Question

1. Suppose financial markets initially view the debt loads of households and businesses of a domestic country as reasonable. But then many of these households and businesses borrow a lot more and financial markets then view their debt loads as too high, meaning markets expect there will be lots of defaults by these over-indebted borrowers in the future.

(e) Given an expectation of a near future (1d) change in strength of the domestic currency, where do currency traders want to have their financial assets, in the domestic country or in foreign countries?

(f) What effect does (1e) have on the domestic country’s interest rates?

(g) Overall, what happens to production and employment of the domestic country?

(h) Suppose from a position of high risk, the domestic country eventually fixes its financial risk situation. What effect does this have on the availability of financial capital in the domestic country?

(i) Given (1h), what happens to the economy of the domestic country?

Answer 1

Introduction:-

Business cycles are a part of the overall experience of any country. Due to rapid globalization and the interconnected nature of countries, most countries face a time of increased flow of money or decrease and also of increase or decrease of loans given out as illustrated in the example.

This may lead to speculation, the results of which can vary depending on the country we are dealing with respectively.

(E) Given an expectation of a near future (1d) change in strength of the domestic currency, where do currency traders want to have their financial assets, in the domestic country or in foreign countries?

Given a status, in which the flow of money is reduced due to increased loans being granted to the extent that the expectation is that bad loans may occur, domestic currency would depreciate. Further since markets basically run based on speculation the prices of shares in the domestic country would most likely be directly impacted. In such a condition, it would be best for investors to place their money in other countries since the local conditions are not favorable for investment and may not allow for reasonable returns respectively.

Thus, in such a situation it is most desirable for investors to put their money in a foreign country which can offer significantly higher rates of returns due to the problems of the domestic country.

(f) What effect does (1e) have on the domestic country’s interest rates?

When countries feel, that the banks have given out loans in such a manner that the overall loans have increased to the extent of having high bad debts, it displays restraint and restricts the flow of money which reaches the commercial banks by raising the interest rates by increasing the reserve requirements which is the minimum amount which the banks cannot give away as loans and participating in other open market operations.

This in turn, has a direct impact on the overall interest rates which the commercial banks charge. Due to reduced availability of money to the commercial banks, the resultant is an increase in the country's interest rates respectively.

g) Overall, what happens to production and employment of the domestic country?

Faced with higher interest rates, business owners find it difficult to cover their expenses since the availability of capital is significantly lower.

As a result of reduced profits, companies tend to lower their production levels and this causes jobs to be lost as well since companies want to lower their costs to maintain profit levels. Further due to loss of employment a cycle emerges.

This cycle can be explained as lack of production causes jobs and employment opportunities to be lost and the economy slows down since people do not have the money to purchase goods.

This is also known as recession respectively.

(h) Suppose from a position of high risk, the domestic country eventually fixes its financial risk situation. What effect does this have on the availability of financial capital in the domestic country?

Once, the country moves from a position of high risk and eases the financial position, the interest rates reduce due to the increased flow of money in the economy.

Further economic activity stabilizes and investor confidence is back in the country thus the country recovers and finds itself better placed in terms of economic growth and stability respectively.

The interest rates and growth trends are reflective of the change and rapidly change once such a situation is over across almost all countries.

(I) given (1h), what happens to the economy of the domestic country?

As explained the country recovers from high interest rates and lack of capital and the growth stabilizes and people can find higher employment opportunities respectively.

The country in a favorable business environment finds investors not only from the country but abroad starting to invest and this creates ample opportunity for it to fill in the earlier created gap.