BBCF4073 International Finance

ASSIGNMENT 2 (15%)

ANSWER ALL QUESTIONS:

1. Explain dollarization and why would some countries practise dollarization?

Dollarization is the term for when the U.S. dollar is used in addition to or instead of the
domestic currency of another country. It is an example of currency substitution.
Dollarization usually happens when a country’s own currency loses its usefulness as a
medium of exchange, due to hyperinflation or instability. Dollarization is when a
country begins to recognize the U.S. dollar as a medium of exchange or legal tender
alongside or in place of its domestic currency. Dollarization normally occurs when the
local currency has become unstable and begun to lose its usefulness as a medium of
exchange for market transactions.Dollarization can have both benefits and costs. It
typically results in enhanced monetary and economic stability, but necessarily involves
loss of economic autonomy in monetary policy.

2. The International Monetary System went through several distinct stages of evolutions
from The Gold Standard, 1876-1913till present.Explain Protectionism and Isolationism
in the Inter-War years.
Protectionism is a form of economic isolationism, designed for the benefit of some
members of society at the expense of all others. It consists of import restrictions and/or
export subsidies. Isolationism is a refusal to participate in interactions among other
nations that may include the refusal to import or export anything as well as refusal to
assist any other nation or interact with any other nation. banks. A system was required
that would keep countries from changing exchange rates to obtain a trading advantages
and to limit inflationary policy. This meant that some sort of control on rate changes
was needed, as well as a reserve base for deficit countries. It should be kept in mind
that currency and interest rate exposures arising out of funding decisions should not be
viewed in isolation. The firm should take a total view of all exposures, those arising out
of its operating business and those on account of financing decisions.
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3. At the end of World War II (1944-1945), majority of the Allied Powers met in New
Hampshire, United States and created a post-war international monetary system.
i. What is the name of that monetary system?

The international monetary system is the framework within which countries borrow, lend,
buy, sell and make payments across political frontiers. The framework determines how
balance of payments disequilibriam is resolved. Numerous frameworks are possible and most
have been tried in one form or another. Today’s system is a combination of several different
frameworks. The increased volatility of exchange rate is one of the main economic
developments of the past 40 years.

ii. Why are they creating the new monetary system?

The international monetary system had many informal and formal stages. For more than one
hundred years, the gold standard provided a stable means for countries to exchange their
currencies and facilitate trade. With the Great Depression, the gold standard collapsed and
gradually gave way to the Bretton Woods system.The Bretton Woods system established a
new monetary system based on the US dollar. This system incorporated some of the
disciplinary advantages of the gold system while giving countries the flexibility they needed
to manage temporary economic setbacks, which had led to the fall of the gold standard.The
Bretton Woods system lasted until 1971 and provided the longest formal mechanism for an
exchange-rate system and forums for countries to cooperate on coordinating policy and
navigating temporary economic crises.While no new formal system has replaced Bretton
Woods, some of its key elements have endured, including a modified managed float of
foreign exchange, the International Monetary Fund (IMF), and the World Bank—although
each has evolved to meet changing world conditions.

iii. Is the monetary system still survive? Why or why not?

International trade is complicated by the fact that most countries have their own currencies,
which move in idiosyncratic ways and can be held down to boost competitiveness.
Governments’ efforts to manage currencies are constrained by certain trade-offs. Pegging
them to an external anchor to stabilise their value means either ceding control of domestic
economic policy or restricting access to foreign capital flows. Systems of monetary order,
which resolve these trade-offs in one way as opposed to another, work until they do not. The
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context for America’s economic showdown with China is a system that worked once but no
longer does. There is no longer any need for the United States to compete with one hand tied
behind her back,” Richard Nixon, then America’s president, told his countrymen in August
1971. With that speech, he heralded the end of the post-war economic order, suspending the
convertibility of the dollar into gold and putting up tariffs on imports. The survival of today’s
order, which emerged from the chaos that followed, now also looks in doubt. In other
circumstances, its demise might not have been mourned. But with each passing August day,
the prospects for a happy shift from one global monetary regime to another look ever
grimmer.

4.The Balance of Payments can be formally defined as the statistical record of a country’s
international transactions over a certain period of time presented in the form of double entry
bookkeeping. Explain the relationships between Balance of Payment (BOP) and Inflation
rate.

A change in a country's balance of payments can cause fluctuations in the exchange

rate between its currency and foreign currencies. The reverse is also true when a fluctuation
in relative currency strength can alter the balance of payments. There are two different and
interrelated markets at work: the market for all financial transactions on the international
market (balance of payments) and the supply and demand for a specific currency (exchange
rate).

These conditions only exist under a free or floating exchange rate regime. The balance of
payments does not impact the exchange rate in a fixed-rate system because central
banks adjust currency flows to offset the international exchange of funds. The world has not
operated under any single rules-based or fixed exchange-rate system since the end of Bretton
Woods in the 1970s.

To explain further, suppose a consumer in France wants to purchase goods from an American
company. The American company is not likely to accept euros as payment; it wants U.S.
dollars. Somehow the French consumer needs to purchase dollars (ostensibly by selling euros
in the forex market) and exchange them for the American product. Today, most of these
exchanges are automated through an intermediary so that the individual consumer doesn't
have to enter the forex market to make an online purchase. After the trade is made, it is
recorded in the current account portion of the balance of payments.
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The same holds true for investments, loans, or other capital flows. American companies
normally do not want foreign currencies to finance their operations, thus their expectation for
foreign investors to send them dollars. In this scenario, capital flows between countries show
up in the capital account portion of the balance of payments.As more U.S. dollars are
demanded to satisfy the needs of foreign investors or consumers, upward pressure is placed
on the price of dollars. Put another way: it costs relatively more to exchange for dollars, in
terms of foreign currencies.

The exchange rate for dollars may not rise if other factors are concurrently pushing down the
value of dollars. For example, expansionary monetary policy might increase the supply of
dollars.The impact of an increase in interest rates on the current account balance of payments
is uncertain. There are a few different implications. Interest rates affect both consumer
spending (imports) and have an affect on the exchange rate (which affects the price of
exports/imports) The effect of interest rates on the current account depends on which factor
proves the most powerful. It is not possible to say definitely whether the current account will
improve or worsen

5. Based on the following product prices, calculate either product X is undervalued or

overvalued in Switzerland.

Price of product X in Price of product X in Actual Interest Rate

United States (USD) Switzerland (CFH)
$ 3.10 ₣ 6.30 ₣ 1.21 / $

CFH/USD = 6.30/3.10
CFH/USD = 2.0322

Actual rate = 2.033 x 1.21

CFH/USD = 2.459 ( undervalued in Switzerland)
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6. If EUR/USD = 1.12 and MYR/USD = 0.2343, what is the rate of EUR/MYR? Assume
that you have €1,000 and you would like to convert to MYR, how much MYR will you
have?

EUR/USD = 1.12

MYR/USD = 0.2343

EUR/(MYR/0.2343) = 1.12

EUR = 1.12 x (MYR/0.2343)

EUR/MYR = 4.780