Good E A1 D Essay Example

International Finance

Question 1
Exchange rate pass-through occurs when international traders adjust the prices of their commodities to reflect changes in the exchange rate. Incomplete pass-through occurs when not all changes in the exchange rate are adjusted in prices. The exchange rate pass-through is incomplete due to the existence of international trade costs as well as the practice of pricing to market. It can only be complete when trade costs are constant, but this is not the case because the costs vary from one country to another. In addition, some firms apply price discrimination strategies in international trade. This implies that different prices are charged for similar commodities hence exchange rate pass-through is not complete. Studies have indicated that the magnitude of exchange rate pass-through for Canada and the USA is very low. This attributed to the presence of well-established firms in the USA and Canadian markets that makes the markets so competitive. Firms will be unwilling to transfer the effects of exchange rate movements as this makes them less competitive.
Recent years have seen a decline in the degree of exchange rate pass-through. This is due to the increased market segmentation by international traders. In addition, most international traders apply price to market strategy in pricing their commodities. The dealers charge different prices in different domestic markets due to economic differences between countries. This is promoted by the lack of international arbitrage opportunities which allows international price discrimination.

Question 2

Shadow banking involves activities of unregulated financial intermediaries. These unregulated financial intermediaries engage in credit creation and other banking services just like traditional banks that are regulated. The IMF attributes the growth of shadow banking to tight banking regulations which make it difficult for firms to enter the sector. In addition, presence of abundant liquidity coupled with the rules promotes the growth of shadow banking. It also caused by the desire by participants to gain from capital and tax arbitrage.
Shadow banking assists in the development of the financial system by offering the participants alternatives for funding. In addition, it helps in reducing financing costs since the financial intermediaries are not required to meet capital and reserve conditions like traditional banks. Financing cost is also reduced as a result of competition in the financial sector. The disadvantage of the shadow banking system is that it encourages people to borrow as it faces fewer or no regulations. Uncontrolled lending can increase leverage levels and increase systematic risk as witnessed in the past financial crisis. Shadow banking also leads to unfair completion in the banking sector as the unregulated financial institutions have unfair regulatory advantages over traditional banks.

Question 3

Under the AA/DD model, a shift in the AA curve can result from a change in the money supply among other factors. If the Central Bank implements the quantitative easing policy, the supply of the Euro will fall as the people will use the Euro to purchase the bonds. A fall in the supply of the Euro will cause a shift of the AA curve to the left (inwards) as shown below. The inward shift will result in a decline in GDP (Y) and a fall in expected exchange rate (E).

A2
E1
E2
D A1
A2

Y2 Y1 Y

Question 4
The AA/DD model provides that a change in government, private or investment demand causes a shift in the DD curve. A drop in the demand for oil in Saudi and Canada will, therefore, result in a leftward shift in the DD curve. Since the decline in demand will no0t affect the AA curve, the net impact will be an increase in expected exchange rate from E1 to E2 as shown below. On other hand, GDP will fall from Y1 to Y2.

E A2 D2 D1

E2
E1
A1

Y2 Y1 Y

The change in the exchange rate can be corrected by the central bank through a quantitative easing policy. This will involve selling government bonds and other securities to the public. The policy will reduce the amount of Riyadh circulating in the Saudi economy. It causes an inward shift in the AA curve from AA1 to AA2 as shown above. The expected exchange rate will fall to the initial value. This is possible since Saudi operates a fixed exchange regime.
Canada cannot regulate the exchange rate since it runs a floating exchange system. Therefore, it cannot reduce the exchange rate. At the high exchange rate, Canadian commodities become more expensive thereby reducing exports and increases imports. This will continue until the market forces change the situation. This indicates that Canada does not gain from the floating exchange rate system.

Question 5

GDP-linked bonds will reduce pressure on the government’s budget especially during the recession when the GDP growth is low. It will pay less interest thereby reducing the need for further borrowing to meet other activities. The demerit is that they put pressure on the budget during periods of high GDP growth. During these periods, more interest is paid thus leaving the government with less to finance other activities. It may be forced to borrow additional funds, and this increases the debt-to-GDP ratio.