Japan Exchange Rate Regime - Essay Example

? Japan Exchange Rate Regime By Insert Presented to Location Due Exchange rate History in Japan The major currency that is used in Japan is Yen and all matters related to the currency were normally administered by the Ministry of Finance. However, the administration was carried out with the cooperation of the Ministry of International Trade (MITI) and Industry and the bank of Japan. MITI also handled licenses related to exports and imports. However, the authority for approving major payments was given to the authorized banks in Japan. Studies reveal that trade in Japan was being regulated by the government directly before 1949 (Ziemba , Bailley, & Hamao, 2000). During this time, the country practiced multiple exchange rates. However, the direct control by the government was gotten rid of in 1949 and a new system that was meant to regulate foreign trade was introduced since the market economy was under transition (Currency Information, 2013). This was meant to ensure that the foreign trade system in the country would be compatible with the market economy that was in transition. Japan also shifted from plural exchange rate regime to the single exchange rate regime. This regime continued to play as the dominant force in Japan until the early 1960s (The Chinese University of Hong Kong, 2000). The major force that interrupted the performance of the Japanese currency was the US dollar. In this case, Japan sustained a fixed exchange rate of 360.00 Yen for every US dollar up to 1971. However, in 1971, the Yen was permitted to float above its fluctuation ceiling whereby an effective fluctuation rate was implemented (Trading Economics, 2012). However, since the US dollar continued to devalue, the Bank of Japan was forced to place a control that would regulate the exchange rate and facilitate a floating basis (Trading Economics b, 2012). The Effective rate of Japan was later set in a manner that allowed it to float in a free manner. However, since the floating exchange rate was introduced in Japan in 1973, the economy of Japan has been experiencing significant fluctuations while dealing with foreign exchange rates. The Interbank Rate was also in traduced in Japan in 1973. In this case, the Yen was supposed to be determined on the basis of the demand and supply forces in the Japanese economy. The bank of Japan was only supposed to intervene whenever the Yen was observed to be fluctuating in an abnormal manner in the currency market (The Chinese University of Hong Kong, 2000). Discuss three relationships that describe the behavior of exchange rate Covered Interest Rate Parity (CIP) Interest rate parity describes an equilibrium situation whereby investors are normally indifferent regarding the interest rates that are available on the bank deposits between two countries. However, since this condition does not always hold, investors are normally provided with an opportunity to earn riskless profits while under the covered interest arbitrage mechanisms (Economy watch, 2012). Therefore, in the case where the no-arbitrage condition is satisfied while under the use of a forward contract that would help to hedge against the risks that are present in the exchange rate markets. In this case, the interest rate is described as covered. In this case, the forward exchange rate sustains an equilibrium state (Trading Economics b, 2012). In this case, the return on the dollar to dollar deposits normally equals to the return on the dollar to foreign deposits. This means that the potential for making profits in the case of covered interest arbitrage is eliminated. Moreover, the covered interest rate parity also helps while determining forward exchange rate. For example, assuming japans currency trades at par with the US currency and the interest rate in Japan is 6 percent while the interest rate in the US is 3 percent, then it would be advisable to borrow the currency of the US and convert it in the spot market to the currency of Japan when all other factors are held constant. However, in order to repay the loan, in US currency, one would be required to enter into a forward contract so as to exchange the currency back to the Japanese Yen (OECD, n.d). In this case, the covered interest rate parity is normally observed when here is a forward rate in the case there is a forward rate of exchanging the Yen to dollars thereby eliminating all chances of gaining profits from the transaction. Purchasing Power Parity (PPP) The purchasing power parity is an economic term that describes the amount of adjustment that would be required while exchanging currency between countries. This form of adjustment aims at keeping the exchange equivalent to the purchasing power of the participating countries. Purchasing power is normally calculated as S=P1/P2 In this case, S represents the exchange rate of currency 1 to currency 2. P1 illustrates the price of a certain good x in currency 1 while P2 illustrates the cost of a good x in currency 2. In this case, the exchange rate normally adjusts so that a certain good in different countries can cost the same price while expressed in the same currency (OECD, n.d). For example, a good that costs C$1.5 in a city in Canada should be estimated to cost US$1.00 in a US city. This is normally the case when the exchange rate between the two countries is 1.5 USD/CDN. For instance the GDP (Purchasing power parity) of Japan was estimated to be $4.497 trillion in 2011, $4.531 trillion in 2010, and $4.339 trillion in 2009 (ET Bureau, 2012). This process is essential because it tends to stabilize the prices of goods from one currency to another and in different countries. It is therefore an important concept with regard to describing the behavior of interest rates. International Fisher Effect (IFE) This is an economic theory which stipulates that an expected change in the prevailing exchange rate that exists between two countries is approximately equal to the difference that is observed between the nominal interest rates of the two countries. It is computed as follows. E = (i1-i2)/ (1+i2) ? i1-i2 (InvestopediaUS, 2013). In this case, E represents the percent change in the exchange rate, i1 represents the interest rate of country A while 1i represents the interest rate of country 2. For instance if the interest rate of Japan is 10 percent and the interest rate of US is five percent, the currency of US should appreciate by approximately 5 percent to Japan’s currency. The rationale for IFE is that the country that has a higher interest rate would tend to have a high rate of inflation (Economy watch, 2012). The high rate of inflation would make the currency of the country that has a high rate of interest to depreciate while compared to the country that has a slightly lower rate of interest. Today however, the interest changes do not occur more often like they used to occur in the past. Therefore, most bankers today focus on inflation rate since most interest rates are normally determined by the expected inflation rate. Most bankers today therefore focus on the Consumer Price Index (CPI) so that they can manage to adjust the prevailing prices in an economy (Investopedia US, 2013). Therefore, from the paper it is evident that exchange rates play a vital role in terms of determining the interest rates and prices of goods and services in different currencies. Therefore, in order to stabilize the transactions that take place internationally, institutions such as the International Monetary Fund (IMF), Organization for Economic Cooperation and Development, and the World Bank to monitor the performance of the exchange rate market in order to ensure that they are favorable thus boosting the performance of the global economy (Economy watch, 2012). Covered Interest Rate Parity (CIP), Purchasing Power Parity (PPP), and International Fisher Effect (IFE) since they are the once that explain the behavior of the exchange rate market thus allow for efficient transactions in the exchange markets. References Currency Information, 2013, Japanese Yen: History, viewed 2 March 2013, . Economy watch 2012, Japan GDP Per Capita (PPP), US Dollars Statistics, viewed 2 March 2011, . ET Bureau 2012, ET explains the concept of purchasing power parity, viewed 2 March 2013, . Index Mundi 2013, Japan GDP- Purchasing Power Parity, viewed 2 March 2013, . Indexmundi b 2013, United Stated GDP: Purchasing Power Parity . Investopedia US 2013, The International Fisher Effect: An Introduction, viewed 2 march 2013, . OECD n.d, Purchasing Power Parities, viewed 2 March 2013, viewed 2 March 2013, . The Chinese University of HongKong 2000, Historial Exchange Rate Regime of Asian Countries, viewed 2 march 2013, . Trading Economics 2012, Japan GDP Per Capita, viewed 2 March 2013, . Trading Economics b 2012, GNI Per Capita: PPP in Japan, viewed 2 March 2013, . Ziemba , W, Bailley, W & Hamao, Y 2000, A History of Yen Exchange Rates, viewed 2 March 2013, . Read More