International Finance: Review

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Introduction

This paper seeks to present a critical discussion of how the floating exchange rate system allows the central bank to control the money supply in a country. The control of money supply is an ability that has a major influence on a country’s interest and inflation rates. The discussions seek to employ the concepts of monetary approach assumptions. Finally, the discussion concludes with a concise explanation of the limitations of the monetary approach.

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The floating exchange rate system

An exchange rate is the cost charged for converting the value of a country’s currency into the value of another. Floating exchange rate is a regime that allows the exchange rate to be freely determined by forces of demand and supply. An open market trade of currencies and other economic transactions between a domestic and a foreign country influence the levels of exchange rates. To explain how a floating exchange rate system works, let us use a hypothetical situation involving an American investor who is interested in exchanging a dollar for a pound. Assuming that at an exchange rate of 1.4$/£, the demand for pound exceeds the supply. That is, more U.S investors buy pound whose availability is limited. Due to the forces of demand and supply, further increase in demand for pound will result in an increase in the price to $1.6/£ and set it at equilibrium. At equilibrium, the demand and supply of pound are equal. The increase indicates that the exchange rate has increased for American investors (Wright 1984, pp. 50-62)

From another point of view, it is wise to say that the dollar value has weakened against pound to set the two market forces at equilibrium. If the exchange rate were set at a price above the equilibrium, say $1.9/£, the situation would create an opportunity for the British to buy more dollars for less pound thus will increase the supply of pound. At this level of exchange rate, the pound is said to have gained more strength whereas the dollar is said to have weakened further. A further increase in the supply would saturate the market thus lowering the demand for pounds. The only way for suppliers to get rid of excess pound is by lowering the price to induce an increase in the demand. Therefore, the exchange rate would be set back to the equilibrium point. The above process would continue so long as the regime is still in operation. Therefore, this is the mechanism involved in a flexible exchange rate regime (Bigman & Taya 2002, pp. 57-71)

The monetary approach

The monetary approach is comprised of two principal elements: the classical model of determining price level and exogeneity of real exchange rate. Exogeneity of the real exchange rate implies that inflation in a domestic country would not affect the price of goods from a foreign country. The classical model of determining price implies that the level of money supply in a country determines the price level of commodities. The basic idea of the monetary approach is that monetary issues influence the balance of payment. The key assumptions of this approach are stable money demand function, vertical aggregate supply and purchasing power parity.

According to the stable demand function, the fundamental of money demand function is the quantity theory of money ( Md = kPy) where P is the price level of commodities in the domestic country, y is the real domestic income and k stands for the sensitivity of money demand to variations in the nominal income. From the above function, if k is constant, then an increase in y leads to a proportional decrease in P. In other words, an increase in real income leads to a proportional decrease in the price level. An increase in the money supply leads to an increase in the levels of aggregate demand and thus an increase in the price levels. Therefore, if the money supply increased by double digits, the price levels would follow in the same path. However if the government of a country that uses flexible exchange rate regime decides to increase the money supply, the following would happen: the individual spending levels would increase (Ball 1966, pp. 85-90).

The demand for local goods would be higher because of increased consumption. If the level of production remains the same, further increase in demand would lead to increase in commodity prices thus inflation. The situation would make local products more expensive than imported goods. The local consumers would then prefer foreign products to those available in the local market. The rate of imports would increase thus increasing the demand for the foreign currency and increasing the supply of local currency in the foreign exchange market. A further increase in the supply of local currency more than its demand would reduce the value of local currency in the exchange rate market. The events would lead to local currency depreciation thus increase the exchange rate. Since the local country would import more products than it would export, it would experience a deficit in the balance of payment (Serletis 2001, pp. 21-35)

On the other hand, if the government decides to reduce the money supply, the following would happen: the individual spending levels would reduce. The demand for local goods would be lower because of decreased consumption. If the level of production remains the same, a further decrease in demand would lead to a decrease in commodity prices thus deflation. The situation would make local products cheaper than imported goods. The foreign consumers would then prefer foreign products to those available in the local market. The rate of exports would increase thus increasing the demand for the local currency. There would be an aggregate increase in the demand for local currency in the foreign exchange market. A further increase in the demand of local currency would increase the value of local currency in the exchange rate market. The events would lead to local currency appreciation thus a reduction in the exchange rate. Since the local country would export more products than it would import, it would experience a surplus in the balance of payment. Therefore, in a flexible exchange rate system, the central Bank has the ability to control the money supply to influence the rate of inflation. However, precaution is necessary because changes in the money supply have indirect influence on a country’s exchange rate and balance of payment. Therefore, it would not be economically wise if the central bank heavily engaged the monetary policies to influence the rate of inflation (Rabin & Yeager 1982, pp. 15-24)

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According to the vertical aggregate supply schedule, the labor market is always assumed flexible enough because the economy is at full employment. Therefore, an increase in the price of domestic commodities does not lead to an increase in the total output because wages adjust. As a result, there would be no advantage for producers with intentions to increase their output levels by increasing the number of employees. If the central bank increases the money supply in an economy to induce an increase in the levels of production, the move would only increase price levels and cause inflation (Arize 2000, pp. 34-39)

According to purchasing power parity, same products sold in different countries, in a competitive market without consideration of transportation cost and trade barriers, should cost the same price when converted to a common currency. In an efficient market (a market that experiences free flow of goods and services), the price of a collection of identical goods should be the same in each country. However, due to information asymmetry, trade barriers and transportation costs, it is not possible for absolute purchasing power parity to be maintained. In essence, changes in relative prices result to change in exchange rates. If the central bank through its open market operation decides to buy bonds from holders in a bid to increase the amount of money in circulation, money supply will increase. The increase would lead to a rise in consumption levels. However, if the production levels were not increased proportionately with the increase in the money supply, fewer commodities would be available for many consumers leading to increase in prices. The situation would cause inflation. The following is an explanation of how it would happen: inflation would make local commodities more expensive than foreign commodities. Local consumers would prefer foreign goods to local ones. The events would cause more supply of the local currency in the foreign exchange market than the demand. The value of the local currency would decrease and so would be to the currency exchange rate (Arize 2000, pp. 34-39).

Arguments in favor of flexible exchange rate system

  • Automatic balance: automatic changes in the exchange rates due to the forces of demand and supply tend to restore the balance of payment automatically. Under flexible exchange rate regime, the forces of demand and supply will depreciate the external value of the country’s currency to a level that will reverse the excess supply. The balance of payments disequilibrium will disappear at the new exchange rate level thus restoring the equilibrium (Quirk 1987, pp. 95-121).
  • Setting internal policies free: As long as the forces of demand and supply is determining the exchange rate, the equilibrium exchange rate and balance of payment can be achieved automatically. This means that the government’s fiscal and monetary policies would be free. Therefore, the government would focus its free policies on achieving other economic goals (Quirk 1987, pp. 95-121).
  • Low foreign exchange reserves: foreign exchange reserve is the amount of foreign currency held by the central bank to meet emergency demands of foreign currency. Under the flexible exchange rate regime, there would be no need for higher levels of the foreign exchange reserve. Therefore, the held foreign exchange reserve could be used for other economic pursuits (Gagnon & Hinterschweiger 2011, pp. 56-60)

Limitations of the monetary approach

The approach is said to ignore some opinion of the monetarists. There is a sharp divergent of views as some hold the opinion that the increase in the money supply might not be reflected in the decrease of reserve levels. Secondly, the assumptions of the approach are unrealistic because in the short run, the money demand function is said to be unstable and economies hardly experience full employment levels. Lastly, the approach ignores the issue of indebtedness due to the deterioration of the current account, which is financed by the capital account (Arestis 1988, pp. 53-61).

List of References

Arestis, P 1988, Post-Keynesian monetary economics: new approaches to financial modelling, Edward Elgar, Aldershot.

Arize, A, C 2000, Balance of payments adjustment: macro facets of international finance revisited, Greenwood Press, Westport, Conn.

Ball, R, J 1966, Inflation and the theory of money, Allen & Unwin, London.

Bigman, D & Taya, T 2002, Floating exchange rates and the state of world trade and payments, Beard Books, Washington, D.C.

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Gagnon, J, E & Hinterschweiger, M 2011, Flexible exchange rates for a stable world economy, Peterson Institute for International Economics, Washington, DC.

Quirk, P, J 1987, Floating exchange rates in developing countries: experience with auction and interbank markets, International Monetary Fund, Washington, D.C.

Rabin, A, A, & Yeager, L, B 1982, Monetary approaches to the balance of payments and exchange rates, Kluwer Acad. Publ, Boston.

Serletis, A 2001, The demand for money: theoretical and empirical approaches, Kluwer Acad. Publ, Boston.

Wright, E, H 1984, The exchange rate system lessons for the past and options for the future ; a study by the Research Department, International Monetary Fund, Washington, D.C.

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