Analysis of the Gold Standard and the Spot Exchange - Essay Example

 The Interest Rate Parity (IRP) Condition states that the rate of return on investment in dollar securities is equal to the expected rate of return on investment in securities valued in a given foreign currency, in this case, the South Korean Won; (This holds on the assumption that there are no risks of default on given securities), (Suranovic, 2005). Hence considering;

The interest rate on South Korean government securities (1-year maturity) =4%

Expected inflation rate (S. Korea 1 year period) =2%

The interest rate on U.S government’s securities (1-year maturity) =7%

Expected inflation rate (U.S 1 year period) = 5%

Current spot exchange rate: $1=W1, 200

the IRP condition implies that a $1 investment in US securities will total $1.07 in one year factoring in the exchange rate.

Investing the same amount in Korean security, we convert it into that currency hence, $1=W1200.

Factoring in the interest rate of 4%, well have; 1200× (1.04) =W1, 248

To predict the on the spot exchange rate we compare the return on one dollar between the two countries after one year hence;

1.07 Dollars = 1,248 Wons what of 1 dollar

= 1248/1.07=1,166.35 Wons.

Therefore the expected exchange rate after one year will be:

1 American Dollar=1, 166.35 Wons.

Question 2

Background

            The international gold standard, fairly effective prior to the 20th Century, had collapsed by 1939 due to a number of factors. Hubbard, (1991) documents that this was a result of structural flaws of the gold standards during world war one and policy responses by various economies that led to unpredictable international monetary contraction and deflation. In essence, the tying of countries’ money to gold is noted as directly responsible for the onset of the great depression, for example, Hubbard (1991) notes that countries that abandoned the gold standards earlier enough recovered from the great depression comparative to those that remained on gold.

Causes of Collapse

 Hubbard, (1991) attributes the collapse of the gold standard to its mismanagement by global financial stakeholders during the interwar period most specifically, the 1920s and the 1930s. They establish that after World War I, the redrawing of international boundaries limited the free circulation of both real bills and consumer goods leading to the distortion of the gold standards. This led to the scuttling of the bill market and the ultimate government control of foreign trade in consumer goods favored due to political rather than economic interests thereby leading to a large-scale collapse of the gold standards. According to Hubbard, (1991), the gold standard also collapsed as a result of sabotage by countries during the interwar period rather than the general belief that it collapsed due to its inner contradictions. Additionally, banking panics in the 1939s initiated by deflation which was imposed by the gold standard interfered with the normal flows of credit thereby negatively affecting the performance of the real economy.

A return to the gold standard would therefore limit various governments’ ability to borrow therefore, in cases of budget deficits, expenditures have to be lowered or taxes increased thereby stabilizing the country’s financial system. Conclusively, it is however imperative to note that even the advocates of a return to the gold standard affirm that the process remains extremely complex, more than a mere technical or financial restructuring, (Hubbard, 1991).