Econ 434: International Finance And Open Economy Macro

Econ 434 International Finance And Open Economy Macroin

Analyze the following questions related to international finance and open economy macroeconomics. Describe how arbitrage occurs in the foreign exchange (FX) market with given exchange rates; compute returns, interest rate differentials, and exchange rate expectations based on the uncovered and covered interest parity conditions; evaluate the misalignments and equilibrium conditions in foreign exchange markets; analyze the monetary approach to exchange rate determination, including inflation differentials, real exchange rates, and the effects of monetary policy changes; assess the impacts of monetary growth, inflation, and policy regimes on exchange rates and currency valuations; interpret how changes in money demand, monetary policy, and investor expectations affect the FX market through diagrams; compare different exchange rate policies, such as pegs, adjustable bands, and currency unions, especially during crises; and discuss the policy implications of the policy trilemma involving exchange rate stability, monetary independence, and capital mobility.

Sample Paper For Above instruction

In the realm of international finance, the foreign exchange (FX) market plays a crucial role in facilitating global trade and investment. Arbitrage opportunities arise when discrepancies exist in exchange rates across different markets, prompting investors to exploit these differences until equilibrium is restored. For instance, considering dollar-euro quotes in New York and Tokyo, arbitrageurs would buy euros where the euro is cheaper relative to the dollar, and sell where it is more expensive, exerting downward pressure on the higher-rate market and upward pressure on the lower-rate market. Consequently, this process leads to the convergence of exchange rates, aligning the dollar price of the euro in New York and Tokyo and eroding the initial discrepancy.

Further, when assessing cross-country deposits, such as Dutch euros and British pounds, the interest rates and forward rates must align to prevent arbitrage. Through the use of uncovered interest parity (UIP), investors compare the expected depreciation of currencies to the interest rate differentials. If the euro interest rate in the Netherlands exceeds that in Britain, but the forward rate does not reflect this, arbitrage opportunities could emerge, indicating disequilibrium. Using the covered interest parity (CIP), the forward premium or discount on the pound reflects market expectations of future exchange rate movements, influenced by interest rate differentials and risk perceptions. Theoretical equilibrium forward rates derived from CIP should align with market expectations when no arbitrage exists.

Moving into the monetary approach to exchange rates, inflation differentials between countries influence the real exchange rate and consequently the nominal rate. The relative version of the Purchasing Power Parity (PPP) suggests that if inflation in the U.S. is lower than in the U.K., the dollar should appreciate against the pound in the long run. The expected inflation differential, combined with the convergence process, determines the future exchange rate, accounting for deviations from parity through the speed of adjustment parameter. The approach also emphasizes the importance of monetary policy, specifically money supply growth, which impacts inflation and exchange rate dynamics.

In analyzing monetary policy impacts, increasing the money supply typically raises inflation and causes currency depreciation in the short term. For example, excess monetary growth in Korea relative to Japan leads to higher inflation and a subsequent depreciation of the Korean won against the Japanese yen, according to the monetary model. Time series diagrams illustrate the sequence of effects: money supply expansion raises prices, diminishes the real money supply, alters interest rates, and prompts exchange rate adjustments. Policies aimed at maintaining fixed exchange rates necessitate precise control of money growth to prevent misalignments and speculative attacks, especially when market expectations shift suddenly, such as during crises.

During the East Asian Currency Crisis, expectations of currency devaluation prompted capital outflows and pressures on fixed regimes. For example, Thai investors’ anticipation of baht depreciation led to increased demand for foreign currency, challenging the peg and prompting exits from the currency regime. Similar dynamics occurred in Indonesia and Malaysia, but responses varied: Thailand and Indonesia faced currency devaluation and withdrawal from pegs, while Malaysia used capital controls to defend their exchange rate. Policy choices—whether to maintain a peg through intervention or switch to floating regimes—have profound implications for macroeconomic stability, with the policy trilemma highlighting the trade-off between exchange rate stability, monetary autonomy, and capital mobility.

The asset approach to exchange rates incorporates financial market factors and expectations, emphasizing how changes in money demand and investor sentiment influence currency values. A reduction in U.S. real money demand shifts equilibrium, affecting exchange rates temporarily or permanently, depending on whether the change is perceived as temporary or sustained. Graphical analysis shows initial disequilibrium adjustment phases, with interest rate and exchange rate dynamics depending on the nature and persistence of shocks.

Similarly, monetary policy shifts—such as Korea's decision to reduce its money supply—affect exchange rates directly. If the decrease is unexpected, it can lead to a rapid appreciation of the Korean won, while announced but unimplemented policies might influence market expectations without immediate effects. The effectiveness of such policies depends on investor perceptions, credibility, and whether the adjustments are anticipated, underscoring the importance of communication and commitment in exchange rate management.

In the context of currency unions, countries sacrifice some monetary independence to achieve exchange rate stability and economic integration. Joining a currency union implies giving up autonomous monetary policy, thus facing the policy trilemma. If a member country experiences asymmetric shocks, it loses the ability to adjust its exchange rate or monetary policy independently, potentially exacerbating economic instability. While currency unions foster stability and integration, they require careful management of macroeconomic divergences and policy synchronization among member states.

Overall, comprehending these diverse theoretical frameworks and models—such as the uncovered and covered interest parity, the monetary model, and the asset approach—is essential for policymakers aiming to stabilize exchange rates, foster economic growth, and manage international financial integration. The strategic decisions surrounding exchange rate regimes, monetary policies, and crisis management are complex and interconnected, reflecting fundamental trade-offs embodied in the policy trilemma. Successful navigation of these issues requires a nuanced understanding of global financial markets, expectations, and policy tools, especially in an increasingly interconnected world economy.

References

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