Governments and Private Investors Reason of Preference - Assignment Example

?International Finance Table of Contents a. Evaluation of the Governments’ and Private Investors’ Preference towards Fixed Exchange Rate and FloatingExchange Rate Systems Respectively 3 Governments’ Reason of Preference 3 Private Investors’ Reason of Preference 5 b. Evaluation of the Membership Positions of Greek and Irish Government in the Eurozone in Responding towards the Financial Crisis 7 References 12 a. Evaluation of the Governments’ and Private Investors’ Preference towards Fixed Exchange Rate and Floating Exchange Rate Systems Respectively Governments’ Reason of Preference After the downfall of Agreement of the Bretton Woods along with its systems during the 1970s, the financial system of the world had entered into the phase of financial instability. The system of the Agreement was aimed towards keeping the major currencies of the world at a fixed rate. With the collapse of the system, the world economies have been facing the volatility which is continuing at present as well. Under the system of Bretton Woods, the various countries’ major currencies were used to be fixed in relation to the Dollar while the Dollar was fixed with respect to the value of gold. This system indicated that the threat of currency instability was to be abided by the governments. As a result of this system, the corporation houses were to deal with lesser trading activities related with foreign currencies on a large volume. The system of the Bretton Woods Agreement at that time was factually capable of providing significant firmness within the markets of currencies (Hussain, 2010). The governments prefer fixed exchange rates to floating exchange rates which is prevalent at present in the world economies because under the later system, the currencies’ demand and supply factors are the determinant of the rate of exchanges within the market of foreign exchange. Thus, the governments’ power over the fluctuations of the currency valuation gets removed under the floating rate system. Along with this fact, the risk associated with the currency and financials appears in privatised form (Ono, 2004). On the other hand, the distinctive system of the fixed exchange rate allows the governments or respective authorities to bestow controls over certain tools of the monetary policy such as that of the regulation on the rates of interests and supply of money through issuing fresh bills. However, the authorities in charge of the monetary policies function under the control and regime of a board of currency which allows the authorities to enhance the money supply only after ensuring that the particular country has sufficient reserves of the foreign currency that are essential for backing up the enhancement of domestic currency within the nation (International Monetary Fund, 2009). More precisely, it is due to the following advantages of fixed exchange rates in the international monetary system that government prefers to preserve it. Firstly, due to the existence of fixed exchange rate system, price constancy in the international trading market can be ensured for the purpose of effective performance on trading. Price stability in the international trading market aids towards its growth and it also assures less risk for the businesses. Secondly, fixed exchange rates are termed to be inclined towards policies against inflation under this system. The countries are required to operate under strict policies related to both monetary as well as fiscal administration. Thirdly, the regimes under the system of fixed exchange rate demand from the Central Bank that it should uphold huge amount of foreign reserves in the form of both hard currencies and gold as well. This requirement of the fixed exchange rate regime helps in backing up risks that can arise due to any adverse situation of the international market (Fordham University, 2011). Along with the above mentioned benefits, another essential benefit sought by the government that make the fixed exchange rate system preferable for the government is that fixed rates are highly effective in adjusting the disparities in the balance-of-payment situation. The fixed exchange rates adjust the disparities through viably changing the prices in the countries which are affected with deficits and also those countries which are affected with surplus as well (International Monetary Fund, 2009). Private Investors’ Reason of Preference The private players prefer floating exchange rates systems for a number of reasons. In generic terms, floating exchange rate system provides mechanisms for creating an open capital account for the country. An open capital account enhances the amount of foreign capital inflow into the country and also at the same time, it enhances the level of outward capital investment from the part of the domestic investors to the international market. Enhanced capital investment in the foreign market also enhances the scope of foreign capital earnings by the domestic private players. Moreover, the private investors operate with the reliance over the governments’ interventions in the capital market during the time of crisis (Prasad & Rajan, 2005). The private investors prefer floating exchange rate system because under this system government seldom intervenes for correcting any adverse conditions as this system is believed to be adjusted automatically with the organisation of demand and supply within the country. For example, if a currency’s demand is low, it would lead to the devaluation of the currency. As a result of this, the goods which are imported from the foreign markets will become expensive and thus the people within the country will prefer to buy and consume the local or domestic goods and services. This situation will stimulate the number of jobs which the people will strive to avail of and gradually the market will be automatically corrected (Investopedia, 2009). A market where there is flexible exchange rate is believed and evident to be governed by the forces prevailing within the market. The mechanism of the “self-correction” is believed to be provided by the forces along with demand and supply for currency. The private investors who operate within such an economy which has not experienced any situation of fierce financial crisis such as that of Canada are more inclined towards preferring floating exchange rate system to the fixed exchange rate system. The private investors in those countries are not severely motivated to keep themselves confined within an economy governed by stable currency. Thus, the investors endeavour to enjoy more privileges of the floating exchange rate system without being familiar with the adverse consequences of crisis. Another important reason that the private investors prefer floating rates is that they have witnessed situations when countries operating with the fixed regime had not been able to react to sudden crisis in the short run. This is because under the fixed exchange rate system, the government takes more than average period of time for changing the rate of exchange and thus fails to undertake prompt action against the crisis (Jinha, 2008). With the growing prospect of liberalisation all over the world, at present every country of the world is heading forward for the creation of a more liberalised market. This might result in such an economy which is characterised by an open capital market and fixed exchange rate for controlling the domestic investment in the foreign markets by the private investors. At least, the government will maintain this economic condition until the country’s central bank has enough foreign reserves and domestic currencies. Thus, this will lead to such a situation which will be susceptible for matching with a stable financial position where the country’s liabilities are maintained in the form of local currency and the asset in foreign currency. The mismatch will arise because the country with such financial position will not be able to respond quickly towards any crisis looming. The private investors fear that if the exchange rate of currency of the country is made fixed as per the norms of a currency union, then the decision making might become partial and gets more tending towards those countries which possess greater gross domestic product earning. Thus, they prefer to possess a market with flexible exchange rate system along with adequate scope of earning money in terms of foreign currencies (Jinha, 2008). b. Evaluation of the Membership Positions of Greek and Irish Government in the Eurozone in Responding towards the Financial Crisis With the intensifying of the financial crisis within the Eurozone, the member nations grew more conscious about their respective adversity of the economies in spite of resolving towards economic hazards of other member nations. As time passed, the financial crisis grew more adverse and is expected to worsen in the coming years. Thus, it was obvious that the crisis would result in more adverse consequence, the effect of which will dribble upon the entire European region. The crisis which is prevalent in Greece and Ireland during the recent times is of exclusive nature since the Eurozone is composed of diverse countries, their cultures, guidelines and most importantly varied financial systems. It is also due to this reason that any member nation, individually, is not effective enough in addressing the financial crisis in the Europe. For resolving the crisis, it is enormously required that the European Union along with the central bank of Europe handle the crisis situation for responding towards the financial crisis (M.A.D., 2011) However, it is also true that certain limitations prevail for the Eurozone member nations due to their possessing of the membership within this zone. In the following part, the issues will be identified and presented that limited the scope of the Greek and Irish governments in responding towards the crisis. The issues which are otherwise had been taken up by the governments had they retained their own national currencies will also be discussed. Before discussing the above mentioned issues, it is noteworthy to mention as to how the membership in Eurozone contributed towards the crisis in Greece and Ireland and gradually evolved as the limitation in quick response towards the financial issues. The financially strong economies of the European Union such as that of France and Germany volunteered the syndication of currency that created a kind of reliability on the part of other economically weaker member nations such as that of Greece and Ireland. Moreover, the conventionally monitored monetary policy of the European Central Bank ignited the relying position of Greece and Ireland that gradually turned into an over-confidence state for the economies. The discernment of Greece and Ireland about financial stable position of their economies made the member nations to take loan at lower interest rates. The apparently cheap credit conditions of the member nations had been observed due to its member position which ultimately led to the failure of the economies (Nelson & Et. Al., 2010). The above conditions of the Eurozone member nations had evolved due to the holding of membership in the European Union. If Greek and Ireland, which are comparatively weaker member nations, would have retained their respective national currencies, the apparent cheap credit position would not have crept. As a result, Greece and Ireland could have responded earlier to the financial issues and could have avoided crisis. Financial activities with the use of national currencies would have made the economies to access to the loans in an expensive form due to lower valuation of their respective currencies within the international financial market (Nelson & Et. Al., 2010). Being a member of the Eurozone, the economies of both Greece as well as Ireland would have to depend on the actions of the European Union for recovering the crisis situation and better responding to the financial issues. In such a case, the limitations and liabilities of the European Union towards meeting numerous conditions are required to be specifically considered by its member nations. The EU faces challenges towards meeting up the reorganisation requirements for its economic control. Thus, it can be stated that requirements of the EU for fiscal consolidation and stabilisation along with effective management of external relations have limited the scope for the Greek and Irish government to respond effectively to the financial crisis. If the member nations would have been using their respective national currencies, both fiscal consolidation as well as stabilisation would have become prompt (Rodrigues, 2010). Due to diverse cultures prevailing among the European Union member countries, different protest to the reform measures arises from different countries. For example, the reform towards cutting public spending has created social unrest among the people of Spain. Taking into consideration, the possible protests from every member nation, the European Union is bound to consider its policies towards reforming extremely cautiously. This limits the scope for each of the most affected member nations such as that of Greece and Ireland due to lengthening of time period for taking the measures (Sandoval & Et. Al., 2011). The response of Greece and Ireland towards financial issues is not only related to the steps and measures of the EU but also is highly dependent upon the EU’s move towards consideration of the United States economic crises’ impact upon the activities of the East Europe. The combined consideration of the crises leads to political instability and is associated with the valuation of Dollars. With worsening of the US economic crisis, the situations in the East European regions will also become worse which in turn will affect Greece and Ireland along with other member nations of the EU. This chain impact upon Greece and Ireland is a result of the membership position held by the nations. On the other hand, Greece and Ireland could have independently reacted to the global crisis through tightening of fiscal and monetary policies as well with the utilisation of their respective national currencies. However, this would have required no position holding of the countries in the Eurozone (Jackson, 2009). Since Greece and Ireland are members of the Eurozone, therefore any adverse situation of a single member nation would have to be borne by the entire set of member countries under the EU. The economic crisis in the Eurozone has resulted in budget deficits for each of the member nations. The future plans for Greece is to reduce its deficits in budget by a percentage of 10 points within the year 2014. This plan has been initiated in line with the aims of the EU as a whole which aimed to lower the budget deficits by 6 percent after the financial issues stroked economies adversely. This implies that Greece had to consider conventional assumptions for the macro economy as it belonged to the Eurozone. With comprehensive utilisation of flexible exchange rate system of its national currency, Greece could otherwise have considered greater lowering of budget deficits (Papademos, 2010). The policy stimulus of the International Monetary Fund and the World Bank along with the EU towards crisis response of member nations of the Eurozone has helped the member nations resolve their fierce financial crisis situations. The IMF has enormous amount of resource holding which is typically the most important source for assisting the balance of payments deficits. Greece, as a member nation of the EU, received the assistance in terms of resource from the EU according to the viability sought by the EU. The EU provided assistance to the member nations according to the size of the economy. Thus, Greece and Ireland being hugely affected by the crisis received comparatively lesser assistance due to their economic sizes which are smaller than that of Germany and France. If Greece and Ireland would not have held membership within the Eurozone, there these countries could have received greater assistance from the IMF and the World Bank that would have boosted up their national currencies’ valuation within the international competitive market (Economic and Financial Affairs, 2009). References Economic and Financial Affairs, 2009. Economic Crisis in Europe: Causes, Consequences and Responses. European Economy. [Online] Available at: http://ec.europa.eu/economy_finance/publications/publication15887_en.pdf [Accessed June 29, 2011]. Fordham University, 2011. CHAPTER 2: The International Monetary System. Public. [Online] Available at: http://www.bnet.fordham.edu/public/finance/goswami/eiteman_178963_im02.pdf [Accessed June 29, 2011]. Hussain, A., 2010. Covering Currency Markets. 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