E A1 D Essay

International Finance

QUESTION ONE
A)
When the effects changes in exchange rates get transferred to import prices, it results into the occurrence of exchange rate pass-through. Within a free international trade, that is, lack of costs of trade, there should be complete exchange rate pass-through. When the law of one price holds not anymore, this cause incomplete pass-through as the engagement of most traders leans on the price to market (PTM). The variations caused as a result of differences in costs of trade between countries due to economic factors, is the reason for the difference in the price of the same basket of commodities in the foreign and domestic markets.
Moreover, there is engagement of some traders in price discrimination by imposing different prices for the same service / service in the foreign or domestic market. The engagement of firms in international price discrimination, make the exchange rate pass-through to be incomplete as long as the commodities market lack opportunities for international arbitrage.
B)
The recent years has experienced a decline in the degree of exchange rate pass-through because of the increased practices of price to market by the traders in the international market. The aspect of price discrimination has got its roots in the enhancement of the market segregation due to the practice of price to market by the international market traders. The practice of price discrimination is only dependent on the nature of the domestic market in that particular country. The high competitive markets cause the traders to charge low prices. Therefore, the decline in the degree of exchange rate pass-through has been due to increased market segregation.

QUESTION TWO

A)
The situation in which financial institutions which are subject to regulatory oversight carry out unregulated credit creation activities is one termed as the shadow banking. A system of shadow banking may again compromise financial institutions which perform the roles of traditional banks but with no or little regulation. Most countries have put stringent banking sector regulations and this has been deduced to the growth of the shadow banking system. In the case where the stringent banking regulations and the abundance in liquidity, there is growth of the shadow banking system in facilitation of the development of financial system in areas where the banking sector has not covered.
B)
Additional source of funding and liquidity is provided as a beneficial aspect of the shadow banking to the corporate entities and likewise to individuals. Through the provision of alternative funding and liquidity, the shadow banking enhances the growth and development of the financial institutions in a country and at a global angle too. Furthermore, the institutions of shadow banking provide additional credit due to less restrictions and confinements as they are not subject to reserve and capital requirements, unlike the traditional banks. On the limitations part of the shadow banking is the increase in systematic risk the system cause. The fact that they are not restricted make them to have no boundaries in unleashing their lending capacity. This increased leverage then result to increased systematic risk. On the other hand, shadow banking system create difficulty for the traditional banks which are subject to the stringent banking regulations.

QUESTION THREE

The European market experiences a reduction in the supply of the Euro currency due to the process of quantitative easing undertaken through the purchase of bonds. There is an inward shift from AA1 to AA2 of the AA curve due to fall in the supply of the Euro as depicted in figure 1 below. The policy has no effect on government, private and investment demands, therefore no effect on the DD curve as shown below. As AA curve shift inwards, there is decrease in output from Y1 to Y2 and a consequent decrease in expected exchange rate from E1 to E2. There will be an increase in the value of the Euro currency as more U.S. Dollars will be bought by one Euro than ever before.
Figure 1

A2
E1
E2
D A1
A2
0 Y2 Y1

QUESTION FOUR

A)
The two countries majorly trade on oil, hence when there is a decline in the demand for the oil, there would be a fall in the aggregate demand. The decrease in demand leads to a shift in the DD curve to the left as the figure 2 depicts below. There will be no effect on the AA curve, thus output will decrease as the expected exchange rate increases.
Figure 2

E A D2

D1

E2 A2

E1 D2
D1 A A2
0 Y2 Y1
B)
It is possible of the Saudi Central Bank to regulate the movement of the exchange rates since the bank runs a fixed exchange rate system, and also be able to restore it to its initial rate. For this case, the central bank undertake a quantitative easing by selling the government bonds. This will result into reduction of the supply and thus the AA curve shifting inwards to AA2. This makes the exchange rate to fall as depicted in the figure 2 above.
C)
The inability of Canada to restore the exchange rate in case of unfavorable movements, makes her not to benefit from the system of the floating exchange rate. For example, if there is appreciation of the Canadian Dollar, Canada losses because its exports will be expensive than its imports. Canada will not be able to restore this unfavorable change, unlike Saudi whose central bank can restore the initial rate by means of open market operations.

QUESTION FIVE

During recession, GDP-linked bonds are very important to governments. The interest paid by the government for the GDP-linked bond is based on the GDP growth rate. The times of low economic growth, the government pay less interest to the bond holders. As a result the government put in place a favorable budget and will not be required to borrow funds in such periods. On the contrary, the GDP-linked bonds are never desirable when the growth rate of GDP is high. The government pay more interest, and thus exerting more pressure on the budget. There will be an increase in the debt-to-GDP ratio because the government could be forced to borrow additional funds to finance other undertakings.