Financial Management Homework Help
The theory of optimum currency is also called as the optimum currency region in which the economic efficiency is maximized to have the entire region adopt single currency. As explained in our financial management homework help there are certain criteria for these regions in order to be a part of OCA that are identified. The criteria are represented by the symmetry of external shocks, the degree of labor mobility and the openness of economy. However, the impossible Trinity as shown in our financial management homework help depicts that it is impossible to have all the three policy goals at the same time. Empirical evidences are pointing both ways. However, there is a unanimous opinion that stability of the exchange rate can promote trade. And hence, fixed exchange rate can help to promote the growth of emerging economies and investments.
- What is the usefulness of the theory of optimum currency areas in making the explanation to why countries make a choice of exchange rate regime that they do. As an extension to your explanation refer to the empirical evidence that explains the choice of exchange rate regime.
In the international economy, an optimum currency area (noted with OCA, sometimes also referred as optimal currency region noted with OCR) is defined as a geographical region where the economic efficiency would be maximized if a single common currency will be used (or in which the Member States will adopt a fixed exchange rate between the national currencies).
An optimum currency area can be – and often is – formed by several countries. For example, the reason which was behind the creation of the financial management homework help Euro is that the European countries, taken individually, do not form an optimal currency area, but the Euro Area of the European Union as a whole form such regions. In theory, an optimum currency area can be even smaller than a country. Some economists believe, for example, that the United States help with financial management homework consist of two optimum currency areas. Therefore, the country should have, according to this view, two coins, one for the eastern part and another one for the west.
has identified a number of criteria that a country must meet in order to be part of an optimum currency area, which also represent the major criteria for the appropriateness of a single monetary zone. These criteria are represented by:
The symmetry of external shocks (and the similarity of business cycles). The asymmetric shocks and asynchronous business cycles are the greatest financial management homeworks help danger to the optimality of a single monetary area. If the economic cycles are less similar from one country to another, then specific measures of adjustment for each country are required. The optimum currency area, however, strictly limits the possibilities for these adjustments, prohibiting member countries to use monetary policy tools. In this situation, the only possibility for the member states is to use the fiscal policy, which can have a negative impact on economic welfare.
The degree of labor mobility. This mobility facilitates adjustments in the case of adverse shocks, reducing the need for realignment of exchange rates. For example, in the case of a drastic reduction in the export demand, if a country cannot reduce its exchange rate to improve competitiveness (and this is the case in a monetary union), the result will be an increase in unemployment. If the labor force is financial management homework assistance sufficiently mobile, the redundant workers will go elsewhere, where needed (in the union), thus reducing the unemployment rate. The same logic can be applied to capital mobility.
The openness of the economy. The degree of openness of the economies, or more accurately, their rate of participation in the economic exchanges of the monetary union area, calculated as a percentage of the gross domestic product of the country. A single currency would reduce the unproductive costs of foreign exchange assistance with financial management homework and eliminate the exchange rate. The more intense is the country’s trade with the member states, the more advantageous is the creation of the monetary area.
- The economic diversification. Countries that produce and sell a variety of goods and services are less vulnerable to financial management homework help the shocks which affect various economic sectors. This is because different shocks (positive and negative) tend to offset each other. The country will be less inclined to use the exchange rate as an adjustment mechanism.
These criteria are used, for example, if a country is relatively financial management homework help open in terms of trade to another or to a regional bloc, but it has not a significant mobility of the workforce, its economy is not very diverse and faces asymmetric shocks, the flexibility exchange rate is a good choice.
OCA theory has given a new shape to the debate on the choice of exchange rate regime for a country. The exchange rate is an instrument of help with financial management homework economic policy. In this context, a great importance has the type of the exchange system adopted by a country. Its efficiency can be analyzed according to how three major objectives are achieved, respectively:
The adjustment – this represents the process by which the financial management homework solution disequilibrium (or imbalance) of the balance of payments can be corrected without generating tensions in the national economy.
The confidence – the adopted system must assure the economic agents that the international payments can be financial management homework help online made effective and safe, without the risk of large losses of value.
- The liquidity – this refers to the existence of a sufficient amount of the official reserves to stabilize the exchange rate.
drew attention to the wrong idea that flexible exchange rates give a high degree of freedom. In a balanced system there is only one degree of freedom. The system is characterized depending on how this degree of freedom is used. A country has the choice to set targets, such as: price level, money supply, exchange rate and gold price. The gold standard system is no longer available, but together with the optimum currency area it represents a fixed exchange system. However, in the International Monetary System of 1960, the gold price was set by the USA and the dollar price by the foreign countries. Moving to flexible exchange rates, four main possibilities are known; the analysis presented by can be summarized in the following table.
Table 5.1. Fixed target in different etalons view
|Goods||Price level||Exchange rate||Money supply||Gold price|
|Monetary||Money supply||Exchange rate||Price level||Gold price|
|Foreign currency||Exchange rate||Money supply||Price level||Gold price|
|Gold||Gold price||Money supply||Exchange rate||Price level|
When the problem is such, a variable is fixed and three are fluctuating. Of course, in some cases the system should set more than a single variable. However, quantitative increases in financial management homework writing help the price level, money supply, exchange rate and gold price generate instability.
There are two fundamental benefits that an optimum currency area can bring.
The first one is represented by the stability of exchange rates. The existence of a single currency removes all the fluctuations and the exchange rate risks. This has a positive consequence in terms of economic welfare, especially for the small economies opened for international trade. The elimination of the exchange rate lowers the risk premiums for the loans needed to finance the international trade financial management homework help service transactions and the insolvency risk of borrowers is also reduced. In addition, since there is not much room for practicing political opportunism (by massive borrowing from abroad, followed by currency devaluation), the single currency area increases the credibility of the online financial management homework help government, which also has a number of positive impacts on the economy.
The second important benefit of the optimum currency area is given by the elimination of the unproductive transaction costs. Here, most visible example is the exchange fees. Given the level of the international transactions and financial management homework help the exchange rate differentials on sale and purchase, the currency unification leads to huge savings in terms of ballast loss due to currency exchanges. Moreover, with the removal of the ballast, the volume of international trade tends to increase, which allows countries to benefit from trading in the common currency more than they have received help with financial management homework in the case of several different national currencies. These advantages have as consequences a number of other positive side effects, such as greater price transparency, reduced travel costs and others. It should be noted that a monetary union is preferable to other international arrangements aimed at maintaining stability in exchange rates because a single currency makes easier to maintain the commitment financial management homework assistance of the fixed exchange rates in comparison with the situation in which there are multiple currencies and, so many independent monetary authorities.
The introduction of a single currency, however, presents a major cost: the loss of sovereignty in monetary policy for countries that are members of the monetary union. A country taken individually cannot longer decide independently on the exchange rate and on the interest charged by the central bank. Thus, it loses an important adjustment tool. There are cases, for example, when the monetary authority is interested in reducing the exchange assistance with financial management homework rate to boost exports, or on the contrary when it is interested in increasing the exchange rate to attract capital to finance the current account deficit. In the case of the optimum currency area because there is a single monetary unit or a fixed rate system, the national monetary authority of the member states cannot manipulate the exchange rate in its benefit. These costs are felt especially in the situation of asymmetric shocks. The central bank cannot manipulate the exchange rate of its currency and is no longer able to determine the amount of currency in the economy. Furthermore, this can be perceived as a negative influence especially for the states with little influence in the union, because the decision making process is established by all the member states. The size of the costs associated with the loss of economic policy instruments depends mainly on the differences between financial management homework solution countries, both in terms of economic structure and in terms of legal and institutional environment. The economies which adhere to an optimum currency area must have alternative monetary instruments to adjust shocks.
This led us to a fundamental macroeconomic “trilemma”, also known as the “Impossible Trinity”. This dilemmatic situation arises because a macroeconomic policy regime can include at most two out of the three major policy goals. These goals (as can be seen from the figure below), are represented by:
- Free cross-border capital flows,
- A fixed exchange rate, and
- An independent monetary policy.
The Impossible Trinity refers in fact to the impossibility to simultaneously have fixed exchange rates, capital mobility and independent monetary policy. According to the financial management homework help service incompatibility triangle an economic area consisting of several countries can not simultaneously have perfect capital mobility, a fixed exchange rate regime and an autonomous domestic monetary policy. As it can be observed from the figure below, they can benefit simultaneously only from two features (corresponding to two adjacent sides of the triangle) and give up to the third feature (associated to the opposite side of the triangle). A group of countries can choose to accomplish only two (from three) criteria. In our case, for example, an environment characterized online financial management homework help by perfect capital mobility and a fixed rate regime is not compatible with autonomous national monetary policy.
The information resulting from the analysis of the incompatibility financial management homework help triangle had important consequences for European monetary construction of the Euroland. Given the fact that the capital was quite mobile in the European Union area, Member States (from Eurozone) had to give up their sovereignty in monetary terms in favor of a help with financial management homework viable system with fixed exchange rates.
Given that capital is perfectly mobile from one country to financial management homework help another, in the absence of a significant currency exchange risk, the interest rates set for comparable assets are equal. The economic agents will look to place their funds to the most remunerative areas. The national Central Banks cannot individually financial management homeworks help influence the interest rates and lose any effective power of monetary control. The monetary policies, in this condition, cannot be independent. If one of the domestic Central Banks individually pursues to reduce its interest rate, by increasing its money supply, the result would be a drain of capital to other countries. This would be compatible with maintaining the fixed exchange rate only financial management homework assistance if the central bank would intervene in the market to redeem its currency under depreciation. It should give currencies, but could not do this forever, because its reserves are limited. In this case, it has no choice but to control its expansionary monetary policy.
Figure 5.1 – The Impossible Trinity
Choosing an exchange rate regime financial management homework help online is one of the most important and challenging decisions in macroeconomic policymaking.
The adoption of a particular type of exchange rate regime is based on the advantages and the disadvantages induced in the economy by its given characteristics, knowing that an exchange financial management homework help rate regime cannot be applied in the same conditions by each economy.
Fixed exchange rates system:
The currency risk related to the international help with financial management homework transactions and foreign investments diminishes;
- The costs of international finance can be reduced due financial management homework help to maintaining a fixed exchange rate;A reduction in the domestic interest rates financial management homework writing help can be recorded in comparison with those of the international market;
- A reduction in the rate of inflation can be achieved by maintaining stability in the exchange rate level and monetary level (interest rate reduction);The currency supply is controlled by a central monetary authority (such as in the case of the Euro Zone of the European Union), case in which there is no longer a need for a national official reserve to finance the balance financial management homeworks help of payments’ deficit of that area. The economic agents will no longer have problems financial management homework help related to the variations of the exchange rate. As a result, the criteria of liquidity and confidence are satisfied. As a mention, the criterion of liquidity was problematic in the gold system, because the gold reserves were limited; however, since this regime is no longer available, in an optimal currency area this criterion is satisfied.
- Disadvantages: The manifestation of financial crises can generate high costs for macroeconomic adjustment, leading ultimately to reduce the credibility of the monetary authority. The main problem in this case is related to the adjustment mechanism of the balance of payments’ disequilibrium. This cannot be longer realized by manipulating the exchange rate (because it is fixed) or by help with financial management homework monetary policy (the currency supply of a country cannot be separated by the currency supply of the optimum currency area). This objective can be reached with the help of the factors of production’ mobility (labor and capital), both within each member country and within the optimum currency area as a whole.
- The national monetary policy is dependent on the monetary policy related to country issuing the anchor currency or the member states which have adopted a single currency or a fixed exchange rate regime; in this case, the criterion of adjustment is no longer available.
- The external shocks generate strong pressures financial management homework help on the economy, resulting in high costs for maintaining the exchange rates.
Floating exchange rates system:
- Neutralizes the impact of external shocks, of the shocks generated by the real economy and the inflation impact on the competitiveness of export operations. A main advantage of this system is the financial management homework assistance automatic adjustment mechanism. The exchange rate can fluctuate depending of the imbalances that arise on the currency market. As a result, the criteria of liquidity and adjustment are satisfied.
- The exchange rate volatility has a greater effect on the unfavorable international transactions (especially on foreign investment). The exchange rate volatility can be amplified by the speculators’ interventions on the market. However, these actions can have both a destabilizing effect and a stabilizing one.
- In this case, the criterion of confidence cannot be satisfied, since the adjustment mechanism is dependent on the automatically financial management homework help exchange rate modification on the market. The economic agents can be discouraged because of the exchange risk.
- The Marshar-Lerner condition cannot be fulfilled.
In reality, however, the exchange rate regimes encountered are rather intermediate than fixed or floating, because of a so-called fear of floating or fear of anchoring.
Summarizing, the optimum currency area theory claims that that the symmetry of business cycles is an important argument in favor of a common financial management homework solution currency or a fixed exchange rates. The main criterion in this case is that a country’s choice of an exchange rate regime is determined mostly by the connection formed between macroeconomic performance, exchange regimes, and currency crises.
Even that it seems most emblematic to give example from the European Union with its Euro Zone, first of all we must mention that this area, is a monetary union which has adopted a single currency, but it is not an optimum currency area. The most financial management homework help important reasons are the following ones:
- Firstly, even if the European Union assume between its main four liberties (of capital, people, goods and services) the free movement of labor force is not completely fulfilled. A main cause of this situation is reflected by the cultural diversification between member states. In this scenario, for example, a major impediment of the labor force to freely migrate from country to country is the difference in the official languages. Beside this impediment (which we can say that can be easily exceeded) is the fact that the academic studies and diplomas are not recognized from a member state to another in every case. This is a major impediment which does not allow a full mobility of the labor force. However, as we could see, a high degree of cross-border labor mobility between member states is an important factor of an optimal currency area.
- Secondly, an optimal currency area will necessarily assume a high flexibility of prices and wages (since it involves a high degree of labor and capital mobility). This second condition is not fulfilled.
The arguments in favor of the monetary union formation in the European Union were:
- The completion of the single market (single market needs a single currency).
- To speed up the monetary flows’ transfers and to eliminate the conversion costs.To reduce the risks related to trade and investment by financial management homework help online eliminating the exchange rate fluctuations.
- To offer price transparency.
- To obtain a monetary discipline in the sense that financial management homework help governments are not able to use currency as an instrument of economic policy.
- To lower inflation due to the imposed discipline on the Euro Zone economies.
- To merge the financial markets, process that could lead to economies of scale.
- To increase the efficiency and to achieve high economic growth rates.
- To strengthen the European Union’s position in the international monetary system.
- To help achieve the goal of creating a political union.
The arguments against of the monetary union formation in the European Union were:
- The loss of control and power of decision on monetary issues.
- The loss of flexibility, in the sense that the national governments will not be able to take monetary policy decisions that can preserve their economies to external shocks on the expense of other countries.
- The relatively large differences in business cycles and living standards between Member States – this could have a negative effect to divide the European Union. The monetary and material costs that implies: the replacement of the national currencies with the Euro and the creation of institutional and legislative changes required by this approach. However, as we already claimed, the Euro Zone is not an optimal currency area. It only has a single currency adopted by the member states. The Greek crisis financial management homework help has raised financial management homework writing help some problems related by the manner in which a national crisis can influence the entire financial management homework help area which has adopted a fixed exchange rate or a single currency. The dangers involved are economic, social and also politic.
(b) Why is it that countries that have chosen a pegged exchange rate regime often seem reluctant to abandon it even when economic circumstances may have financial management homework help changed in ways that suggest that they should?
There are three major causes for which a country that have chosen a pegged exchange rate regime often seem reluctant to abandon it even when economic financial management homework help service circumstances may have changed in ways that suggest that they should.
- The cost to abandon the pegged exchange rate regime can be higher, both for the country and for the other member states from the monetary union.
- A so called fear of floating can appear. Its definition is based on the assumption that highly volatile exchange rates limit the gains from trade, increase the risk premium of the interest rates and reduce welfare. The floating exchange rates can involve high risk, evidenced by financial crises occurred in emerging countries.
- There are some psychological factors which make more difficult to abandon the pegged exchange regime.
The costs of abandon a pegged exchange rate regime would be multiples, both for the country and for the other member states. The negative impacts would financial management homework help manifest mostly on short run. The elimination of these costs would take a long period of time, especially for the country. To study these effects we will consider the example of Greece. The country entered in the Euro Zone in 2000 and by the end of 2009 its debt crisis became a severe problem. At the beginning of 2011 there were many discussions which promoted an exit of the country from the Euro Zone, scenario which was not materialized after all.
- The negative effect on the debt
A country that would leave a monetary union area would have two options: to keep its debt in the old common foreign currency or, more likely, to convert it to the new (or old in the case in which the country would adopt the pre-aderration) domestic currency. In the first case, the end result would almost certainly be a default. The second case would be considered a default too by the investors, and the costs for them would be very high. Also, a domino effect would trigger almost immediately. The losses would concentrate among banks and institutional investors in the entire help with financial management homework monetary union. This would have as a first effect, on short run, a strong depreciation of the common currency. However, the common currency might appreciate on long term, because the quality of the financial management homework help monetary union would improve (after the elimination of the country which has economic problems). On long term, if the country will keep its dept in the old common currency, its value would rise if the common currency would appreciate.
In the case of Greece, experts have estimated a cost of Euros 170 billion.
- A disaster for the Banking System
The collapse of the monetary union of the USA in the years 1932-1933 can provide a picture of what might happen in such case. The case is based on the on the example of the financial crisis in Argentina. The financial institutions of the Member States would immediately and massively reduce their exposure to the currency which is leaving the area. The country would get in a position to suspend the operation of the banking system in its territory or to significantly reduce the amount that can be withdrawn from the banking agencies from its territory. The forced conversion of the national debt from the common currency into the domestic currency which is now depreciated, associated with possible defaults, would lead to the collapse of many banks. In addition, to attract liquidity, banks would be forced to provide an interest rate of 50-60% on deposits.
In the same time, the financial sector of the monetary area would be strongly affected. The equilibrium of the financial sector would be affected. The banking industry of the monetary area would need years to recover. Among the negative financial management homework help effects would be counter bankruptcies and hard lending conditions for companies and persons.
- High interest rates and high inflation in the long term
Leaving the monetary area would translate into a strong increase in interest rates on long run for the country. Moreover, the country might even be, in first instance, unable to find long-term creditors, both foreign and domestic. Thus, the country should base its economic activity on short-term funding and flexible rates to cope with the negative effects of the growth rates on long-term. This shift from a long-term refinancing to less maturity dates would add an element of uncertainty.
As for inflation, it would be high. This would take place at the beginning on the fond of the exchange rate depreciation and then on the fond of the public debt monetization.
In the Greece case, the inflation could rise to more than 30% if the country would exit the Euro Zone (compared to the 2% level of inflation, value which was registered in the country before the economic disaster and the discussion about its exit to be on the European Union agenda).
- The risk of a high unemployment rate and a disaggregation of the social organism
The weak currency of the country which would leave the monetary union together with the high inflation on a long period will certainly affect the unemployment rate, especially in the areas with the high exports. Thus, it will appear a risk of social disintegration. However, when social instability installs the risks for a diminishing the financial management homework help institutions’ authority grows. The unemployment rate would have increased with almost 12%, as the specialists claimed (from a registered level of 22% in the collapse year to an estimative value of 34%).
- A negative effect on the trade
Leaving the common currency area would be advantageous for a country only if it would depreciate its new domestic currency in rapport to the common foreign currency. This process can led to a negative response from the rest of the member states which remain in the area. These countries can impose, in this case, custom duties equivalent or higher than the rate of depreciation of the exchange rate for the goods which came from the leaving country. As a result, the foreign trade of the country would significantly decrease.
- The leaving process from a monetary area is expensive and takes long
The exit will require a significant period of time in which the physical amount of money in the old common currency would be replaced with the new domestic currency. This process will also have important costs. Furthermore, the economy contraction (related to the GDP value) will be significant.
The experts have evaluated that in the case of Greece, the new currency would have significantly depreciated with 65% and the contraction of the economy would have encountered a level of 22% (over the 14% reduction in GDP which was recorded in period of 2009-2011).
- The political costs are likely to be particularly serious
The exit of one member would raise doubts about the future of the monetary union.
In the case of Greece, for example, The Treaty of European Union did not make provision for such exit. Also, if such a case would have materialized, some important effects would have been represented by the diplomatic tension and the political acrimony which would follow after the separation. The cooperation on nonmonetary issues would be severely affected.
- Technical and legal barriers to exit
In this case, for example: notes and coins will have to be placed into the country; all the vending and payment machines will have to modify their systems for the new domestic currency etc. This process will be the opposite of the one for renouncing to the domestic currency and adopting a common one.
“Fear of floating” can be explained starting from the following considerations:
- The exchange rate volatility is a prominent feature of an open economy. The tendency of the nominal exchange rate to move volatile and unpredictable was accused of reducing the welfare and the gains from trade. The desire to moderate this volatility is one of the most important motivations that underlie the controlled or fixed exchange rate regimes in different countries. The question that arises from here is whether a particular currency arrangement has or has not a significant impact on trade. The answer is not clear, empirical evidences pointing both ways. However, there is a unanimous opinion that stability of the exchange rate can promote trade, especially of the monetary union. Therefore, fixed exchange rate helps in promoting the growth of emerging economies and investments.
- Most developing countries cannot borrow from outside their domestic borders in local currency, because their debts are denominated in foreign currency. Therefore, a sharp depreciation of the domestic currency can lead to severe pressure on the balance of payments.
The psychological factors related to the exit from the monetary union and adopting the domestic currency. In the area of behavioral finance, many authors have argued that the psychological elements are important factors in all the decisions, even in the economic life. In this case, people can manifest a fear from moving from something which they consider safe, because they know it, to a new situation. The Role of Defective Mental Models was used especially in financial management homework help the investigation of the 2007 financial crisis’ causes, but they can be use to analyze a large spectrum of economic decisions. In our case, the main psychological factors that can determine the decision makers of a country to abandon a pegged exchange rate regime even in the situation in which the domestic conditions are requiring this, are related to the cognitive errors. These are represented by:
- The overconfidence bias – the tendency of a person to have excessive trust in his own abilities.
- The anchor effect – the tendency to rely too much on a specific feature or information in making a decision.
- The “Bandwagon effect” – the tendency to do (or believe) certain things because many other people do (or believe) the same. It is mostly related to group thinking or to the so called “herd” behavior.
- The confirmation error – the tendency to seek and interpret information in ways that confirm a particular perception or belief.
- The distinction error – the tendency to see and interpret two options more different when they are evaluated simultaneously rather than when they are evaluated separately.
- The illusion of control – the tendency to believe that one thing can be controlled or at least influenced, when it is clearly that this option is not possible.
- The negativity error – the tendency to give more attention and more weight to negative experiences than positive ones.
All these cognitive errors might have an important influence when the decision makers analyze the abandon of the pegged exchange rate regime and the transition to the domestic currency.