no legal reserve requirements, banks would still have to embrace cash reserves as vault cash or on deposit with Federal Reserve so as to have money to meet up withdrawals by the public and to clear checks. However, the problem is that with no officially authorized reserve requirements, the multiplier correlation connecting reserves and money supply would fluctuate by a great deal The discount rate is an annual interest rate the Federal Reserve charges to those financial institutions that borrow money from the Fed. Through the discount rate, the Federal Reserve manipulates the need for financial institutions to borrow reserves. Although there is a weak link between the discount rate and money supply, it is a reactive tool rather than a proactive tool. 2. a) If the nominal interest rates in America rise but real interest rates fall, predict what will happen to the U.S. exchange rate. Explain. The U.S exchange rate will rise. An expected increase in interest rates results to an expected increase in the returns to the dollar. In other words, the demand for the dollar will go up hence people will tend to buy more dollars resulting to an increase in the U.S exchange rate. b) If the European central bank decides to contract the money supply to fight inflation, what will happen to the value of the U.S. dollar? Explain. The value of the U.S dollar will fall. Reduced money supply will result in an increase in interest rates. This will raise the value of the euro and the expected return on the euro will also go up. The effect of this is that it will cause the value of the dollar to depreciate. U.S dollar A B Expected Return 3. a) Under what conditions/circumstances does a bond have virtually no interest rate risk? Explain. Investors investing in bonds expect to get returns from the bond over some time horizon. However, actual returns may be different from the expected returns hence giving rise to risk. However, there are two conditions under which a bond could be said to virtually have no interest rate risk: (1) if the actual returns may well be equal to the expected return; and (2) taking the context in which the bond investment behaves compared to other investments, its returns should be uncorrelated with risky investments in the market or delivers the same return regardless of the state of the market. b) Does a coupon bond that satisfies the conditions/circumstances in (2) have absolutely no interest rate risk? Why or why not. No. For the actual return and the expected returns on a bond investment to be one and the same, there must be no reinvestment risk. For a coupon bond, coupons or interest payments are paid to the bond holder. These interest payments may be reinvested at future interest rates that are unknown now. 4. Brian mortgaged $200,000 on his house 10 years ago. The mortgage was 25-year fixed rate at 8%. He realizes today that a refinance opportunity is available at 5% for the rest of his mortgage. Assume there are no additional fees. For simplicity, assume annual mortgage payment. a) What was Brian’s annual mortgage payment? In the formula; P = Principal amount, i = interest rate and n = number of years b) If he took the refinance opportunity, what is his new annual mortgage payment? 5. “Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets are.” Is this statement true, false, or uncertain? Explain. The statement is false. Secondary markets play an important role too since stock prices in secondary markets are referred to when companies decide the prices they would use to sale Initial Public Offers (IPOs) in primary markets. Also, secondary markets make securities more liquid and hence quite easy to put up for sale in the primary markets. In light of this, secondary markets could if truth be told be more important than primary markets. 6. Explain the role of expectation on the volatility of exchange rates. The government, through the fed, intervenes in the foreign exchange market so as to maintain order through trading. Exchange rate volatility has been found to affect the government’s monetary policy and today stock trading is global and diversified. Investors from expectations regarding exchange rate movements (volatility) and therefore have to be considered in policy formulation. Therefore expectations on the volatility of exchange rate are factored in when forming stable policies that are intended to last for a loner time (Fisher, 1992). 7. What are the pros and cons of exchange rate targeting (pegging)? Explain. Pegging of exchange rates is preferred because of trade and export dealings. By fixing the exchange rate a country improves its global trade competitiveness since the sale of goods in other countries will be stable hence reduce uncertainty and cheaper for weaker currency exchange rates. Also, a country with a low cost of production, such as Thailand, trading with a country with a stronger currency, such as the United States, will gain from exchange rate translations to the domestic currency hence result in more profits. In general, it improves the overall economy of a country and also protects the home economy from exchange rate fluctuations that have adverse effects on the economy. However, pegging the exchange rate requires a country to sustain a fixed exchange rate. This calls for enormous amounts of reserves in form of the international reserve currency (US dollar) seeing as the country has got to keep on buying and selling its local currency. The problem with this is that it may result in higher inflation given that the money supply in the economy has to be increased hence causing prices to go up. 8. How can persistent U.S. balance-of-payments deficits stimulate world inflation? Explain. The US dollar is the international reserve currency. Other countries buy U.S. dollars to increase their reserve currency hence keep their exchange rates from fluctuating in relation to the dollar. Given U.S. balance-of-payments deficits, they increase their international reserves also their monetary base goes up. The effect of this is that the money supply in those countries grows at a higher rate hence leading to higher inflation all over the world. 9. Assume you are the manager of a financial institution. You are considering some strategies for hedging interest-rate risk. Would you prefer using futures or option contracts? Why? I would prefer futures. A future is a contractual agreement entered between two parties where one party promises to provide a security and the other party promises to buy the security at some time in future. A future leads to an obligation(s) and the buyer has unlimited liability. This minimizes risks associated with future price fluctuations. An option is a right to either buy or sell the security in future at a specified price. The buyer of the options has a right to exercise the options or otherwise ignores the option. This brings in an element of uncertainty and the buyer does not have unlimited liability. 10. “Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans”. Is this statement true, false, or uncertain? Explain. The statement is false. Loans are the main sources of banks revenue. However, in the midst of this is the risk involved in offering loans. Hence banks have got to thoroughly screen borrowers to minimize default on loans. Through specialization, banks are able to easily separate risky borrowers from the rest. It also cuts down on monitoring expenses. References Fisher, P. Expectations in Macroeconomic Models. (1992). Dordrecht: North Holland. Howels, P.G.A. and Bain, K. Financial Markets and Institutions. (2007). 5 edn. Prentice Hall/Financial Times Levinson, M. Guide to Financial Markets. (2009). 5th edn. John Wiley & Sons. The Economist: Economist Guide to Financial Markets 24 Santomero, A.M. & Babbel, D. Financial Markets, Instruments, Institutions. (2000). 2nd edn. McGraw-Hill/Irwin Syllah, R, Tilly, R and Tortella, G, The State, The Financial System and Economic Modernization, 2007, Cambridge University Press, 1st edn. Read More