The Continuous Changes in Political and Financial Conditions - Essay Example

Neither overshooting nor undershooting is the inevitable consequence of monetary disturbances. Rather, the short-run exchange rate response is governed by a variety of factors such as the relative speeds of adjustment in real and asset markets”. Discuss. 1. Introduction The continuous changes in political and financial conditions worldwide have influenced the economies of countries around the world; both developed and developing countries have been affected by the global financial and political crisis; measures need to be taken in order for the global economy to be stabilized – even for the short term. The specific situation is expected to influence the monetary policies adopted by governments internationally; usually these policies are chosen in accordance with the benefits offered to the state (either directly or indirectly); the role of these policies to the potential attraction of foreign investment is also carefully examined in advance. In most cases, it has been proved that a system of financial liberalization could help to improve the strength of an economy (Kwon, 2004); however, there is always the risk of failure – the development of the stock market may be inadequate – towards the profits expected. In accordance with the above, it is supported that ‘financial liberalisation erodes the potency of monetary policy by rendering tenuous the link between monetary aggregates and important macro-economic magnitudes (such as income, prices and exchange rates)’ (Nachane et al., 2007, 47). On the other hand, global market conditions change continuously; the needs of markets worldwide are also differentiated. Regarding this issue it is noticed that ‘rapid and voluminous movement of international finance capital increased liquidity in domestic markets and led to rises in asset prices, including property’ (Dehesh et al., 2000, 2581). Current paper focuses on the examination of the factors that can influence the short-run exchange rate response focusing on the speed of adjustment in real and asset market. At a next level, monetary disturbances are examined – in all their aspects – as they have the power to influence the structure and the content of the monetary policies established by governments worldwide. The research on the above issues has led to the assumption that overshooting and undershooting can appear as a consequence of a specific monetary policy; however, there are other factors like the short run exchange rate response that can also lead to monetary disturbances especially when the political and financial conditions of a country are characterized by instability. 2. Monetary disturbances – aspects and causes 2.1. General characteristics of monetary disturbances In order to understand the role of monetary disturbances in various parts of the national economy, it would be necessary to refer primarily to the general characteristics of these disturbances as well as the common forms of monetary policies used in states within the international community. In the literature, the importance of the monetary policies applied on a specific country has been found to be high for the financial development of the above country. In this context, it is supported that ‘macroeconomic performance can be improved if monetary policy reacts to asset price misalignments over and above the reaction to fixed horizon inflation forecasts’ (Wadhwani, 2008, 25). In other words, the establishment of an effective monetary policy could help the national economy to be kept at high levels – a fact that can be proved also through the ability of the specific country to support the development of its various industrial sectors. The various aspects of monetary disturbances can be differentiated through the years – the political and financial conditions of states internationally change continuously and the specific fact influences the effectiveness of monetary policies – either in the short or the long term. 2.2. Monetary disturbances – overshooting and undershooting The effects of monetary policies chosen by governments worldwide can be differentiated in accordance with the scope/ structure of these policies but also the support offered throughout their application. There are cases, like the European Union, where the application of a monetary policy is related with the interests/ benefits of many countries (member states in the case of EU); in most cases, monetary policies can affect only the national economy – only when the country under examination belongs to a monetary union the application of specific rules related with the country’s monetary system can affect the interests/ benefits of other states. An indicative example is the case of European Union: member states are obliged to participate in the monetary union even if their currencies are strong enough in order to survive within the global market (Arrowsmith, 1995). The support of the principles of the Union is then presented as being the priority for all member states; in these cases, the examination of the causes of monetary disturbances could lead to the assumption that the use of the orders of a particular monetary policy could put the country to a severe risk: interests may be different among countries worldwide and in this way no common monetary policy should be adapted before its careful examination of its consequences on the countries involved. The monetary system used by European Union is highly integrated (Mushin, 1981, Page, 1975). Still, it presents weaknesses and failures; the cooperation between the member states regarding the monitoring of the phases of the specific system should be improved. The above failures prove that monetary disturbances are inevitable even in well structured markets. In the literature, the relationship between monetary disturbances and overshooting is strongly support. In accordance with Kapur (1989), ‘J-curves conjunction with imperfect asset substitutability and rational expectations necessarily results in overshooting of the exchange rate in response to a real disturbance’ (Levin, 1983, in Kapur, 1989, p. 85). On the other hand, overshooting can occur only if the expectations regarding the exchange rates are not met; another prerequisite is the fact that the price of a currency has been increased at extremely high level – compared to other currencies; the radical decrease of the price of the specific currency is also required in order for overshooting to exist; otherwise, it would be just a differentiation in exchange rates affecting the level of development of the national economy – in accordance with the position of the national currency compared to the foreign currencies. Under the above terms, monetary disturbances could lead to overshooting; the changes in the value of the national currency would affect the price of the currency internationally; exchange rates then would be influenced accordingly and overshooting could result – the fall of the currency’s price towards the foreign currencies is required otherwise there will be no issue of overshooting. Within the same context, monetary disturbances could lead to the undershooting but only under specific terms – like in the case of overshooting. Undershooting would be viable only if the value of the currency is not appropriately estimated; the currency is traded in the market under its actual value; in this context, even if adjusted in order to represent current status of the national economy, national currency could not compete foreign currencies – this would be a severe failure for a country’s government. The specific issue is also highlighted in the study of Allen (2005). In the above study, it is noticed that ‘financial instability can have large adverse effects on an economy; one major cause of instability is asset price bubbles; banking crises can arise due to panics or as a result of the business cycle; contagion and financial fragility can cause small disturbances to have large effects’ (Allen, 2005, 57). In the above study, the various aspects of ‘monetary risk’ are analyzed; emphasis is paid on the role of financial institutions in the success of the whole effort; the role of financial institutions to the development of a country’s monetary system (and the success of its monetary policies) is also highlighted. 3. Factors that lead to the short-run exchange rate response 3.1 Main aspects of the short-run exchange rate response The prices of exchange rates are depended on the value of currencies – as expressed through the difference in value of national currency towards the foreign currencies. However, when a state participates on a monetary union (like the case of European Union) the level of exchange rates is depended on the financial status of the whole region/ area to which the specific monetary union refers. In accordance with Babeck et al. (2008) ‘membership in the monetary union imposes higher demands on factor market flexibility, since neither the exchange rate nor monetary policies can be used to deal with country-specific shocks’ (Babeck et al., 2008, 126). The above view is supported by the study of Cobham (2002) where it is noticed that ‘the exchange rate has not generally functioned as a useful automatic equilibrating mechanism or as a useful policy instrument’ (Cobham, 2002, 96). Referring specifically to the short run exchange rate response the following comments should be made: a) the specific rate is influenced rather by the performance of monetary policies in the short term – the potential benefits from these policies in the long term are usually not taken into consideration when the specific rate is measured; b) the above rate can be valuable in order to estimate the performance of the national economy towards the economies of other countries worldwide; however, if the state involved belongs to a monetary union, the use of this rate can be only limited – no assumption can be made on the performance of national economy – it will be the union’s performance that is under analysis and c) the level of this rate is highly volatile; the risk of radical changes related with the specific rate cannot be avoided. 3.2 Relative speeds of adjustment in real and asset markets – relationship with the short-run exchange rate response – Dornbusch’s Overshooting Hypothesis – Frenkel and Rodriguez model The estimation of the speed of adjustment has to be based on specific criteria; moreover, particular methodology should be used ensuring that the value of currencies/ assets used throughout the relevant procedure is carefully estimated – using all appropriate models. In this paper, the Dornbusch’s Overshooting Hypothesis (1976) and the Frenkel and Rodriguez model (1981) on exchange rate dynamics are used in order to justify the need for appropriate models in the particular field. In order to understand the role of speed of adjustment in the development of real and asset markets, it should be necessary to explain primarily the specific term. In accordance with Nsouli et al. (2002) ‘the speed of adjustment can be defined as the time elapsed between the moves from an initial set of macroeconomic variables to a targeted set of such variables’ (Nsouli et al., 2002, p. 4). The speed of adjustment – as described above – can have a different role in real and asset markets – as described in the work of Frenkel and Rodriguez (1981). The specific theory is based on the work of Dornbusch (1976) who also made a clear distinction between the asset market and the goods market as of their speed of adjustment. More specifically, in the work of the above theorist it is mentioned that ‘as a first approximation, asset markets clear instantaneously while adjustment in commodity markets is sluggish’ (Dornbusch, 1976 in Frenkel et al., 1981, p. 3). Under these terms, the evaluation of monetary disturbances occurred within a specific market can be differentiated in accordance with the criteria used but also with the time point chosen for the specific task. More specifically, it is noticed that ‘a monetary expansion induces an immediate depreciation of the currency in excess of its long-run equilibrium value; that is, a monetary expansion results in an overshooting of the exchange rate’ (Dornbusch, 1976, in Frenkel et al., 1981, p.3). The differences in the speed of adjustment between the asset markets and the goods markets could be possibly identified through the mathematical formulae developed by Frenkel et al. (1981). More specifically, for the goods market, the following formula is proposed by Frenkel et al. (1981): D=A(Y) + T (SP*IP) [Frenkel et al., 1981, p.4]. In the specific formula, the letters used represent the following values: ‘A denotes domestic absorption, T denotes the balance of trade, S denotes the exchange rate, P* denotes the fixed foreign price level (in terms of foreign currency) and P the price of domestic output’ (Frenkel et al., 1981, p.4). As for the asset market, another formula is proposed by Frenkel et al., 1981): ‘a = M’ + F [where M’ denotes the value of domestic currency holdings in terms of foreign exchange and F is the foreign money]’ (Frenkel et al., 1981, p.18). The simplicity of the second formula can lead at a first level to the relevant comment of Dornbusch (1976) that asset markets clear within an extremely short period of time – almost instantly. The differences in the speed of adjustment between the asset market and the goods market can be also based on the fact that these two markets address different needs; they should therefore present different time-limits regarding the completion of their phases/ parts. In this context, the views of the above two theorists on the differences on rate of adjustment between the above two markets can be fully justified. 4. Conclusion One of the most common characteristics of markets worldwide is the change of the methods used for the identification of the value of a specific asset (of any kind); more specifically, because the traditional methods of evaluation have been proved to be ineffective a series of proposal have been made by researchers for the appropriate development of the relevant theoretical framework - so that the needs of the country are met. The case of USA is presented as an indicative example of the potential failure of the stock markets even under the terms that the home market is carefully monitored and the phenomena of false data are identified on time. On the other hand, because markets influence one another, the failures of one market are expected to influence negatively the performance of other markets – related with the above market with common historical, political or educational ideas. The study of Flemming et al. (1999) led to the conclusion that ‘the risk now has to be faced that, if the bubble in the US stock market should burst, recessionary influences would spread throughout the OECD area and beyond; and this could happen at a time when the conventional wisdom has lost faith in the effectiveness of reflationary monetary and fiscal policies’ (Flemming et al., 1999, 55). It should be noticed that different factors can be used in order to develop the relevant model. Because of the above facts, it is noticed by Eichengreen (2002) that ‘distinctive characteristics of the policy environment that bear on its feasibility: these include the speed of pass-through, the difficulty of forecasting inflation, imperfect credibility, and liability dollarization; none of these complications renders inflation targeting infeasible, although a number render it more complex’ (Eichengreen, 2002, 11). On the other hand, the use of theoretical models (like the one of Frenkel and Rodriguez) for the evaluation of the relatively speed of adjustment can be an appropriate solution; however, it should be necessary that efforts are made for the improvement of existing system and the further development of the legal framework regulated the particular issue. Finally, overshooting and undershooting have been found to be possibly related with the monetary disturbances but other factors, like the relative speed of adjustment in real and asset market have been found to be more closely related with monetary disturbances. The models proposed by Frenkel et al. (1981) and Dornbusch (Overshooting Hypothesis) regarding the estimation of the speed of adjustment in real and asset markets and the level of overshooting that is expected to follow the monetary disturbances in a specific market can be characterized as quite effective within current market conditions – which are highly volatile to the changes caused because of the need of firms’/ individuals’ to achieve a high profit within a short term. The study of Frenkel et al. (1981) revealed that ‘the overshooting is not a characteristic of the assumption of perfect foresight, nor does it depend in general on the assumption that goods and asset markets clear at different speeds’ (Frenkel et al., 1981, 28). The formulae used for the identification of the ‘speed of adjustment’ in goods markets and asset markets – as presented by Frenkel et al., 1981 – clearly show that both these markets can operate effectively within a context of a quick speed of adjustment – even if the conditions held in these two markets are different. References Allen, F. Modelling Financial Instability. National Institute Economic Review, Vol. 192, No. 1, 57-67 (2005) Arrowsmith, J. Economic And Monetary Union in A Multi-Tier Europe. National Institute Economic Review, Vol. 152, No. 1, 76-96 (1995) Babeck, J., Dybczak, K. Real Wage Flexibility in the Enlarged Eu: Evidence From a Structural Var. National Institute Economic Review, Vol. 204, No. 1, 126-138 (2008) Cobham, D. The exchange rate as a source of disturbances: The UK 1979-2000. National Institute Economic Review, Vol. 181, No. 1, 96-112 (2002) Dehesh, A., Pugh, C. Property Cycles in a Global Economy. Urban Studies, Vol. 37, No. 13, 2581-2602 (2000) Eichengreen, B. International Monetary Options for the Twenty-first Century. The ANNALS of the American Academy of Political and Social Science, Vol. 579, No. 1, 11-25 (2002) Flemming, J., Posner, M., Sargent, J. Global stability: risks and remedies. National Institute Economic Review, Vol. 169, No. 1, 55-67 (1999) Frenkel, Z., Rodriguez, C. Exchange Rate Dynamics and the Overshooting Hypothesis. NBER Working Paper No W0832 (1982) Giacinto, V. Differential Regional Effects of Monetary Policy: A Geographical SVAR Approach. International Regional Science Review, Vol. 26, No. 3, 313-341 (2003) Kapur, B. THE J-CURVE AND SHORT-RUN EXCHANGE-RATE DYNAMICS. International Economic Journal, Volume 3, Number 3, Number 3, 85-104(20) (1989) Kwon, H. Markets, Institutions, and Politics Under Globalization. Comparative Political Studies, Vol. 37, No. 1, 88-113 (2004) Minford, P. What are the Right Models and Policies for a World of Low Inflation? National Institute Economic Review, Vol. 196, No. 1, 92-106 (2006) Mushin, J. Exchange - rate adjustment in a multicurrency monetary system. SIMULATION, Vol. 36, No. 5, 157-161 (1981) Nachane, D. Financial Liberalisation and Monetary Policy. Margin: The Journal of Applied Economic Research, Vol. 1, No. 1, 47-83 (2007) Nsouli, S., Rached, M., Funke, N. The speed of adjustment and the Sequencing of Economic Reforms: Issues and Guidelines for Policymakers. IMF Working Paper, IMF Institute (2002) Page, S. The Effect of Exchange Rates On Export Market Shares. National Institute Economic Review, Vol. 74, No. 1, 71-82 (1975) Wadhwani, S. Should Monetary Policy Respond To Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, Vol. 206, No. 1, 25-34 (2008) Read More