Posted: March 23rd, 2023

Finance

Question 1

Impact of Chinese Currency Devaluation

Currency devaluation regards to the reduction of the value of currency in respect to foreign currencies. It is an economic strategy applied in creating a favorable internal financial situation. China is one of the countries known to use devaluation policy over the years. The approach has an economic impact on both China and the global market. Particularly, the strategy is applied in the post-economic crisis where the government intends to have the economy driven by internal consumption rather than over dependent on exports. Through devaluation, the Chinese products become cheaper in the global market where the products gain competitive advantage, hence increasing the overall export in volumes. On the other hand, with the weak Chinese currency, the importation of goods and services become considerably expensive. The Chinese consumers could therefore not afford the imports unless they are not readily available locally (Economicshelp.Org, 2016). The demand for the products also grows from the internal market. The end point from the devaluation is that more internal production will be driven by demand, hence creating more job opportunities and income for the people.

The devaluation of the Chinese currency would also have a significant impact in the global economy since China is the second largest economy in the world and the largest exporter. With the cheaper products from China, products from other countries will experience a reduction in foreign income, while their industries will have to reduce their production capacity. Additionally, economies exporting their products to China will have a shrinking market affecting their foreign income adversely (Economicshelp.Org, 2016). Such countries will end up experiencing increased unemployment and income levels.

Foreign exchange rate is an important economic aspect as it affects foreign trade and income. A country can apply either a fixed or a floating exchange rate policy. In floating exchange policy, a country’s currency is allowed to exchange with other currencies based on the forces of demand and supply. A fixed exchange rate is applied to a policy where the government through the central bank decides on the amount of the local currency offered in return to a foreign currency. A peg policy applied in Saudi Arabia implies that the Riyal is exchanged for a given amount of the US dollar irrespective of the changes in demand for the currency. However, Saudi Arabia is likely to drop the pegged policy following the decline in the price of oil, which has reduced the country’s foreign income drastically. As a result, the economy’s deficit has been on the increase, implying that its foreign reserve has been declining (Tradingeconomics, 2016). In the future, the government may not be able to control the exchange rate due to lack of adequate reserves in dollars.

The exit of Britain from the European was driven more by politics than knowledge of the economic and social implication. The exit has so far done more harm to the Britons with no assurance of the better economic performance as predicted during the Brexit campaign. The most fundamental effect has the devaluation of the Sterling Pound against the Euro and US$ (Economicshelp.Org, 2016). Due to the devaluation, the exports from Britain have turned cheaper and competitive in the international market. Secondly, the imports have become more expensive as a pound can be exchanged for less of the foreign currencies, particularly the Euro and the US$. As a result, there is an increase in aggregate demand for goods and services produced locally. The rise in the cost of foreign goods leads to cost pulled inflation, while the growth of demand leads to demand-pulled inflation.

A graph showing the devaluation of the Pound against the Europe since Brexit (The Economist, 2016).

The graph on the effect of changes in aggregate demand (Economicshelp.Org, 2016)

Question 2

The Monetary Trilemma That Policymakers in Open Economies Inevitably Face

The monetary/financial trilemma regards to the economic goals that economic policymakers across the world strive to achieve. Economies are usually faced with three options in creating favorable situations in consideration to the international economic community and situation. The first option regards making the economy open to foreign capital flow. According to Mankiw, under this option, the citizens are allowed to invest in viable options abroad with the aim of bringing in foreign income (1). In addition, the option aims at attracting foreign investors to bring in resources and expertise; hence, creating employment and boosting output. The second option is to apply the monetary policy to help stabilize the economy. Under the option, the central bank acting on behalf of the government increases the money supply and decrease interest rates during the economic depression. The increase in money supply leads to the multiplier effect, while the reduced interest rates encourage borrowing to invest while deposits are discouraged. On the other hand, when the economy is overheated, the money supply is decreased, and the interest rates are increased. The third option is to maintain stability through currency exchange rate. Economies using floating exchange rates are faced with volatility since speculation drives them. On the other hand, fixed exchange rates are applied to stabilize the economy and make it easier for households and businesses to enjoy economic stability.

The interesting part of the financial trilemma is that it cannot apply all the approaches. Upon selecting two of them, one has to forgo the third one. For instance, in the United States, the first two options are applied. According to Mankiw, Americans can invest in foreign projects by sending foreign direct investment in other countries, while foreigners can invest in the US market through the open stock market (1). Secondly, through the Federal Reserve, the monetary policy is adopted in maintaining full employment and price stability. On the other hand, China has a different approach. Through its central bank, it applies monetary policy and tight control on the exchange rates. The international flow of capital from China is highly regulated; only foreign direct investments that are considered necessary are allowed, while the citizens are restricted from investing abroad.

The Case for Floating Exchange Rate After the Financial Crisis

The financial crisis experienced in the late 2000s affected economies across the world. It was evident that a crisis can arise from one economy and spread to others due to increased economic integration, globalization, and international trade. Many countries were affected due to reduced output, declined foreign income, and rise in the unemployment rate. Before the crisis, floating exchange rate policy was highly advocated to encourage international trade cash flow. However, many countries started cautioning their economies against such incidences by adopting a pegged or a controlled exchange rate. Through the controlled exchange rate, governments try to control international trade and internal inflation rate depending on internal factors and situations in the global economy. For instance, export-dependent economies would like to create more demand for their products to keep the foreign income at favorable levels.

The high inflation rates in foreign markets, it would imply that the consumers in various markets might have a reduced purchasing power. With the pegged or controlled exchange rate policy, the countries can devalue their currencies to make their products more affordable in the international market. In other words, countries are very cautious to apply the floating exchange rate, which is more speculative. The governments are more interested in controlling the local economies as much as possible while trying to shield them against the spillovers from the foreign economies.

Questions 3

Purchasing power parity is a theory used in exchange rate determination. The application of a theory is a way that compares the price of goods and services between countries. The theory assumes that the trading activities of the importers and exporters as motivated by the price differences, which lead to the changes in the spot exchange rate. Purchasing power parity (PPP) proposes an absolute or a relative exchange rate. An absolute exchange rate is based on the law of one price, which implies that the price of identical goods should be the same in the two separate countries. For instance, for a commodity costing P150 in the Mexico, it should cost a consumer in the US the same price regarding dollars in the United States market. For instance, if the spot exchange rate p/$ is 10p/$, then the commodity should cost 150/10 = $ 15 to the American consumer.

The law of one price does not hold in many cases due to arbitrage opportunity when individuals buy the products from the market perceived to have lower prices to benefit from the margin earned. For instance, if the same product as above is sold at $20 in the US and P150 in Mexico, it implies that the product is cheaper by $ 5 in the Mexican market. Traders would purchase the product in large quantities from Mexico to sell them in the United States. Consequently, the supply in the American market will increase substantially hence likely to push down the price. For instance, the price can decline to about $18. On the other hand, the increase in demand in Mexico can push the price higher, to say, for example, p180. In this case, the law of one price holds, since with the application of the spot rate, the Cost in America is equal to the price in Mexico. P180/10p/$ = $18. In other words, for the law of one price to hold, the inflations from one country should be offset by deflation in the other country. However, in case the change in prices does not match, a relative PPP arises when the inflation rates between the two countries are different.

According to Fisher’s effect, the increase in the inflation rate in a country should lead to an increase in domestic interest rates. As a result, the rate of return on assets held in the domestic currency remains unchanged. In essence, the monetary policy adopted in an economy should have no implication to the relative prices. It is upon this argument that the PPP approach to exchange rate hold.

The graphs showing an ideal relationship between inflation and interest rates in the long run

Inflation and interest rate percentage per year for Italy

Inflation and interest rate percentage per year for Switzerland

Nevertheless, the PPP model has its share of weaknesses. First, there are trade barriers and non-trade products. The trade barriers include transport costs, while the governmental restrictions increase the price of goods and services and hence affecting the exchange rate. Besides, services are non-tradable and hence the theory may not be applicable. The second shortcoming of PPP is the imperfect competition, which allows firms to sell the same product at different prices in different countries. In essence, the pricing decisions determine the price in this regard by the firms but not the market forces.