Purpose Of Issuing Currency Finance Essay - Free Essay Example

Sample details Pages: 8 Words: 2339 Downloads: 6 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? In 1907, the Currency Board was established for the purpose of issuing currency and protecting its value. The World Banking Mission which examined economic situation and potential development of a country. It had recommended composing a Centre Bank and eventually the Central Bank of Malaya Ordinance was established in 1959. Don’t waste time! Our writers will create an original "Purpose Of Issuing Currency Finance Essay" essay for you Create order However, the currency issuing authority was transferred to Bank Negara Malaysia after 1967 (Institut Bank Malaysia, n.d. ). According to Intitute Bank Malaysia (n.d.), under the Financial Sector Master Plan (FSMP), the financial industry is now undergoing consolidation phase. Commercial banks are merging with their finance companies. This is to increase competitiveness of the financial institutions by providing one-stop financial services. Malaysia has three derivatives exchanges which commodities, fixed income and equity products. Besides, Malaysia is the one who introduce KLCI futures earlier than India, Taiwan and Korea. The first Malaysian derivative exchange was established at 1980 which is KLCE. The initial derivative product was the Crude Palm Oil (CPO) contract. The CPO futures contract was the only product in its category and remained as the main product (Bacha, 2004). Bacha (2004) found in 1995, Malaysia introduced financial derivatives together with introduction o f Kuala Lumpur Options and Financial Futures Exchange (KLOFFE) (which currently known as KLSE CI Stock Index Futures contracts). After two years, the Malaysian Monetary Exchange (MME) was launched and traded the 3 month KLIBOR contract. The three exchanges, KLCE. KLOFFE and MME have now been consolidated into a single exchange, the Malaysian Derivatives Exchange (MDEX). Thus, nowadays we can trade commodity, equity and interest rate derivatives on MDEX (Bacha, 2004). The relationship between the percentage changes in the spot exchange rate over time and differential between comparable interest rates in different national capital markets known as the International Fisher Effect (IFE). International Fisher Effect (IFE) attributes changes in exchange rate to interest rate differentials, rather than inflation rate differentials among countries. The International Fisher Effect, (IFE) or fisher-open, states that spot exchange rate should change in an amount equal to but in the opposite direction of the difference in interest rates between countries. International Fisher Effect (IFE) to estimate the equilibrium future spot exchange rate S*ÂÂ ¥/$ assuming International Fisher Effect (IFE) holds. Justification for the International Fisher Effect (IFE) is that investors must be rewarded or penalized to offset the expected change in exchange rates. The International Fisher Effect (IFE) predicts that with unrestricted capital flows, an investor should be indifferent between investing in dollar or yen bonds, since investors worldwide would see the same opportunity and compete it away (Moffett, 2012; Madura, 2012). The International Fisher Effect (IFE) is unpredictable due to the different short-term factors that influence the exchange rates and the predictions of nominal rates and inflation. However, the long-term International Fisher Effect (IFE) just provides a little better result. Interest rate differentials always offset by exchange rates, but error alwa ys occur when forecast the future spot rate (Shalishali, 2012). Shalishali (2012) stated that exchange rate fluctuation and interest rate difference are affecting consumers and the worldwide economy. Among others, exchange rates fluctuations can cause inefficiency and misrepresent world prices and further capture investors attention to countries inflation. In addition, the long term investment return and international trade are affected by long-term movements in exchange rates. By knowing some short-term foreign exchange movements, international businesses that deal with foreign exchange transactions on daily basis could benefit. Exchange rate movement will create higher risk. Hence, companies may utilize information available to determine how many derivative securities such as options, forwards, and futures to hedge in order to minimize risk arising from exchange rate movements. Moreover, the actual return of investors portfolio with overseas holding will directly affected by ex change rates. The world has experienced at least two financial crises that have strong contagious effects within the decade of 1997/98 and 2007/08. The Asian Financial Crisis 1997/98 began in July 1997 with the devaluation of the Thailand currency. The key financial institutions in South Korea and Japan shut down due to the worries of global fund withdrawal and at last lead to a collapse of financial market and currency depreciation in regional. In those East Asian countries, there was a dramatically increase in interest rate in 1997 since their currencies collapsed. For instance, short-term rates in South Korea rose from 12 to 30 percent within a month (Li Wong, 2011; Cho Kenneth, 2003). Figure 1 (refer to appendix) reports data characterizing the situation in some Asian countries during the 1997/98 Asian crisis. The Asian crisis is the best characterized as triggered by a mixture confidence crisis in a few countries, which then spread- through trade and depending on the co untry, also financial channels to other countries within and outside the region. It shows that, as a result of the crisis, exchange rate depreciate over the second half of 1997. Increase in interest rate move exchange rate in opposite direction. However, Malaysia was an exception. Even with capital control, the exchange rate still depreciating until it re-pegged Ringgit Malaysia against the US dollar (Sanchez, 2005). Literature Review In IMF point of view, the relationship between interest rate (also known as monetary policy) and the exchange rate is that a rise in interest rate will stabilize the exchange rate. This relationship has been frequently discussed by the World Bank, IMF and US Treasury especially during economy crisis since it is important for policy implications. Hnatkovska, Lahiri, and Vegh (2012) conducted a study and the research studies have established the relationship between the exchange rate and short term interest rates is non-monotonic. This study expressed when there is a smaller increase in the nominal interest rate, the currency will be appreciated. On the contrary, larger raise in nominal interest rate lead to the currency depreciated. Besides, some research studies stated that the nominal exchange rate has negative relationship with the nominal interest rate differential and has a positive relationship with expected long run inflation differential (Shah Rehman, n.d.). A short term interest rate is the premium policy instrument that policymakers applied in order to change currency values. There are three effects that will influence the exchange rate by increasing short term interest rate. First, the money demand effect which indicated higher interest rates will increase the demand for domestic-currency denominated assets hence appreciate the currency. On the other hand, higher domestic interest rates reduce domestic output through a credit channel and this effect will depreciate the currency which defined as output effect. In addition, fiscal effect emphasized on a rising in interest rates tends to increase the debt service burden of the fiscal authority and consequently it increases inflationary expectations and weakens the currency. Besides, physical capital can cause both appreciations and depreciations on the effect of temporary increases in interest rates (Hnatkovska et al., 2012). Other factors of no co-integration between real effective exchange rate a nd interest rate differential such as permanent fluctuation in exchange rates as a result of high inflation rate and interest rates, instable monetary policies, unemployment, poor GDP growth rate, poor administrative system, political instability and improper policies (Shah Rehman, n.d.). Shah and Rehmen (n.d) did a research on the relationship between real exchange rate and real interest rate differential on developing country. In this study, they unable found any evidence to shows the relationship between the variables. Theoretically, the relationship between real exchange rate and real interest rate should hold better in long term than in short term. MacDonald and Nagayasu (2000) have conduct a study on 14 developed countries on the similar topic, the empirical result using the single equation method of Johenson shown the existence of long run relationship, the relationship is even clearer when long term interest rate is used. According to the study of (Li Wong, 2011), on e inspiring finding is that the inter-temporal relationship between real interest rate differential and real exchange rates in Iceland, Singapore, Thailand and India is extremely low. The change in their monetary policy did not generate a significant impact on their capital movement. It suggested the interest rate of other countries has efficiently been adjusted, thus there will not be any impact on real exchange rate. Furthermore, many researchers are interested in conducting studies on countries which involved in economic crisis. Researchers had extended the study to Asian countries that other researchers never been done the research using the period Asian economic crisis. He found the relationships pattern different between pre and post economic crisis, where it changes from positive relationship to negative relationship especially for Indonesia. (Bautista, 2006) Economic crisis has strongly aroused the researchers interest to conduct study on Korea as well. Dekle, Hsiao, and Wang (2001) proved that the empirical result are supportive the traditional view. Monetary tightening and the rise in interest rate successfully appreciating Korea won. In fact, it is consistent with the expectation of IMF as they request Korea to raise their short term interest rate after a sustained period of stability depreciated precipitously. An extended study of Meese and Rogoff (1998) with the purpose to find a stable long run relationship between real exchange rate and real interest rate differentials using Korean Won exchange for US Dollar data for period 1991 to 2011, real interest rate did not affect the real exchange rate significantly before crisis (as cited in Park, n.d.). After the crisis, real interest rate differential had a positive significant effect and Korean foreign exchange reserve a negative significant effect on the real interest rate respectively. They also mentioned that the data fitted the interest rate parity theory better after crisis than before crisis , this is reasonable given openness and integration into global market of Korean financial market. The study on ability of interest rate as a defend tool during economic crisis also is a topic concerned by IMF and World Bank (Caporale, Andrea Cipollini, Panicos, 2005). They investigate the monetary tightening policy in defending the exchange rate from speculative pressure during the Asian financial crisis from 1991 to 2001 on Indonesia, South Korea, Philippines, and Thailand. They found that during the crisis period, there was a simultaneously increase in domestic interest rate in respond to exchange rate depreciation. The effects of an increase in the domestic interest rate on domestic currency, owning a higher probability of bankruptcy of highly leverage Corporation. However, during tranquil periods the nominal exchange rate appears to appreciate sharply in response to rise in the domestic interest rate. A similar study been carry out by (Chen, 2007), while the main study is f ocus on interest rate and exchange rate volatility, the empirical result presented supportive view of high interest rate would no help to defend the exchange rate. He suggested that any structural model proposed in this paper suitable to predict the relationship between real interest rate and exchange rate volatility due to all model are consistent with empirical regularity and provide one of cause and effect. Some researchers are interested to identify the pattern of relationship of fixed exchange rate and interest rate during economy crisis. G. Benigno, P. Benigno, and Ghironi (2007) revealed the relation between interest rate rules, exchange rate regimes, and determinacy of the rational expectation equilibrium of the economy. In this paper, follower country is in the exchange rate regime, it means the country that trying to peg the exchange rate, while foreign is the leader. As discussed inÂÂ  Obstfeld and Rogoff (1996), although a fixed exchange rate implies equality bet ween the domestic and foreign interest rates, pegging the domestic interest rate to the foreign one is not sufficient to fix the exchange rate in all periods (as cited in G. Benigno, P. Benigno, and Ghironi, 2007). It results in instability and indeterminacy. This paper proposed a solution to this problem in terms of interest rate feedback rules for the follower countries so that can ensure the determinacy of the fixed exchange rate equilibrium in a rational expectations setting under relatively weak conditions. The class of rules proposed by this paper is differs from other approaches in the literature (such asÂÂ  Taylor, 1994;ÂÂ  Wieland, 1996) because it does not require the specification of any point in the money supply path (as cited in G. Benigno, P. Benigno, and Ghironi, 2007). Recommendations Based on the research studies, we found that the relationship between interest rates is well explained through the International Fisher Effect, however the previous study more focus on the Purchasing Power Parity (PPP). According to Alan and Mark (2004), PPP is a disarmingly simple theory that hold the nominal exchange rate between two currencies should be equal to the ratio of aggregate price levels between the two countries, therefore a unit of currency of one country will have the same purchasing power in a foreign country. We suggest that either each of the theory should not be ignored because both also will influence the exchange rate effectively. Furthermore, previous researches more focus on their studies using the economy crisis background. So we suggest that they can do some researches on the relationship between interest rate and exchange rates under stable economy conditions. Will the results have the differences if compare to the crisis economy? In addition, we also identified that most researchers only emphasize on the inflation that will depreciate the exchange rate. We recommend that they can also take the deflation into the considerations. Actually deflation can be considered as a natural phenomenon, as far as hard currency economies are concerned. Besides that, deflation can leads to the escalation in the purchasing power parity of each unit of currency. Conclusion In conclusion, excluding factors like inflation and interest rate, the most important determinant of a countrys relative level of economic health is exchange rate. It plays an important role in a countrys trade level which is vital to most every free market economy in the world. Many research studies showed that there are negative relationship between interest rates and exchange rates. Interest rates, inflation and exchange rate are highly interrelated. The exchange rate of the currency holds the bulk of investments determine that portfolios real return. Actually the exchanges rates are established by frequent difficult reasons that often leave even the most experienced economists confused, financiers should still have some understanding of how the currency values and exchange rates play a main role in their investment.