Course: Fundamentals of Money & Banking (1414) Semester: Autumn, 2020
Level: Renamed as Associate Degree in Commerce Total Marks: 100
Pass Marks: 50
Assignment:No. 2
(Units: 5-9)
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Q.1:What is foreign exchange market? Explain its main functions and factors which
influence rate of exchange. (20)
FOREIGN EXCHANGE (FOREX) MARKET
A foreign exchange market is a place where the currencies countries are traded. Foreign exchange market is just like any ofc The only difference is that in other market we can purchase g< foreign exchange market the currency is purchased and sold.
Foreign exchange market consists of commercial banks exchange dealers that legally buy and sell foreign currencies. rent Is but in foreign
DEFINITION:
Two definitions of foreign exchange market are giverpfegjbw to have a clear idea about foreign exchange market. .
(i) F. E. Perry
. “Foreign exchange market is a market where foreign currency can be ’ purchased and sold." •
(jj) Kindle Berger '
A highly respected economist Kindle Berger has defined the foreign exchange market in the following Words:
. “Foreign exchange market is a place where foreign money is bought and sold".
FUNCTIONS OF FOREIGN EXCHANGE MARKET
Following are the main functions of foreign exchange market: • ;
Transfer function: An important.function of foreign exchange market ' < is=the transfer of foreign currencies between countries. The currencies ' -are transferred by means of bills of. exchange, cheques, travellers, cheques, credit card, letter of credit, etc.
Credit functionz-An other important function of foreign exchange market is to provib4credit to the importer. The main instruments used for providing credit to importer are letter of credit, bills of exchange,
(I)
(ii)
(iii)
(iv) ion: Literally hedging means protecting oneself from eign exchange market the term hedging means protecting nd exporter against exchange rate risk. Hedging is an imoorrciu .unction of foreign exchange market. To protect the importer and exporter from the risk of future fluctuation in foreign exchange forwarding exchange rate is determined at the exchange rat prevailing in the market. The payment which will be made afte. . specified time will not be affected by fluctuation in oHOreign
Speculation function: Speculation is an ore^n
exchange market.. Speculators are buyers andI sellers of currencies in the hope to earn profit from f^°^ Ls oppOrtun,ties . value of currencies. Foreign -exchange market provides pp to speculators to buy and sell foreign currencies
FACTORS INFLUENCING EXCHANGE RATE ..............................
FACTORS CAUSING CHANGES IN EXCHANGE RAT^O The exchange rate, between countries changes due to changes demand and supply, in the foreign exchange market. T ctors th T change, in both demand and supply will ultimately i oe the exh^' rate. Following are the important,factors which influe
(i) Changes in price levek.Changes in price I foreign exchange rate. For example if price exchange
rate.
(ii) Changes in exports and imports: Volume of export and import of country causes changesjn the; exchange rate. For example if imports of Pakistan from America awjeed than the exports to America — the-demand for dollar .(foreign .cw^S^y) increases in Pakistan. Thus
the value of Pak. Rupee will decrease against dollar and exchanqe rate will change.
(iii) Capital flow: The capital. flowSrom orje country to another causes changes in the. exchange tete. For example if capital flows from America to Pakistan for investment or in the shape of loan, the . demand for Pak. Rupee will increase. The rate of exchange of Pak Rupee will rise in termsG^American dollar.
(iv) Banking operations: Banking operations also influence the foreign exchange rate. If the State Bank of Pakistan increases the bank rate, the interest rate in the market will rise. The higher interest rate will attract the foreign capital in Pakistan. The demand for Pak rupee will • increase. The rate of exchange of Pak. Rupee in terms of foreign currency
(v) Political foreign e instituti ease. nditions: Political conditions also cause changes in ange. If there is political stability in a country and various r® functioning smoothly, it will attract foreign investors.l will fly in that country; The demand for currency of that will increase in the foreign exchange market. The rate of anfge o that country in terms of foreign exchange will rise.
a ion. Speculation causes short run fluctuation in the p.inlT9e-iiaiJ lf speculators in currency think that in the future Pak d^'reciate and American • dollar will appreciate, the rfS a exchan9e . Rupee for American dollars. The * ninaa ‘ii L me’,can dollar will increase. The value of Pakistani /Qi qSs will decrease as against American dollar.
(vii) Stock exchange operations: Stock exchange operations । securities, bonds, shares, etc., affect stock exchange rates..
iv-jhtry, business of shares, securities, bonds etc., is promoting, the ds from foreign countries will flow into that country to take vantages. This will appreciate the value of the home currency in .... ns of foreign currency. Improvement in technology: Innovations and advanceme in the production of improved products. The dema products increases at home and abroad. The exp< which results in the appreciation of curren ia:
Q.2 change. . Policy of protection: If the of protection to home i encourages ex currenc; of ill increase ]e rate will a country follows the policy discourages imports and
decrease in imports, the demand for foreign le rate of foreign exchange will be in favour
Since and against the foreign currency. there is inflation in the country, the value of home
currency falls and the. value of foreign currency increases. The rate of exchange of home currency will decrease in terms of foreign currency. Deflation: If there is deflation in the country, the value of home currency increases-and the value of foreign currency decreases, so there is change in exchange rate. ,
International debts: When a country takes loan from any other country, the demand for currency of borrower’s country increases and as a result the value of currency increases. Thus, he exchange rate is changed. - . ' .
Define the International Monetary Fund (IMF), World Bank and also describe their functions. (
and fiscal policies. It sends technical experts to the member balance of payment
Structural Adjustrator
facility is provided
Rendering technical advice: The International Monetary Fund renders technical advice to its members on mone
FUNCTIONS OF INTERNATIONAL MONETARY FUND
The IMF functions in such a way as to fulfil its objectives as laid down in (he Bretton Woods Articles of Agreements. The main functions of Fund am follows: Besides the above schemes, funds are also provided b Qynember countries under the following schemes- '
(d) Compensating finance scheme (CFS): Compensatini finance scheme was started in 1963. The IMF provides financi to a member country facing difficulty in the receipt of expor credit. -
balance of payments difficulties.
Guardian of good conduct: The fund functionavas the guardian of I good conduct in the sphere of balance of payments. It works for i reducing tariffs and other trade restriction imposed by member! countries. It is the function of fund to observe the monetary and fiscal*! policies being adopted by the member countries.
Providing financial assistance (Loans): The International Monetary! und provides financial assistance to mdmber countries to solve their1 balance of payments problemsv«|d financial crises. 'Financial! assistance (loan) is provided by vhQrf’the following schemes:
(a) Basic .Credit Facility (BCF): Basic credit facility is provided to :ontrol short-term disequilibrium of
lent Facility (SAF): Structural adjustment ,. .... . 0 member countries to correct long-term
disequilibrium of balance of payments. I
Extended structural adjustment facility (ESAF): Under MnnS st™ctural adjustment facility, the International . tn<? ProvidGS lar9er funds at concessional interest □nd fA nr ? he S6Vere disGC1uilibrium balance of payments and^promote economic growth of the member countries. - proper manner. .
Information service: The IMF provides financial and monetary information to the member countries. It conducts research studies and publishes the same for the guidance of member countries.
Training facilities: The IMF also conducts short training courses on fiscal, monetary and balance of payments for personnel from member countries.
INTERNATIONAL BANK FOR RECONSTRUCTION* AND DEVELOPMENT (IBRD) OR WORLD BANKrfjl
The International Bank for Reconstruction and called as World Bank, was establishedr3liv2^
The head office of the Wort
is a sister institution of the International
Bank started its functions on 25th Juna
specialized agency of the United NationInter-organi: inter-organiz capital for fig of the developed
is promoting tonal cd-operation. The co-operation between the Wor
Training facilities: known as “The Ecoi officials of the memb the management of
Promotion of foreign investment: The World foreign private investment by means of guarai participation in loans and other investments of or through made by private
assistance in the Construction and development of terri member governments by facilitating investment of productive purposes. The World Bank is also encoura; development of productive facilities and resources of less member countries.
bank established a Research Policy Council (RPC) to pMW leadership in the guidance, co-ordination and evaluation of all Bans'
Settling international investment disputes: The Bank has set up the International Centre of Settlement of Investment Disputes (ICSID) The World Bank has successfully settled many international investment disputes such as Indus Water dispute between Pakistan investors.
Promotion of balanced growth: The Wprld Bank is promoting the long range balanced growth of international trade of member World Bank set up a staff college in 1956 ' Trie Development Institute” for training senior developing countries. It helps tl Tm to improve ir economies and to increase t'*.e efficiency .
FUNCTIONS OF THE WORLD BANK
The World Bank performs the following functions to achieve its objecti' (i) Construction and development: The World Bank is p
Bank and other international organizations is based on formal agreer.. . _ . ....
(viii) Economic and social research: The World Bank has reserved abouti 03 percent of its administrative budget- for economic and sociaj research. The research programme was started in 1971. In 1983, the their investment programmes. co-operation: The World Bank is engaged countries by encouraging internationafihybstment.
Maintaining equilibrium: The World Bank is helping members countries in maintaining of equilibrium of balance of payments.
Providing technical assistance^ The World Bank provides technics assistance to its member countries on financial matters. The bar. sends technical experts to tlflfe^ member countries having balance^ payment difficulties. The bank also settles investment disputes of iti member countries.and India and of the Suez Canal dispute between Egypt and United (x) Evaluation of Projects: The World (BtaQ Afagrowers member countries-Jn iheTpost-evaluation "*of their Bank assisted projects. EpfrIHs purpose the Bank has set up "Operation Evaluation Department" -'The borrower countries officials visit this department for seeking help in preparation of project completion report.
ind institutions and :ction of deposited
fer money from one place to another.
KINDS OF BANKS
With the increase in population and people interest in banking sectors the banks perfo many other different functions to facilitate different economic sectors By increasi demand of banks, it becomes difficult for banks to perform all functions properly
banks were divide into different types based on their functions: al Bank
commcrcial Bank
Saving Bank
Exchange Bank
Cooperative Bank
Central Bank:
Central bank does not dcaLdjjgfctly with general public but acts as regulator of other bank. Its main function is to regulate the monetary policy and to control the working of all commercial bank for the proper regulation of monetary and economic policy. A central bank has sole authority of issuing currency. Commercial Bank:
A commercial bank main objective is to eam profit by lending to the eligible businesse&Y»bpk receives deposits from people and pay interests and lends apportiom^frlhose deposits to the people who need it and charge high interest. Conwy iffiaF banks also perform functions like collecting cheque, safe locker, transtxJf money.
Exchange Bank:
Exchange bank provides foreign exchange to importers and exporters of country. Main functions of exchange bank are as: discounting of foreign bills, helping import and export trade and transfer of money from one country to another.
reign based shareholders and they provide services in
Domestic Bank:
These are ownecH^local shareholders and provide services in their own country of origin as commercial or other type of bank.
: banks are established for collecting saving through collection of money that ng idle with people. Directorate of National Savings is working in Pakistan on iattem for promoting savings.
Bank:
. These banks are formed to facilitate the small formers or workers to increase their income level. Usually, governments support these types of banks by providing subsidized credit.
DEFINITION OF DEVALUATION Following are few definitions of devaluation.
Simple definition . I
DevkiaatfSn can be defined in the simple words as under: I
“Devaluation means officially lowering the exchange value of a currency.
I EFFECTS OF DEVALUATION
Effects of devaluation may be discussed under the following two headings:
• Good effects or advantages . . . _
• Bad effects or disadvantages
GOOD EFFECTS ADVANTAGES
rable effects on the economy of the
Devaluation helps to increase the export in the
.Devaluation makes the domestic goods and services cheaper in the international market. This helps to increase exports.
Devaluation makes the expod more paying. To earn more, the ' exporters try io increase exports. Decrease imports: Devaluation makes the imports costly; thereto^ there is decrease in imports. .. • ‘ '
Increases foreign remittances: Foreign remittance is the arnc, sent by the family members working abroad to their families. DueT devaluation the remittances automatically increase. Q-\
Foreign loans: Devaluation makes the home curre . other countries. This helps the country to get loan at
of interest for productive purposes. ' • -
Correct of balance of payments: Devaluatio currency cheaper to other countries. This helps of exports and decreases the volume of import^
the deficit balance, of payments. _
More jobs: As a result of devaluation, the exports of the country are increased and more foreign loan can be obtained. Both factors help to increase output and jobs in the country.
Economic growth: Devaluation help^To increase exports, decreases imports, attracts foreign investors anS-creates more job. All these factors-help the economic growth and bring economic prosperity in the
country. '
Better competition: As a result of devaluation, the country is in a position to compete with its foreigfrcompetitors in a better way.
Discourages Import: As a result of devaluation, the importers in the devaluing currency have to pay more for the imports. They shrink their orders. Thus, devaluation discourages import. Creates inflation: Devaluation decreases the value of money and increases the cost of production. It pushes up the general price level and creates inflation. . " •
Increases foreign debts: As a result of devaluation, the burden of
increases. The borrower countries have to pay more
foreign debts in terms of home currencies.
Declines/in terms of trade: A comparison by money value of the imporU and exports of a country is called terms of trade. Devaluation caused decline in terms of trade. This means double loss, on the one hand the country has to pay more for imports and on the other hand it gets less for exports. The result is decline in terms of trade.
Shortage of domestic goods: As a result of devaluation, the exports increase. It sometimes creates shortage of essential goods in the country.
Merits r.
(i) Automatic Adjustment in BOI^J
The chief merit of the freely fluctuati gets corrected automatically wi
If a BOP deficit arises, tl fall in exchange rate sir export goods cheaper a
ttld be an excess supply of home currency leading to a the market forces of demand and supply. This causes )rt goods dearer.
As a result, export tends to rise while imports tend to decline—thereby removing deficit in the BOP account. Similarly, supply in the BOP account means excess demand for home currency and, thus, rise in the exchange rate. This, in turn, encourages imports and discourages exports. As a result, the BOP accounts^ill reach equilibrium by the
same logic. Thus, this exchange rate makes an auti an economy and that too without governmental ir
atic adjustment in the BOP crisis of •vention.
(ii) No Collusion Between Internal-External Objectives:
Surplus and deficit in the BOP accounts rises, respectively. In a regime of fixed requires the adoption of internal poll pegged exchange rate requires a cl deflationary policies of price and c rected if foreign exchange rate falls and nge rate, the removal of BOP deficit
ike fall income and price level. In other words, in domestic macroeconomic policies like
iut reduction.
But, under flexible exchange rate system, a government can adopt independent monetary policy. In other could be maintained by tl mechanism to restore BO) vords, under this system of exchange rate, internal balance i government. It is further argued that, as it is a self-adjusting equilibrium, a government can put more effort in tackling
internal problems of inflation, unemployment, etc. (iii) Absorption of Sudden Shocks:
In a flexiblqhxtdiange rate, the domestic economy remains insulated from external shocks and pressures. Under this system, the threat of‘importing inflation’ from outside the country is minimum. In other words, price feedback effect is imperceptible.
(iv) Minimum Buffer of Foreign Exchange Reservesent of exchange rate, the ange reserves as a buffer
Since exchange rate is not pegged under the floating arran central bank of a country need not hold adequate forej against unforeseen developments in international tr;
Desmerits
(i) Uncertainty and Confusion:
Flexible exchange rate and trade presents chemosphere of uncertainty and confusion in trade and investment. Susceptibility tq^^ertainty is greater as soon as exchange rate fluctuates freely. Suppose an Indian has despatched an export ‘invoice’ to the foreign buyers. But the Indian exporters do not know at what price foreign currency will be converted into Indian currency. This kind of uncertainty hampers trade. However, such uncertainty can be largely through forward exchange contracts. The
uncertainty involved in thi exchange rate may cause trading community to lose some confidence in the
(ii) Hampering Investment:
Unregulated free- floating exchange rate often discourages foreign investment as
(iii) Risk, Instability, and Speculation:
Flexible exchange rate encourages wide speculation since foreign exchange prices are not known in advance as in fixed exchange rate. It is because of speculation there occurs disruptive hot money flows. To put it elaborately, it can be argued that when the exchange rate tends to decline, speculators anticipate that such would continue to
decline further and the possibility of the flight of money to another country will brighten. This will then cause a further fall in the exchange rate. Thus, greater t speculation against a currency, the deeper the economic crises.
However, economists are not unai the flexible exchange rate system.
(iv) Inflationary in Character:
By nature, flexible exchange rate is in automatically, consequent upon the BOP deficit, import goods become expensive. High cost of imported goods then fuels inflationary tendencies. As depreciation of a currency
;tic economy faces both demand-pull and cost-push
It is because of these drat s of the freely fluctuating exchange rate that countries
attach importance to ‘managed exchange rate’ with their central banks buying and selling currencies in the foreign exchange market so as to moderate the degree of fluctuations as far as practicable.
Level of Employment Increase:
A country economic development depends industrial and communication sect investment and it automatical
sign. Trade: important element of economic development. Commercial bank businessmen of two countries to do work with each other, i.e. letters of credit and banks discount foreign bills of exchange and issue LOC.
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