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.

(a) What happens regarding the perceived financial risk in the domestic country?

(b) Given the change in perceived risk, what happens to the amount of financial capital in the domestic country?

(c) Given the change in perceived risk, what happens to the domestic country’s interest rates?

(d) Given the change in perceived risk, what happens to the strength of the domestic country’s currency?

Answer 1

Introduction

Speculation and market conditions are a very important factor which regulate where a country is headed in terms of its growth rates.

Over a period of time, capitalists and investors try to analyze the general mood of the economy while deciding upon their investment decisions.

Borrowing is a very big factor that has a great impact on the overall market conditions of an economy. Uncontrolled borrowing as in the case of the recent slump of 2008 in the United States due to the Housing Scenario can lead to big problems for the entire globe.

The case has been explained as follows:-

Case Specifics:-

(A) What happens regarding the perceived financial risk in the domestic country?

Due to increased financial risks in the country, investors shy away from putting their money in such economies because they fair that their capital would be lost.

As a result, the country sees reduced flow of money in the economy. Further the central bank would increase the interest rates to keep a check on the inflation rates which will rise in the country as a result.

Employment opportunities would decline since companies would find it harder to arrange for funds from investors or from banks and the end result could be a depression which would require careful analysis and planning to be averted.

In general bad loans or a higher risk of bad loans turns away investors from the country and leads to great economic problems respectively.

(B) Given the change in perceived risk, what happens to the amount of financial capital in the domestic country?

As explained above, due to the increase perceived risk of investing in the country as bad loans could eventually increase, the country would find itslef in a position where foreign investors might not be inclined to invest money as they would get significantly lesser or negative returns to their capital investments.

As a result, the overall financial capital available to the corporations would decrease both from foreign as well as domestic investors respectively.

(c) Given the change in perceived risk, what happens to the domestic country’s interest rates?

In a situation of increased perceived risk, it is a known fact that countries tend to increase their overall interest rates. This is done by using the Central Bank of the country which is known as Federal Bank in revising the reserve requirements which the commercial banks need to maintain.

As a result, commercial banks have significanly lower ammounts of capital to be granted as loans and this leads to increased overall interest rates in the country respecitvely.

(d) Given the change in perceived risk, what happens to the strength of the domestic country’s currency?

A countries domestic currency is valued on the basis of market conditions and overall speculation and investor confidence respectively.

In a situation wherein the perceived risk of default is relatively higher, foreign flow of money into the country reduces and so does the demand for the currency reduce.

Lack of business causes a negative effect on the currency exchange rate and the strength of the currency largely gets reduced.

Please feel free to ask your doubts in the comments section if any.