Analysis And Response To Midterm Economic And Financial Q&A

Analysis and Response to Midterm Economic and Financial Concepts

The assignment encompasses a variety of economic and financial questions centered on exchange rates, international interest rates, currency valuation, and governmental financial management. It requires explanation of concepts such as forward rates, interest parity, currency undervaluation or overvaluation, and the maintenance of monetary and exchange rate regimes. Additionally, it involves analyzing long-term and short-term determinants of exchange rates, effects of currency depreciation on trade balances, financial sector stability, historical impacts of policies like the gold standard and exchange rate regimes, and understanding international cooperation through common currencies. The questions also explore the implications of volatile capital flows, the Asian financial crisis, IMF conditionality, and policy tools for addressing current account deficits, fixed and crawling peg systems, and financial crises influences. Moreover, the tasks ask for critical evaluation of economic policies, including their advantages and disadvantages, and the historical context relevant to the evolution of these policies, particularly in the context of the Great Depression, Asian economies, and global financial stability. Each query requires detailed, scholarly explanation integrating both theoretical knowledge and real-world examples to provide comprehensive insights into international monetary and fiscal policies, their mechanisms, outcomes, and policy debates. The response should aim to fulfill these academic expectations thoroughly and coherently, demonstrating a solid grasp of macroeconomic and financial principles as they apply across different economic environments and historical contexts.

Paper For Above instruction

The first question examines the implications of the forward rate exceeding the current spot rate. When the forward rate for a currency is higher than the current spot rate, the markets signal that investors expect the future spot rate to be higher than the current rate, suggesting an anticipated appreciation of the foreign currency or a depreciation of the home currency. This expectation often reflects the market's belief that the foreign currency will strengthen over time due to factors such as economic growth prospects, interest rate differentials, or inflation expectations. According to the unbiasedness hypothesis of the forward rate, forward rates serve as unbiased predictors of future spot rates, although empirical evidence sometimes challenges this assumption (Madura, 2018). Consequently, an elevated forward rate indicates market anticipation that the currency will appreciate, aligning with a risk premium or differential in interest rates, which can influence trading and hedging behaviors.

In the second question, the focus is on calculating the forward discount or premium and evaluating interest parity. The given interest rates are 6% in the U.S. and 3% in Canada, with a spot rate of 1.1 ($/CAD) and a forward rate of 1.3 ($/CAD). The forward premium or discount is calculated as:

Forward premium = (Forward rate - Spot rate) / Spot rate × 100

= (1.3 - 1.1) / 1.1 × 100 ≈ 18.18%

This indicates that the U.S. dollar is trading at an approximately 18.18% forward premium relative to the Canadian dollar. According to the interest parity condition, the difference between forward and spot rates should reflect the interest rate differential. The formula for covered interest parity (CIP) is:

(1 + i) / (1 + i*) = F / S

where i and i* are domestic and foreign interest rates, F is the forward rate, and S is the spot rate. Plugging in the values:

(1 + 0.06) / (1 + 0.03) ≈ 1.06 / 1.03 ≈ 1.029

and the actual forward to spot ratio is:

F / S = 1.3 / 1.1 ≈ 1.182

The discrepancy suggests the no-arbitrage condition of interest parity does not hold, implying potential opportunities for arbitrage or indicating market expectations of future rate movements, inflation, or risk premiums. If interest rates and forward rates do not align, rapid adjustments and market interventions might occur to restore equilibrium.

Regarding exchange rate determination over various horizons, long-term factors include relative productivity, inflation differentials, and government policies, which influence price levels and thus exchange rates (Krugman, 2019). Medium-run fluctuations are often driven by interest rate differentials, speculative activities, and macroeconomic shocks. Short-term movements are frequently due to order flows, market sentiment, and central bank interventions (Mishkin, 2018). Understanding these dynamics helps policymakers and traders predict currency movements and devise appropriate strategies.

The interest parity condition is succinctly expressed as the equilibrium where expected returns on domestic and foreign assets are equal when adjusted for exchange rate expectations. The derivation from the provided equation, (1/R)(1+i)F = F/R(1+i), involves manipulating the expression to show that the forward rate equals the expected future spot rate, discounted or adjusted by interest rates. This ensures no arbitrage opportunities in the foreign exchange market, linking forward rates directly to interest differentials and expectations of future spot rates (Obstfeld & Rogoff, 2017).

In the currency valuation example, with a dollar/pound exchange rate of $2/£, the price of a Big Mac costing $5 in New York and £4 in London provides a basis for valuation. The implied exchange rate based on Big Mac prices is $5 / £4 = $1.25/£, indicating that the actual rate ($2/£) is higher. The actual rate suggests the pound may be undervalued because the Big Mac prices reveal a purchasing power parity (PPP) discrepancy; US consumers are better off in the US market regarding Big Mac affordability, signaling potential undervaluation of the pound. When examining currency undervaluation or overvaluation, the Big Mac Index is a colloquial measure, and based on this, the pound appears undervalued, making London more expensive for US tourists or consumers.

The gold standard required countries to follow certain rules to maintain stability. These include maintaining a gold reserve ratio to back the national currency, fixing the exchange rate to gold, and allowing convertibility of currency into gold at a fixed rate. Countries had to avoid manipulating the exchange rate, limit excessive inflation, and ensure that gold flows were balanced to prevent shortages or surpluses that could threaten the stability of the fixed rate (Eichengreen, 2015).

Groupings of countries may adopt a common currency to facilitate trade, reduce transaction costs, promote financial integration, and enhance economic stability. Four reasons include: fostering regional economic integration, eliminating exchange rate risk, increasing price transparency, and strengthening negotiating power in global markets (Berg & Borenzstein, 2017). These benefits make a common currency attractive, especially among closely linked economies seeking to boost regional trade and investment.

A sudden increase in demand for foreign exchange under a fixed exchange rate regime creates pressure on the monetary authority. To sustain the fixed rate, the central bank must intervene by selling foreign reserves and buying domestic currency, which tightens monetary supply, potentially leading to higher interest rates. If reserves are exhausted, the central bank can no longer defend the peg, risking devaluation. Graphically, the central bank’s interventions are represented by shifts in the supply and demand curves, with the intervention point maintaining the official exchange rate (Krugman et al., 2020).

The J-curve illustrates that after a currency depreciation, the current account initially worsens due to existing contracts and price stickiness, but over time, it improves as exports become cheaper and imports more expensive, leading to a better trade balance. The shape—bottoming out and then rising—results from the time lag in adjustments. For a positive effect, the elasticity of export and import demand must be sufficiently high to respond to prices and competitiveness over time (Engel & Rogers, 2019).

Weak financial sectors exacerbate problems caused by volatile capital flows by reducing the availability of credit, increasing vulnerability to external shocks, and limiting the capacity to absorb capital flight. A fragile banking system often fails to smooth out fluctuations, leading to credit crunches, reduced investment, and increased risks of banking crises, which further destabilize the economy (Honohan & Laeven, 2017).

During the Great Depression, exchange rate policies, such as the gold standard and fixed exchange rates, contributed to economic contraction. Countries that maintained rigid exchange rates faced difficulties in adjusting to declining gold reserves and shrinking international trade. Many resorted to deflationary policies and trade protectionism, deepening economic downturns, and causing currency crises in some cases (Romer, 1992).

A crawling peg is a compromise exchange rate regime where the currency is allowed to fluctuate within a band that gradually adjusts according to a predetermined path. The pro is that it provides stability and gradual adjustment to misalignments; the con is that it can create speculative attacks if markets believe the peg is unsustainable (Calvo & Reinhart, 2000). It offers flexibility compared to a fixed rate but requires credible commitment and effective management to prevent misalignments and market volatility.

To correct a current account deficit, a nation can implement policies including fiscal restraint to reduce domestic demand, monetary policies to influence interest rates and exchange rates, and structural reforms to improve competitiveness. Fiscal tightening aims to reduce domestic consumption and investment, thereby decreasing imports; monetary policy can seek to devalue currency or raise interest rates to make exports more attractive; structural reforms improve productivity and competitiveness (IMF, 2019). Each policy type serves to rebalance the external position and restore macroeconomic stability.

In fixed exchange rate economies, monetary policy loses its efficacy in expenditure switching because the central bank must prioritize maintaining the fixed rate over domestic economic goals. When a country fixes its rate, it cannot freely use monetary policy to influence inflation, output, or employment, as doing so might undermine the peg (Mishkin, 2018).

The Asian financial crisis was driven by vulnerabilities such as excessive reliance on short-term foreign borrowing, inadequate financial regulation, and currency pegs that became unsustainable when capital flows reversed. The crisis was exacerbated by speculative attacks, declining reserves, and overvalued currencies, leading to abrupt devaluations, banking collapses, and severe economic downturns across the region (Corsetti et al., 1999).

IMF conditionality refers to the policy measures imposed on countries receiving financial assistance, including austerity, structural reforms, and austerity measures aimed at fiscal consolidation. Critics argue that these conditions often worsen economic hardship, increase unemployment, and lead to social unrest while delivering limited economic stability or growth (Stiglitz, 2002).

References

• Berg, A., & Borenzstein, E. (2017). Regional Currency Unions: Convergence and Challenges. Journal of International Economics, 106, 48-65.
• Calvo, G., & Reinhart, C. (2000). Fear of Floating. The Quarterly Journal of Economics, 115(2), 379–408.
• Corsetti, G., et al. (1999). The Asian Financial Crisis: Causes, Policy Responses, and Lessons. IMF Staff Papers, 46(1), 1-77.
• Eichengreen, B. (2015). Golden Fetters: The Gold Standard and the Great Depression. Oxford University Press.
• Engel, C., & Rogers, J. H. (2019). Currency Unions and International Trade. Journal of International Economics, 119, 190-208.
• Honohan, P., & Laeven, L. (2017). Financial Sector Policy for Developing Countries. Annual Review of Economics, 9, 251-273.
• IMF. (2019). External Sector Reports. International Monetary Fund Publications.
• Krugman, P. (2019). International Economics: Theory and Policy. Pearson.
• Krugman, P., et al. (2020). International Economics. McGraw-Hill Education.
• Madura, J. (2018). International Financial Management. Cengage Learning.
• Mishkin, F. (2018). The Economics of Money, Banking, and Financial Markets. Pearson.
• Obstfeld, M., & Rogoff, K. (2017). Foundations of International Macroeconomics. MIT Press.
• Romer, C. (1992). The Great Depression. Journal of Economic Perspectives, 6(1), 19-40.
• Stiglitz, J. (2002). Globalization and Its Discontents. W. W. Norton & Company.