Tuesday, August 28, 2012

Essay on Exchange Rate Systems

Essay on Exchange Rate Systems

We are going to analyze the option for Canadian company to acquire goods from non-Canadian supplier, and see how the exchange rate fluctuations of different currencies may effect the economic benefit of the selected company derived from the transaction, as compared to the case if the transaction and payment were delayed for three months. After the calculations are made and the best option out of the six possible options is identified, we will elaborate on the importance of exchange rate movements to the international importer/exporter.

From the table, we can see that the performance of the Canadian dollar on the international markets would have improved significantly over the next three months, as the currency has appreciated over all three of its counter parts (USD, JPY and EURO). Looking at the calculations provided above, and on the % increase of the value of Canadian dollar over time, it is apparent that the best option out of the six options initially available for the company would be to purchase the materials in three months from now from the American supplier.

Since the fall of the Bretton Woods system, nominal and real exchange rate fluctuations exhibit large and persistent departures from purchasing power parity.

The interpretation of this phenomenon relies on the failure of the law of one price among internationally traded goods. Firms tend to set prices in the buyer’s currency (pricing-to-market, PTM) and do not adjust prices to changes in the nominal exchange rate. (Betts and Devereux, 2000) As a consequence, following a money expansion, the money market equilibrium requires an increase in the consumption price level.

With sticky-product prices and PTM, nominal exchange rate hardly affects import prices. For a given change in relative money supplies, a larger nominal exchange rate depreciation is needed to clear the money market. As a result, PTM magnifies exchange rate responses to monetary shocks. “PTM behavior generates deviation from the law of one price whose volatility is somewhat consistent with the data.” (Betts and Devereux, 2000)

Large nominal exchange rate fluctuations are attributable to the presence of non-traded goods. The more closed the economy, the larger the exchange rate fluctuations. Indeed, when the law of one price holds, non-tradables reduce the impact of import prices on the consumer price level. The money market equilibrium requires a larger exchange rate depreciation following the expansion in the money supply. The literature tends to discard this explanation to exchange rate fluctuations since Chari the researchers assert that the relative price of non-traded goods play no role in accounting for real exchange rate fluctuations. (Betts and Devereux, 2000)

It turns out that financial structure, international price setting, preference parameters and nature of shocks are key determinants. Concerning price setting schemes, nominal prices are fixed in the producers’ currency, so that prices for consumers change one-for-one in the short run with changes in the nominal exchange rate (“producer-currency-pricing,” hereafter PCP). (Betts and Devereux, 2000) A number of recent papers are based on models in which nominal prices are set in advance in the consumers’ currency. In that case, in the short run, nominal exchange rate changes do not modify the prices faced by consumers (“local-currency-pricing,” hereafter LCP) assumption. (Betts and Devereux, 2000)

The new generation of dynamic general equilibrium models manages to mix simplicity with a rich behavioral structure. Obviously, the optimal outcome depends crucially on the price setting rules and on the kind of shocks that affects the economies. When prices are sticky in the producer’s currency, pure producer price index (PPI)

inflation targeting policies achieve the first best allocation. (Betts and Devereux, 2000) The nominal exchange rate is thus free to adjust to the required fluctuations of the terms of trade. It may be considered optimal to have a flexible exchange rate regime.

Nevertheless, when inefficient shocks hit the economies, monetary authorities face a trade-off between the inflation rate and the output gap stabilization: it is no longer possible to reach the first best allocation. So they cooperate optimally to adjust gradually the producer price levels, the output gaps and the terms of trade.

In that context, exchange rate fluctuations amplify the inflation/output gap trade-offs so that it may be optimal to limit exchange rate movements.(Betts and Devereux, 2000) A fixed exchange rate regime is even fully optimal under some parameter restrictions. As far as coordination gains are concerned, some non-negligible welfare improvements from cooperation are likely to exist even if shocks are efficient.

The liquidity effect has been already analyzed in an open economy setting. The researchers aim at reproducing the dynamic responses of the interest rate, the nominal exchange rate and the output given by a structural VAR model, following a monetary expansion. By using a two-country framework, economists measure the role played by the liquidity effect in the international transmission of economic fluctuations. (Betts and Devereux, 2000) Given the limited participation assumption, monetary shocks generate a nominal exchange rate overshooting that accounts for a substantial part of the huge observed nominal exchange rate fluctuations.

Nevertheless, the law of one price and the purchasing parity power hold such that the real exchange rate equals one.
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