The Challenges Faced By The International Monetary Fund And The Theory Of Purchasing Power Parity And International Fisher Effect Are Essay-worthy.

Summary of the article 'The IMF Unmet Challenges' by Barry Eichengreen and Ngaire Goods

Dsicuss about the Quantitative Investment Management with Derivative.

In this particular section of the assignment, summary of article named “The IMF Unmet Challenges” by Barry Eichengreen and Ngaire Goods extracted from journal of economic perspective have been presented. The article is concentrated around the controversies faced by the International Monetary Fund that leads to provoking of passionate actions regularly due to its intervention. It is argued by some that IMF is an inefficient institutional and other regards it as indispensable institution (Abuaf 2015). Critics present that institution in executing their core operations across its member countries faces the main challenges.  

The questions around the fund is that whether they are structured appropriately for solving the problems for which it is designed to solve. Article provides defending point regarding the usefulness of IMF by discussing the role played by it in solving information and coordinating problems having considerable implications for the national economies operation and financial and monetary system. National authority hand can be strengthened by putting reforms for enhancing stability in place using the lending combination with advice. Arguments is presented in relation to effectiveness of IMF in executing its function as the player view it as impartial and competent and thereby limiting the effectiveness by its failure to meet the challenges (Hattori 2017).

Article presents four challenges faced by IMF that is supposed to threaten the institution authenticity and therefore the capacity for executing the function ineffectively. The challenges presented in the article relating to the operations of IMF are surveillance, conditionality, sovereign debt crisis management and problem of governance. All the challenges faced by IMF is presented by discussing in depth and presentation of factors that make all those reasons imposing challenge to the institution (Hull and Basu 2016).

The first challenge discussed in the article is about how surveillance is organized through which monitoring of financial and IMF does economic policies. IMF gathered information for gauging the threats associated with the financial system and international monetary fund stability. Central focus of IMF surveillance that has been pointed out in the article is risks and spillovers.  Financial stability and economic risks are different for different nationals and depend on the domestic as well as other countries scenario. In this regard, fund has an important role to play conveying and assembling of information about the global economic and financial condition. On this ground, role for IMF surveillance is regarded as corrective. However, it has been viewed that the funds failed to sound louder warnings and the reasons stem from economic analysis practical implications. Moreover, IMF also warned use of capital control and this approach was in doubt due to occurrence of Asian financial crisis (Patel et al. 2014).

Challenges faced by the IMF

The second challenge presented in the article was criticizing of conditionality of IMF. Conditions are the commitment of policy by governments in receiving assistance and there exist disagreement about requirement and number of commitments. Several questions are raises about the conditionality factor that is attached to the loans offered by IMF.   When benefits of loans are deterred and costs are front loaded, then compliance becomes painful. From the analysis of article regarding this particular challenge faced by IMF in their operations, it can be said that it is required by IMF to make the specification of the achievements of conditions of policy and how such policy are designed to achieve. A more focused conditionality is encouraged by discipline the designs of such conditions and thereby it helps in avoiding the political system overloading. The perceived legitimacy of intervention of funds is enhanced by reforms of governance that helps in addressing the associated complaints (Hull and Basu 2016).

Third controversy is around the disagreement between roles of IMF in sovereign debt crisis management. Measures taken by the fund for solving the problems of debt crisis such as international agreed legal framework and transaction costs leads to creation of coordination problems. The efforts taken for the purpose of involvement in solving such issue is confusing and when the debt created by government is sustainable, efforts should be taken to provide emergency liquidity assistance. In this regard, question is imposed on the capability of fund for determining foreign sovereign debt sustainability. Lending by IMF has been continued for too long given the uncertainties faced and putting off the decision of restructuring. It is so because restructuring is more disruptive for organization and more expensive for country. 

Issues pertaining to governance are another challenge faced by IMF that has been discussed in the article. The impartiality of funds of institution is faced with problems of governance. The decision-making is swayed in directions that are consistent with the national interests due to disproportionate voice of some members even if such directions are in odds with the stability of financial system and international monetary and interest of membership of IMF. The funding decision of institution is seen as neglecting the interests because of inadequate representation of other members.

Critics of IMF are concerned around failure to meet the challenges faced in relation to execution of functions that is questioning impartiality and competence. The question about legitimacy of institution is raised in the language of political theory as the failure of institution to meet the challenges. It has been ascertained from the analysis that future of IMF depends upon governance reforms. Arguments against IMF is addresses on strengthening of the funds effectiveness and hence its legitimacy. View of IMF on capital control was also criticized as it brought institution into the conflict with largest shareholders as such capital control lacked the temporary safeguard provisions. The challenge of conditionality relevance, surveillance quality and utilization of fund approach for solving debt problems leads to creation of doubt about the output legitimacy of IMF (Upper and Valli 2016). Challenge faced by funds regarding its failure to adopt governance system questions its legitimacy.

Theory of purchasing power parity

The theory of PPP (purchasing power parity) helps in determination of exchange rate by determining a way to make comparison between average cost of services and goods within the countries. It is assumed by theory that changes in spot exchange rate are induced by the actions of exporters and importers that is motivated by difference in price of cross-country. It is indicative of the fact that value of exchange rate in the foreign exchange rate market is affected by the transactions on current account of country. The variation and extension of law of one price forms the basis of PPP theory. International difference in productive capacity of nation is captured by purchasing power parity (Cowell 2016). PPP is obtained by aggregating all the tradable goods in an economy by suggesting that there should be equality in price levels between two countries when they are expressed in the same currency. Equilibrium relationship for real exchange rate is determined by PPP that is regarded as nominal exchange rate. The existence of PPP would make adjustment of bilateral nominal exchange rate in a way that real exchange rate is constant.

Purchasing power parity depicts long run relationship between ratio of cost of market basket and exchange rate of domestic and foreign country of trade relation. The equilibrium condition of the relationship can be explained with the help of following equation.

E= CFB/CDB

Where E represents exchange rate

CFB represents cost of foreign baskets

CDB represents cost of domestic baskets

Inequality is generated within the equation when exchange rate falls below the relative cost of bundles between two trading countries.

E< CFB/CDB

If the equation is rearranged, then it can be written as follows,

E* CFB< CDB

This equation arises when there is fall in exchange rate below ratio of cost of foreign basket and domestic basket. It is indicative of the fact that comparison to foreign basket, domestic basket will become cheaper inducing the producers to switch to foreign markets for selling at higher prices and customers to switch on to domestic market. This typical movement in price on export market between one time phase and another and received by domestic producers for goods and services sold in home market is measured by PPI.  In case of bilateral trade, there will be more competitive environment if the trade restrictions are lower. This creates greater chance for creating equality between relative cost of commodity bundles and exchange rate (Selmi et al. 2015). Therefore, the law of one price dominating both home market and foreign market indicating perfectly competitive market structure depicts existence of purchasing power parity. In such scenario, the role of derivative market for transactions becomes dispensable. Since the purchasing power parity helps in creating parity between the prices of goods and services between two trading parties such as two nations helps in eliminating the scope of derivatives market or to involve into derivative transactions (Selmi et al. 2015).

International fisher effect

The change in exchange rate over time is explained by IFE (International fisher effect) theory using concepts of rate of interest rather than taking account of inflation rate. The nominal risk free inflation rate according to effect of international fisher theory comprise of anticipated inflation and real rate of return (Iyke 2017). The difference in rate of expected inflation rates between countries is attributable to interest rates differential if investors expect the same real return. Therefore, it is suggested by the particular theory that since expected inflation is reflected by high nominal interest rate and will lead to depreciation of currency of country with higher interest rate. Hence, investors of home countries may not necessarily attempt to make investment in interest bearing securities of foreign countries. This is so because the advantage of interest rate would be offset by the exchange rate. In every period, the advantage of interest rate is not expected to be perfectly offset by effect of exchange rate as in some period, it could be more pronounced compared to other periods. Several short-term factors affect the prediction of inflation and nominal rates and exchange rates for which IFE has proven to be unpredictable (Friedman 2017). This has been the effect of short-term effect of fisher theory. On other hand, the long-term international fisher effect is better. The difference in interest rate is offset by the exchange rate; however, the objective of predicting spot rate in the future is faced with prediction errors. Nevertheless, it is suggested by international fisher theory advocates that investors would not be benefitted by making investment in interest bearing securities with higher rate of interest.

R_D- P_D = R_F- ? P_F

It is stated by above equation that investment will flow in a manner that will equate the real rate of return on investment if there are no barriers to investment capital flows. Existence of IFE depicts that strategy of investing funds in one country and borrowing from another country does not provide a return on average. The interaction between monetary sector, real sector and foreign exchange rate is represented by the equation (Foley and Manova 2015).  Reason is attributable to the fact that interest rate difference on average should be adjusted by exchange rates.

It is suggested by IFE theory that there will be depreciation in foreign countries having relatively higher rate of interests because expected inflation is reflected by high nominal rate of interests. The key variables in the PPP theory is the percentage change in spot exchange rates. As per the theory, the difference in interest rate of two countries forms the basis of change in spot rate of one currency with respect to another (Titman et al. 2017). As a consequence of this, there will be no higher average return on uncovered foreign money market securities on domestic money from the perspective of investors of home country. It is so because the best guess return would be equal to what that can be earned domestically after accounting for effect of exchange rate.

The relationship between exchange rates and PPP

International Fisher Effect and Purchasing Power Parity is mainly used in deriving the accurate exchange rate, which could allow the companies to conduct trade in the international market. Both the theories mainly aim in identifying the accurate currency value of countries, which good conduct relevant exchange, while identifying the actual value for their home currency. The value of the currency is mainly derived from the changing interest rates that is currently present within the country. Moreover, with the help of derivatives market and instrument the difference occurring from International Fishers Effect and Purchasing Power Parity can be reduced by companies conducting the currency exchange. In this context, Chan, Gan and McGraw (2015) stated that with the help of derivatives the rising risk from changing currency value can be reduced by companies, which could help them maintain their revenue stream. On the other hand, Whitelaw and Bruno (2016) criticizes that theories do not provide adequate parity in currency exchange, as it does not comprehend supply and demand of currency.

The derivatives contract has different ways in which it could protect against falling purchasing power parity and International Fisher Effect. The instruments such as, future contract, forward contract, option contract and swaps can be conducted by companies during the failure of above-mentioned theories.

Future contract is a relatively an instrument, which is used by companies and investors to reduce the risk from volatile market. In addition, with the use of future contracts the difference between International Fisher Effect and Purchasing Power Parity can be conducted. Future contracts mainly allow companies and investors to take up relevant bets regarding the price movement of the currency. this eventually helps in reducing the gap between the actual spot currency price and future currency price. Furthermore, the relative demand and supply of the currency is the main factor behind its price, which can relatively differ from the theoretical price. Hence, with the help of futures contract the gap between the actual value of the currency and theoretical price can be hedged, giving the accurate value of the currency.

Futures contract can be conducted on both side, where increment or decline in the theoretical currency value might be compensated by derivatives instrument. International Fisher Effect and Purchasing Power Parity only provides the currency value on the basis of interest rates, while it ignores the actual demand for the currency within the currency market. with the help of futures contract not only the currency converters can reduce the risk from changing currency market but it could help them decline their losses from currency conversion (Alvarez and Hansen 2017).

Bilateral trade and PPP

Forward contract is relatively a great measure for curbing the imperfections derived from International Fisher Effect and Purchasing Power Parity. Forward contract is relatively affix price in which companies and investors are willing to purchase the currency at a given time. This measure relatively helps in reducing the volatility that might create due to change in interest rates. The derivatives market provides adequate instruments such as forward contract, which helps in identifying the actual future value of the currency by quantifying interest rates of both the countries. However, Skinner (2016) argued that due to changes in interest rate be relevant currency valuation of the countries can change drastically, where losses can be incurred due to the implications of forward contract.

The third derivative instrument that can be used for quantifying the relevant gap of problems in derivation of the currency value with the help of International Fisher Effect and Purchasing Power Parity. Option contracts are relatively an obligation that buyers and sellers make to each other for fulfilling the commitments of the contract. option contracts are relatively Available on low leverage and deposits, which provides high trade capacity to the investors, who could adequately have their current exposure to the currency market. Nevertheless, Kawaller (2015) stated that without adequate research using Option contracts might hamper actual profitability and viability of investors capital.

In addition, option contracts have different types of segments, which can be used for effectively hedging the exposure of investors. put options and call options are relatively adequate instruments that is used by investors for reducing the difference, which occurs from International Fisher Effect and Purchasing Power Parity. This relevant instrument is a highly readable substance, which allows investors to leverage more by providing low premiums for their Investments.

The Last and adequate method that is used by investors is swaps, which relatively reduces the impact of currency volatility, as investors use interest swaps to conduct a relevant currency exchange. In addition, swaps contracts create a different level of demand and supply within the derivative markets, which derives the overall prices of currency. However, swap contract mainly helps in driving the overall price level, while it does not correct the differences that is detected from International Fisher Effect and Purchasing Power Parity (Newell and Lee 2017).

Therefore, with the help of the above derivative instruments, the problems faced during the valuation of currency can be minimized by investors. The degradation of currency, as conducted by Switzerland, can be an adequate example, where the central bank purchased more Euros to push down the actual valuation of Swiss Franc in the currency market. this was mainly conducted to degrade the actual valuation of Swiss Franc in the international market (Judge 2015). Hence, it could be assumed that with the help of derivative instruments relevant parity in currency valuation can be conducted by governments, investors and companies. Moreover, the difference occurred from International Fisher Effect and Purchasing Power Parity Can be minimized with the help of derivative instruments. For example, China has been accused of manipulating the currency valuation in the international market, as it directly affects its exports and imports for the period (Kim and Chance 2018). Thus, it could be identified that like Switzerland and China, countries that are not getting the adequate parity in the currency conversion could use different measures provided by derivatives market to reduce the difference.

IFE theory and the relationship between interest rates and exchange rates

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