Finance coursework Research Paper Example | Topics and Well Written Essays - 2500 words

Finance coursework - Research Paper Example According to Gustav Cassel, the purchasing power parity is the appropriate level at which the foreign exchange rate should be set. The rate is measured by calculating the relative departures or deviations of price levels from a chosen base period in which the balance of payments of the concerned countries had been in equilibrium. If countries X and Y were in reasonable adjustment in time period 0, then these countries should choose an exchange rate in time period 1 (R1) which reflects the changes in their prices between time period 0 and time period 1. So, the formula is: The inflation rate has risen by 5% in US from 1993 to 1995, while it has risen by 12% in Zeal during the same period. Taking these rates into account and calculating at the old exchange rates of GP20 for $1, we calculate the new rate of exchange at GP33.6 for $1. The peso is not likely to fall any further. It has overadjusted. The rate would finally be set near the above calculated level. 2. The peso float could have been forecast due to a number of reasons. First, the exchange rate that was set and maintained by the Zeal authorities was clearly overvalued. The purchasing parity theory of exchange rates predicted a rate of GP33.6 for $1, while it was being pegged at the rate of GP20 for $1. Second, the balance of payments was running in deficit for a number of years as can be seen in Table1. The current account deficit was constantly increasing over the years and it was being funded by capital flows from abroad, putting pressure on the currency to depreciate. Thirdly, Inflation was consistently rising and was at 12% in 1995. The money supply was rising at a greater rate than the price level, again placing peso under pressure. Fourth, Zeal central bank was continuously losing international reserves in an attempt to hold the exchange rate. Fifth, the country had to borrow capital to fill the gap in balance of payments. And lastly, a sustainability of a particular level of current account deficit depends on how the capital flows are used and if the country has the appropriate debt servicing capability. A large and persistent current account deficit in the balance of payments of Zeal shows the employment of unsustainable macroeconomic policies. The exchange rate would have finally fallen victim to those policies. So, from the above reasons we can say that the peso float could have been anticipated. (Beenhakker, 2000) 3. Many wealthy individuals of the country have shifted their money out of the country through the dollarization of their assets. This is indicated from the unilateral transfers shown in Table1. The table indicates that the trade balance deficit has been increasing since 1973 and currently it stands at a very high $400,000,000.00. The current account deficit has similarly been increasing constantly over the years to reach $387 million. The international reserves have also been depleting as the current account deficit is increasing. There are still positive figures in unilateral transfers. The transfers have increased from a very minuscule $1 million in 1973 to reach $13 million in 1995. From 1973 to 1993 there was any increase of $6 million in unilateral transfers overall. But in the two years from 1993 to 1995 the country has seen an increase in unilateral tra