Question

1.1. Explain why a decline in a country’s exchange rate will generally increase the demand for its goods and reduce its demand for foreign goods.

1.2 Increased U.S. inflation, relative to other trading partner nations, should have what impact on the value of the U.S. dollar? Explain thoroughly.

1..3 Explain financial intermediation and its benefits.

Answer 1

Answer for question 1.1 = a decline in a country’s exchange rate will generally increase the demand for its goods and reduce its demand for foreign goods.

Exchange rate meaning

• an exchange rate is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country's currency in relation to another currency.

Decline in Exchange rate

• A fall in the exchange rate is known as a depreciation in the exchange rate (or devaluation in a fixed exchange ratesystem).
• It means the currency is worth less compared to other countries.
• For example, a depreciation of the dollar makes US exports more competitive but raises the cost of importing goods into the US.

impact of decline in exchange rate are as follows :

• When there is a depreciation, and the exchange rate goes down
  • Exports will be cheaper
  • Imports will become more expensive
• For example, a depreciation of the dollar makes US exports more competitive but raises the cost of importing goods into the US.
• Therefore there will be an increase in exports and decrease in the quantity of imports.
• Domestic firms will benefit from increased sales. This may lead to job creation and lower unemployment, especially in export industries .

Summary of a fall in the exchange rate are below :

1. Tends to increase the rate of economic growth and reduce unemployment.
2. Tends to benefit exporters, but makes imports more expensive.
3. Benefits the domestic tourist industry. It is more expensive to travel abroad and foreigners will find the UK more attractive.
4. Consumers likely to see higher prices – at least for imported goods.
5. Tends to cause inflation. This is because:
   • imports more expensive
   • higher domestic demand
   • firms have less incentive to cut costs
6. Tends to improve the current account deficit

The impact of a fall in the exchange rate depends on a few factors:

• State of the economy. If the economy is in a recession, a depreciation may help boost growth with little effect on inflation. But, if inflation is already high, a fall in the exchange rate will make inflation worse.
• Other components of AD. If the exchange rate falls, this increases export demand. However, if there is a fall in consumer confidence, there may be no overall increase in AD.
• Time lag and elasticity of demand. In the short term, demand for exports tends to be inelastic (therefore only a small increase in demand). Over time, demand becomes more elastic. Therefore there is a bigger increase in demand for exports.
• Depends on the cause of the fall in the exchange rate.    For example, countries experiencing a balance of payments crisis (e.g. Russia 2007/17) will see an outflow of capital as investors become nervous over the speed of the currency devaluation.

Answer of question 1.2 = Increased U.S. inflation, relative to other trading partner nations, should have what impact on the value of the U.S. dollar? . Are below.

about inflation :

• Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
• Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
• Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
• Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change.
• Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
• People holding cash may not like inflation, as it erodes the value of their cash holdings.
• Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.

impact of inflation , in the value of U S dollar are as follows :

• The impact of inflation has on the time value of money is that it decreases the value of a dollar over time.

• The time value of money is a concept that describes how the money available to you today is worth more than the same amount of money at a future date.

• This also assumes you do not invest the money available to you today in an equity security, a debt instrument, or an interest-bearing bank account.

• Essentially, if you have a dollar in your pocket today, that dollar’s worth, or value, will be lower less one year from today if you keep it in your pocket.

• Inflation increases the price of goods and services over time, effectively decreasing the number of goods and services you can buy with a dollar in the future as opposed to a dollar today.

• If wages remain the same but inflation causes the prices of goods and services to increase over time, it will take a larger percentage of your income to purchase the same good or service in the future .

Effects of inflation are as follows :

• . Erodes Purchasing Power

  This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease in the purchasing power of currency due to a rise in prices across the economy.

• Encourages Spending, Investing

  A predictable response to declining purchasing power is to buy now, rather than later. Cash will only lose value, so it is better to get your shopping out of the way and stock up on things that probably won't lose value.

• Causes More Inflation

  Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in turn, creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly wants. In other words, the supply of money outstrips the demand, and the price of money—the purchasing power of currency—falls at an ever-faster rate.

• Lowers the Cost of Borrowing

  When there is no central bank, or when central bankers are beholden to elected politicians, inflation will generally lower borrowing costs.

Answer for question 1.3 = financial intermediation and its benefits are follows :

financial intermediation definition

• Financial intermediation is a productive activity in which an institutional unit incurs liabilities on its own account for the purpose of acquiring financial assets by engaging infinancial transactions on the market.
• the role of financial intermediaries is to channel funds from lenders to borrowers by intermediating between them.
• Financial intermediaries move funds from parties with excess capital to parties needing funds. The process creates efficient markets and lowers the cost of conducting business.
• For example, a financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate, and other assets.

Benefits of financial intermediation

• Financial intermediaries serve as middlemen for financial transactions, generally between banks or funds.
• These intermediaries help create efficient markets and lower the cost of doing business.
• Intermediaries can provide leasing or factoring services, but do not accept deposits from the public.
• Financial intermediaries offer the benefit of pooling risk, reducing cost, and providing economies of scale, among others
• Benefits for lenders :

(1) Low risk:

Other things being the same, lenders are interested in minimising all kinds of risk of capital and interest loss on leans or financial investments they make.

These risks may arise in the form of risk of default or risk of capital loss on stock-market assets, such risks on secondary securities are far less than on primary securities for individual lenders.

How Fls are able to reduce such risks even though they themselves hold primary securities will be explained later. Besides, government regulation of the organization and working of major FIs helps in reducing risks of their creditors.

Any strengthen­ing of the financial system that goes to inspire public confidence in it reduces further any psychological risk suffered by lenders.

(2) Greater Liquidity:

FIs offer much greater liquidity on their secondary securities to their lenders. Consider a few examples.

Demand deposits of banks are perfectly liquid. They can be drawn upon without notice. Banks allow even time deposits to be drawn upon subject to certain conditions involving only some loss of interest. They, of course, always stand ready to lend against them.

Units of the UTI can be sold back to it. Savings embodied in life insurance policies are not equally liquid, but loans can always be arranged against them from banks or the LIC itself.

Primary securities do not carry any of these features, because primary borrowers need funds for agreed periods to finance their expenditures.

For reasons to be explained later, FIs can offer much greater liquidity to their creditors, and yet lend on a much longer term to their debtors.

(3) Convenience:

Secondary securities sold by FIs are easy to buy hold, and sell. The information cost and transaction cost involved are very low. Banks run branches in all urban areas and several semi-urban and rural areas.

The deposits they sell are standardised and information about them easily available.

So the choice about bank deposits, life insurance policies. UTI units are not as difficult as about (say) corporate equities (primary securities). Much, however, depends on the quality of customer service provided by the FIs which in the case of public-sector FIs in India is deplorably poor. This has hampered greatly the growth of financial intermediation in the country.

(4) Other Services:

Each of the FIs specializes in selling special kinds of secondary securities and other services associated with them. Thus, banks specialise in selling deposits with particular features. In addition, they transfer funds, collect cheques for their clients, offer safe-deposit vaults, and. most important of all are the dominant lender.

All these and several other services attract the public to banks and induce it to hold deposits with them. The UTI sells units (shares) of a balanced asset portfolio of marketable corporate securities to the investing public.

The LIC collects long-term savings of the public by selling life insurance. These other services can be had only when particular kinds of secondary securities carrying them are bought.

• Benefits to borrowers :

1. FIs have big pools of funds, so that big individual demands for funds can be satisfied only by the FIs;

2. There is much greater certainty of the availability of funds with the FIs at all times’

3. The rate of interest charged by the FIs is generally lower than that charged by the lenders

4. Regulated FIs do not fleece small borrowers in the manner moneylenders do. On the contrary, as a matter of official policy, banks and other official lending agencies are required to give small borrowers preferential treatment both in the grant of credit and in the rate of interest charged by them. The actual implementation of policy leaves much to be desired.

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