Question

Define the following pairs of terms and explain the similarity, difference or relationship between the terms: a) Depreciation and devaluation; b) Currency crisis and international financial crisis; c) Internal balance and external balance; d) Debt rescheduling and debt forgiveness; e) Hard peg and dollarization; f) Gold standard and fixed exchange rate; g) Policy instruments and policy targets; h) Country risk and currency risk

Answer 1

a. A devaluation occurs when a country makes a conscious decision to lower its exchange rate in a fixed or semi-fixed exchange rate.

A depreciation is when there is a fall in the value of a currency in a floating exchange rate.

In general, everyday use, devaluation and depreciation are often used interchangeably. They both have the same effect. – A fall in the value of the currency which makes imports more expensive, and exports more competitive.

A devaluation is when a country makes a conscious decision to lower its exchange rate in a fixed or semi-fixed exchange rate. Therefore, technically a devaluation is only possible if a country is a member of some fixed exchange rate policy. When there is a fall in the value of a currency in a floating exchange rate. This is not due to a government’s decision, but due to supply and demand side factors.

b. A currency crisis is brought on by a decline in the value of a country's currency. This decline in value negatively affects an economy by creating instabilities in exchange rates, meaning that one unit of a certain currency no longer buys as much as it used to in another currency. To simplify the matter, we can say that from a historical perspective, crises have developed when investor expectations cause significant shifts in the value of currencies.

The global financial crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009. During the GFC, a downturn in the US housing market was a catalyst for a financial crisis that spread from the United States to the rest of the world through linkages in the global financial system. Many banks around the world incurred large losses and relied on government support to avoid bankruptcy. Millions of people lost their jobs as the major advanced economies experienced their deepest recessions since the Great Depression in the 1930s. Recovery from the crisis was also much slower than past recessions that were not associated with a financial crisis.

c. An internal equilibrium is achieved at the full employment and stable prices. If there is an inflationary pressure or unemployment, the economy will require further adjustment in prices or move toward the full employment output level..

An external equilibrium refers to a balance of payments equilibrium of an open economy. Note that when an open economy achieves an external equilibrium, output y is not necessarily at the full employment rate.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

d. Debt rescheduling refers to restructuring the terms of an existing loan or bond in order to extend the repayment period. It may mean a delay in the due date of required payments or reducing payment amounts by extending the payment period and increasing the number of payments.

Writing-off of a portion of one or more loans to a financially troubled firm by its lender. The objective is to help that firm in its debt restructuring so that it remains viable and is able to pay off the remaining part of the loan. Debt forgiveness occurs when a government creditor entity in one economy formally agrees - via a contractual arrangement - with a debtor entity in another to forgive (extinguish) all, or part, of the obligation of the debtor entity to the creditor, the amount forgiven is treated as a capital transfer from the creditor to the debtor. That is, the balance of payments reflects a reduction of the liability offset by the transfer. Similar treatment is applicable when a government entity’s debt is forgiven by agreement with a creditor entity in another economy.

e. When politicians print money without regard to the needs of the economy, the money can no longer be a store of value, since its value will be inflated away. Neither can it provide a unit of account, or pricing information, since prices could change daily, or even hourly. Consequently, the local currency stops working as money — people stop using it for trade and seek other solutions. The solution to the credibility problem is to fix the exchange rate to some foreign currency that is trusted, which is referred to as the reserve currency. There are 2 general methods of fixing the exchange rate without the un-trusted central bank or government — currency boards and dollarization, where the people start using a foreign currency, which is often the United States dollar — hence, the name. Because the exchange rate is fixed and cannot be varied, using a currency board or dollarization is sometimes referred to as a hard currency peg.

While some governments desire to have a fixed exchange rate, the main purpose of currency boards and dollarization is either to restore confidence in the domestic currency or to adopt another currency that can't be manipulated by local politicians. The fact that the exchange rate is fixed is merely a consequence of how currency boards and dollarization work. If the only objective was to achieve a fixed exchange rate with a foreign currency, then the central bank can easily achieve this goal by acquiring the necessary reserves of the foreign currency and standing ready to exchange the foreign currency with the domestic currency in the desired ratio.

f. The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed against either the value of another single currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate. A fixed exchange rate is typically used to stabilize the value of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent currency (or currencies) to which the value is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions, unlike in a flexible exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP.

g. Policy instrument is a linkage between policy formulation and policy implementation. The intention in policy formulation is reflected in policy implementation through instrument. Policy instruments are often known as governing tools as well, particularly when they are applied with all conditions associated to them. The implementation of governing tools is usually made to achieve policy targets of resource management but adjusted to social, political, economic, and administrative concerns. Thereby, concerns of sustainability largely depend not only on what instruments are selected but also on how they have been applied. Assessment of policy instrument thereby can be an important component of policy sustainability.

Monetary policy targets are specific values of macroeconomic variables, including interest rates, monetary aggregates, and exchange rates, that a monetary authority pursues in the course of conducting monetary policy. The presumption, based on extensive economic theory, is that attaining a monetary policy target subsequently results in achieving one or more of the macroeconomic goals.

h. Country risk refers to the uncertainty associated with investing in a particular country, and more specifically the degree to which that uncertainty could lead to losses for investors. This uncertainty can come from any number of factors including political, economic, exchange-rate, or technological influences. In particular, country risk denotes the risk that a foreign government will default on its bonds or other financial commitments increasing transfer risk. In a broader sense, country risk is the degree to which political and economic unrest affect the securities of issuers doing business in a particular country.

Currency risk, commonly referred to as exchange-rate risk, arises from the change in price of one currency in relation to another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses.