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MECE-004: Financial Institutions and Markets

MECE-004: Financial Institutions and Markets

IGNOU Solved Assignment Solution for 2021-22

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Assignment Code: MECE-004 / AST-1/2021-2022

Course Code: MECE-004

Assignment Name: Financial Institutions and Markets

Year: 2021-2022

Verification Status: Verified by Professor

Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each). In the case of numerical questions word limits do not apply.


Section A


1) Describe the nature of the financial system in a modern economy giving the important types of constituent institutions, markets and instruments. Explain the concept of flow-of-funds in the financial markets

Ans) There are four constituents of a financial system, viz. (i) financial institutions, (ii) financial markets, (iii) financial instruments, and (iv) financial services.

Financial Institutions

Financial institutions are business organisations that act as mobilisers and depositors of savings and as purveyors of credit or finance. They also provide various financial services to the community.

Financial institutions have been variously classified. Two important classifications are as follows:

  1. Banking institutions and non-banking institutions

  2. Intermediaries and non-intermediaries.

a) Banking institutions and non-banking institutions

The banking institutions have quite a few things in common with the non-banking ones, but their distinguishing character lien in the fact that unlike other institutions, (i) they participate in the economy’s payments mechanism, i.e., they participate in the economy’s payments mechanism, i.e., they provide transactions services, (ii) their deposit liabilities constitute a major part of the national money supply, and (iii) they can, as a whole, create deposits or credit which is money. Distinction between the two has been highlighted by Sayers by characterising the former as “creators” of credit, and the latter as were “purveyors” of credit.

b) Intermediaries and Non-intermediaries

Intermediaries intermediate between savers and investors; they lend money as well as mobilise savings; their liabilities are towards the ultimate savers, while their assets are from the investors or borrowers.

Non-intermediary institutions do the loan business, but their resources are not directly obtained from the savers.

All banking institutions are intermediaries, many non-banking institutions also act as intermediaries and when they do so they are known as non-banking financial inter-mediaries.

Financial Markets

Financial market is a mechanism enabling participants to deal in financial claims. The market also provides a facility in which their demands and requirements interact to set a price for such claims. The participants on the demand and supply sides of these markets are financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and others who are inter-linked by the laws, contracts, covenants and communications networks.

Financial markets have been variously classified. Two important classifications are:

  1. Primary market and secondary market; and

  2. Money market and capital market.

a) Primary market and Secondary market

The primary markets deal in the new financial claims or new securities, and, therefore, they are also known as ‘new issue markets.

Secondary markets deal in securities already issued or existing or outstanding.

Primary markets mobilise savings and they supply fresh or additional capital to business units. Secondary markets do not contribute directly to the supply of additional capital, they do so indirectly by rendering securities issued on the primary market’s liquid.

b) Money market and Capital market

Money market is a market for short-term securities with a maturity of one year or less capital market is a market for long-term securities, that is, securities having a maturity period of one year or more.

Keeping in view different purposes, financial markets have also been classified into the following categories: (i) organised and unorganised; (ii) formal and informal; (iii) official and parallels; and (iv) domestic and foreign.

Financial Instruments

A financial instrument is a claim against a person or an institution for the payment at a future data a sum of money and/or a periodic payment in the form of interest or dividend. The term ‘and/or’ implies that either of the payments will be sufficient but both of them may be promised.

Primary securities and Secondary securities

Financial securities may be primary or secondary securities. Primary securities are also termed as direct securities as they are directly issued by the ultimate borrowers of funds to the ultimate user.

Financial institution differs in terms of marketability liquidity reversibility, type of options, return, risk and transaction costs.

Financial Services

Financial intermediaries provide key financial services such as merchant banking, leasing, hire purchase, credit -rating, etc. Financial services rendered by the financial intermediaries bridge the gap between the back of knowledge on the part of investors and increasing sophistication of financial instruments and markets.

Flow-of-Funds Accounts

The flow-of-funds accounts are the financial counterparts of the national income accounts of the real sector of the economy. These provide a systematic way of integrating saving, investment, lending, and borrowing. In so doing, it brings together the real and financial sectors of the economy. For these reasons, an understanding of the flow of funds accounts is an indispensable tool of the financial analyst.

What is flow-of-funds accounts? The flow-of-fund accounts include all the sources and uses of funds for the various sectors of the economy, and by summation, for all sectors.

Although aggregate saving and investment must be equal, ex post, for the entire economy, it is unlikely that saving will equal investment for a particular sector during a given period. Saving may exceed investment; the surplus on current account will have been used for purposes other than financing current expenditures. For example, the surplus funds may have been used to buy securities or to take loans. If a sector has investment greater than saving, sources other than its own saving will have provided the funds necessary to finance these expenditures. Thus, saving is but one source of funds; investment is but one use of funds.

Data for Flow-of-Funds Accounts

Flow of funds data for an economy are derived for a specific period of time by (1) dividing the economy into sectors, (2) preparing a source and use of funds statement for each sector, (3) summing the sources and uses for all sectors, and (4) placing the sector accounts side by side to form a table or matrix.


2) Discuss the Markowitz theory of efficient portfolio selection. How does the Capital Asset Pricing Theory (CAPM) theory build on it?

Ans) Portfolio Theory

Markowitz’s work on portfolio theory considers how an optimizing investor would behave. This theory asserts that in constructing a portfolio of assets, investors seek to maximize the expected return from their investment given some level of risk they are willing take. Those portfolios that satisfy this requirement are called efficient portfolios. Markowitz’s theory explains how this should be done.

Markowitz made certain assumptions regarding the behaviour of investors. These are as follows:

  1. Investors choose portfolios based on their expected mean and variance of return.

  2. Investors are risk-averse expected utility maximisers (we shall study more about risk aversion and expected utility maximization in the next section)

  3. Investors have a single-period time horizon, and it is the same for all investors.

  4. Investors have identical expectations about expected returns, variances, and covariances for all risky assets.

Basically, Markowitz suggested the following procedure for choosing optimal portfolio of risky assets: mark out the set of efficient portfolios; specify the return-risk indifference curves; and choose the optimal portfolio. This is elaborated below.

The first thing to do is visualise a diagram where expected returns are depicted on the vertical axis and risk (variance on the horizontal axis:

Now the thing to notice is that if we drew indifference curves on this space, (the thing on the horizontal axis is a ‘bad’ (a ‘bad’ is something the more you consume of, the less utility you get—like pollution. Here risk is a ‘bad’). Thus, if we were to draw indifference curves on the return-risk space, they will be convex –but upward sloping! They would look like the following:

All points on an indifference curve provides the same level of satisfaction. The steeper the slope of the indifference curve, the greater the degree of risk aversion. As one moves leftward across different indifference curves, the utility increases. Indifference curve I1 gives a higher level of satisfaction than indifference curve I3.

Now let us see how the set of efficient portfolios (what is called the efficient frontier) is delineated. Given the same level of risk, different portfolios will have different returns. The investor will select the portfolio with the with the greatest expected return for a given level of risk. Usually, the procedure for obtaining the highest expected return for a given level of risk is found by using a complicated mathematical technique called quadratic programming, which is an optimisation technique. It is beyond the scope of our discussion. We can give an intuitive explanation.

Given the assets that are available, an investor can create many possible portfolios. Any portfolio that can be created from the available assets is called a feasible portfolio.

The collection of all feasible portfolios is called the feasible set of portfolios. However only a subset of the frontier of the feasible set of portfolios will be the Markowitz efficient set of portfolios. Finally, to choose a single portfolio, the investor will choose that point on the return-risk space where the Markowitz efficient set of portfolios is tangent to an indifference curve. This is the optimal portfolio.

The works by Sharpe by Lintner and by Mossin on the Capital Asset Pricing Model (CAPM for short) is concerned with economic equilibrium assuming all investors optimize in the particular manner that Harry Markowitz proposed. The CAPM is an equilibrium model of asset pricing. As such the CAPM provides an understanding of the behavior of security prices, the risk-return relationship, and the appropriate measure of risk for securities.

In the CAPM some additional assumptions over and above those made for Markowitz’s portfolio theory, are made. Theses are, first, that unrestricted borrowing and lending can take place at the risk free rate; secondly, that investors have homogeneous expectations regarding the means, variances, and covariances of security returns; and finally, that there are no imperfections in the capital market such as transaction costs, and also that there are no taxes.

Section B


3) Critically examine the major theories that have been put forward to explain the term structure of interest rates.

Ans) The theories of interest rate determination listed above are primarily theoretical constructs that attempt to explain the level of the average, or natural rate of interest. These explanations fall short of describing the wide range and variety of interest rates found in a variety of financial markets. What explains the difference in long-run and short-run interest rates, for example? What is the fundamental structure of interest rates? There are times when different assets have varying default risks. On owing by a farmer to a moneylender, for example, may have a higher risk of not being paid (due to the farmer's loan defaulting) than interest on a government bond. Different levels of risk of default might result in different rates of interest being charged. The term 'term structure of interest rates' refers to the yields of interest-bearing instruments like bonds that are identical save for maturity dates, or term to maturity.

We examine debts issued by identical lenders; the only difference between the debt instruments is the maturity dates. The term structure of interest rates refers to yield disparities produced by variances in maturity period. The link between debt instrument interest rates and maturity term can be visually depicted. The yield curve is the graphical representation of this connection. It summarises the returns that can be obtained by purchasing otherwise identical debt instruments with different maturities. For products such as Treasury Bills, bonds, and Certificates of Deposits, yield curves can be mapped. A yield curve is a snapshot of a specific point in time. The rate of interest, as well as the yield curve, may change throughout time. We allow the maturity period to shift in a yield curve while keeping the date at which the curve is relevant, as well as the default risk associated with the instrument, constant. Typically, yield curves are upward sloping. However, in exceptional circumstances where the yields of distinct instruments do not differ significantly from one another, the yield curve may be nearly horizontal. The yield curve may also be downward sloping in unusual cases where the yield on longer-term instruments is lower than the yield on shorter-term instruments. Historically, there have been a few instances of flat or even downward-sloping yield curves.

Now we'll look at various theories regarding why interest rates have such a long term structure. We'll go over three different theories: I the expectancies hypothesis; (ii) the segmented market hypothesis; and (iii) the preferred-habitat hypothesis. The first two are diametrically opposed, whilst the third incorporates features from both. Let's take a look at each one separately. Longer-term interest rates, according to the expectancies hypothesis, are an average of shorter-term interest rates projected to prevail across the asset's lifetime. The hypothesis posits that investors regard a sequence of short-term bonds as perfect substitutes for long-term bonds in order to make this claim. Because short and long-term bonds are considered equal in terms of quality, the sole element influencing an investor's decision is the projected return from buying a larger number of short-term bonds rather than a single long-term bond. The expectations theory also implicitly argues that investors are risk averse and will not pay a premium to lock in a longer-term interest rate. It also assumes no transaction fees, thus the cost of purchasing a short-term asset is the same as purchasing a long-term asset.

where shows yield to maturity for a bond beginning in the current time period and maturing in period n. The left-hand-side of the above equation shows the future value of rupee one invested in an n-year bond, while the right-hand side represents the future value of rupee one invested in a series of 1-year bonds over a period of n years. Of course, the future one-period interest rates Er2, Er3, ...Ern would be expected rates from the point of current time period.

Let us now come to the segmented-markets hypothesis of term-structure of interest rates. It is at the opposite end of the theoretical spectrum from the expectations theory. it says that bonds with different maturity periods are substitutable for each other; their yields are determined independently of each other. It views the markets for bonds with different maturities as separate. In each segment, the yield is determined by the intersection of demand and supply for that type of bond.

The idea behind the market segment hypothesis is that investors have preferences for financial instruments with terms to maturity. If a person has idle cash balances which he will not need for another seven years when he needs it because he retires then, in that case the person will be attracted to and invest in bonds with a 7- year maturity period. Purchasing a holding a bond for seven years is more attractive for him than holding a bond for shorter period and then reselling and buying a bond subsequently because the transaction costs would be higher in the latter case. Also, the interest risk would be greater because in the future the interest may come down. On the other hand, if he holds a short period bond and the interest rate rose in the subsequent period then the price of bond will fall, leading to a capital loss for him when he sold the bond. The segmented-market hypothesis implies that the relative supply of and demand for bonds and other financial instruments of varying maturities determines the shape of the yield curve.


4) Discuss the Black-Scholes formula on derivative pricing.

Ans) The Black Scholes Formula

The Black–Scholes model is a model of the evolving price of financial instruments, in particular stocks. The Black–Scholes formula is a mathematical formula for the theoretical value of European put and call stock options derived from the assumptions of the model. The formula was derived by Fischer Black and Myron Scholes and published in 1973. They built on earlier research by Edward Thorpe, Paul Samuelson, and Robert C. Merton. The fundamental insight of Black and Scholes is that the option is implicitly priced if the stock is traded.

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option’s price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate.

The original formula for calculating the theoretical option price (OP) is as follows: Where:

Advantages & Disadvantages of the Model

Advantage: The main advantage of the Black-Scholes model is speed — it lets you calculate a very large number of option prices in a very short time.

Limitation: The Black-Scholes model has one major limitation: it cannot be used to accurately price options with an American-style exercise as it only calculates the option price at one point in time — at expiration. It does not consider the steps along the way where there could be the possibility of early exercise of an American option.

This is the Black-Scholes equation for pricing options.

In deriving this equation, we assumed that:

  1. There are no arbitrage opportunities (no free lunch).

  2. Short selling of shares is always possible.

  3. No transaction costs or taxes in setting up a portfolio.

  4. All securities are perfectly divisible.

  5. Trading can take place continuously.

  6. The underlying share pays no dividends during the lifetime of the option.

  7. The risk-free rate r and the share volatility ó are known over the lifetime of the option.

What is the relation between Binomial Options Pricing Model & Black Scholes Model?

The same underlying assumptions regarding stock prices underpin both the binomial and Black-Scholes models: that stock prices follow a stochastic process described by geometric Brownian motion. As a result, for European options, the binomial model converges on the Black-Scholes formula as the number of binomial calculation step increases. In fact, the Black-Scholes model for European options is really a special case of the binomial model where the number of binomial steps is infinite. In other words, the binomial model provides discrete approximations to the continuous process underlying the Black-Scholes model.


5) Discuss the concept of leverage for a firm. Discuss the important financial and leverage ratios used. Explain the Merton-Miller theorem.

Ans) Financial leverage refers to the substitution of fixed-charge financing-mainly debt (interest and principal) but also preferred stock for common stock. If the firm finances entirely through equity, fluctuations in earnings per share arise entirely through the firm’s business risk. If some of this equity is substituted by debt, a smaller group of people is holding the remaining shares. So, the risk to them increases because a smaller group of people is holding on to the existing business risk. This added risk is called financial risk. Financial leverage also affects the expected level of earnings per share (EPS) and return on equity (ROE). We state some of the basic results regarding the consequences of leverage:

  1. When the return on assets exceeds the interest cost of debt, financial leverage raises both EPS and ROE and reduces them when the return on assets is less than the cost of debt.

  2. Financial leverage raises the variability or volatility of both EPS and ROE. This is because the creditor claims are of a fixed nature. A fixed amount must be paid to creditors regardless of the financial situation of the firm.

3) Financial leverage generally raises the expected value of EPS as well as that of ROE. Therefore, leverage is likely to raise both EPS and ROE, but increases their variability. So the firm cannot focus on the expected EPS and ROE alone; it has to take variability into consideration as well.

Ans) We now turn to alternative theories of the capital structure of a firm. We just saw that leverage can have both positive and negative effects. Is there then an optimal level of leverage? The traditional thinking on this was that since leverage substitutes debt for equity, what happens is that as the proportion of debt increases, the proportion of cheaper credit increases while that of more expensive equity decreases, and hence, the firm’s weighted average cost of capital (average of debt and equity) declines. This means that the total value of the firm goes up.

This traditional view was challenged in a remarkable article by Franco Modigliani and Merton Miller in 1958 published in the American Economic review. They demonstrated that if we assume that there are no taxes, transactions cost and other market distortions, then the capital structure does not matter. This paper set the stage for financial discipline to acquire a rigorous theoretical edge and no longer be informed by accountancy practices and anecdotal evidence but be based on mathematical economics and empirical studies. Modigliani-Miller’s first proposition is that the value of the firm is independent of its capital structure. Their second proposition is that the cost of equity capital for a leveraged firm is equal to the constant overall cost of capital plus a risk premium. This risk premium itself is equal to the difference between the overall cost of capital and cost of debt multiplied by the debt-equity ratio. Symbolically, it can be shown as:

where Ke is cost of equity capital

Kd is cost of debt capital

Ko is the overall cost of capital, that is, the weighted average cost of capital.

Their first proposition is based on an arbitrage kind of argument. It suggests that in equilibrium identical assets must sell for identical prices, regardless of how they are financed. This arbitrage type of assumption, together with the assumption that the firm’s operating cash flow is independent of its capital structure, gives rise to the first proposition.

Merton Howard Miller was an American economist. He won a Nobel Prize in Economics, together with Harry Markowitz and William Sharpe in 1990, for his pioneering work in the field of corporate finance theory. Miller also co-authored the famous Modigliani-Miller theorem (known as the M&M theorem) that deals with relationship between a company's capital-asset structure and its market value, for which his colleague Franco Modigliani received the Nobel Prize in economics in 1985.

The basic theorem states that the value of a firm is unaffected by how that firm is financed—it does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, this theorem is also often called the "capital structure irrelevance principle." In this work, he not only recognized that which is in a sense obvious if you break it down to the essentials, he was able to apply vigorous empirical and theoretical analyses to the problem and came up with an elegant solution. Miller was recognized as one of the most important developers in the field of corporate finance, and his work continues to inform and stimulate new research in the field. However, as with all economic models, if human nature is not well understood, such that the individual motivations of those involved are considered, the model is not a complete account of economic behaviour.


6) Explain the need for, and role of depository systems in secondary markets. Explain the concept of custodial services.

Ans) Depository, in very simple words, means a place where something is deposited for safekeeping. A depository is an organisation which holds securities of a shareholder in an electronic form and facilitates the transfer of ownership of securities on the settlement dates. The need for depository system arose primarily because of the following factors:

  1. Inordinate delays in transfer of securities.

  2. Return of share certificate as bad deliveries on account of forged signatures/ mismatch of signatures or face certificate/forged transfer deed.

  3. Delay in the receipt/non-receipt of securities after allotment / refund orders to non-allottees.

  4. Delay in getting duplicate shares/debentures, certificates, and

  5. Inadequate infrastructure in banking and postal segments to handle a large volume of application and storage of share certificates.

The bottlenecks became more pronounced with every increase in the number of investors and volume of trading in securities.

In response the depositories Act 1996 was enacted. The Act vests SEBI with the powers of registration of depositories and participants and to approve or amend the byelaws of a depository. The National Securities Depository limited (NSDL) was set up in 1996. the NSDL was sponsored by the IDBI, the UTI and the NSE.

The system of depositories has the following role:

  1. The holders of existing securities have choice of either continuing with the existing share certificate or opt for the depository mode.

  2. Issuers of new securities give an option to investors either to opt for physical delivery of share certificates or join the depository made.

  3. The investors opting for depository mode continue to enjoy the economic benefits form the shares and the voting rights.

  4. The shared in depositories are fungible, ie,. They do not have distinct number or distinct identity.

  5. Investors are allowed exist from the depository and they can claim share certificate form the company by getting their names substituted as the registered shareholder in place of the depository.

  6. After opting for depository mode, the share certificates of the investors get dematerialised, and their names are entered in the books of participants as beneficial owners. In the register of the name of the depository as the registered owner of securities.

  7. The investors joining the depository system must register with or more participants who are agents of the depositories. Such participants are custodial agencies, such as banks, financial institutions, etc.,

Safeguards have been built into the regulations to prevent manipulation of records and transactions in the depository system. The safeguards include protection against unauthorised access to systems, standard transmission and prescribed formats for electronic communication, controlled access mechanisms to data storage procedure and facilities for ensuring protection of records against loss or destruction and arrangements for back-up of records and data. The provision is also to be made for insurance and other arrangements for indemnifying the beneficial owners.

Custodial Services

The provision of efficient custodial services forms an important element in the evolution of a mature stock market system.

Custodian services are provided by the custodians. Custodian services are different than depositories. A custodian is an intermediary who keeps the scarps of the clients in custody or is the keeper of the accounts of its clients. A custodian is not only a safe keeper of share certificates and a trustee of the same but also provides ancillary services such as physical transfer of share certificates, collecting dividends and investment warrants, and conforming to transfer regulations. Besides these, it updates clients on their investment status. To claim benefits on behalf of its clients, a record dates, bonus and rights issues.

Recognising their importance in the securities market, the SEBI custodian of Securities Regulations 1996 was framed for the proper conduct of their business. According to SEBI regulations, custodial services in relation to securities mean (i) safe keeping of the securities of a client who enters into an agreement to avail of these securities, and (ii) providing services incidental thereto.


7) Compare the impact of monetary policy under fixed exchange rates with those under flexible exchange rates.

Ans) There are two basic systems that can be used to determine the exchange rate between one country’s currency and another’s: a floating exchange rates (also called a flexible exchange rates) system and a fixed exchange rates system. Under a floating exchange rate system, the value of a country’s currency is determined by the supply and demand for that currency in exchange for another in a private market operated by major international banks. In contrast, in a fixed exchange rate system a country’s government announces, or decrees, what its currency will be worth in terms of “something else” and also sets up the “rules of exchange.” The “something else” to which a currency value is set, and the “rules of exchange” determines the type of fixed exchange rate system, of which there are many. For example, if the government sets its currency value in terms of a fixed weight of gold, then we have a gold standard. If the currency value is set to a fixed amount of another country’s currency, then it is a reserve currency standard.

When a country has a regime of flexible exchange rates, it will allow the demand and supply of foreign currency in the exchange rate market to determine the equilibrium value of the exchange rate. So the exchange rate is market determined and its value changes at every moment in time depending on the demand and supply of currency in the market.

Some countries (for e.g. China, Mexico and many others), instead, do not allow the market to determine the value of their currency. Instead, they “peg” the value of the foreign exchange rate to a fixed parity, a certain amount of rupees per dollar. In this case, we say that a country has a regime of fixed exchange rates. In order to maintain a fixed exchange rate, a country cannot just announce a fixed parity: it must also commit to defend that parity by being willing to buy (or sell) foreign reserves whenever the market demand for foreign currency is greater (or smaller) than the supply of foreign currency.

We have seen that banks are big players in the foreign exchange markets. Changes in flexible exchange rates are brought about by banks’ attempts to regulate their inventories. However, these inventory changes reflect more basic underlying forces of demand and supply that come from the attempts of households, firms and financial institutions to buy and sell goods, services and assets across nations. Changes in exchange rates, in turn, modify the behaviour by households, firms and financial institutions. Under a fixed.

The forex market that we studied in Section 17.2 was hugely expanded in 1971, when the fixed exchange rate system of the Bretton Woods began to be abandoned and floating exchange rates began to appear. Under the fixed exchange rate system there was no inter-bank markets for national currencies, no dealers carrying out huge transactions. The Bretton Woods agreement prevented speculation in currencies.

The Bretton Woods Agreement was set up in 1945 with the aim of stabilizing international currencies and preventing money fleeing across nations. This agreement fixed all national currencies against the dollar and set the dollar at a rate of $35 per ounce of gold.

If we consider capital flows, then under a flexible exchange rate, capital movements affect the domestic economy, by having expenditure-switching effects income, output and employment, and they can also change domestic prices. Under a fixed exchange rate, capital movements do not affect the domestic economy directly, but may affect it indirectly by altering the money supply, interest rates, and so on. In fact, with high capital mobility, the central bank is unable to control the money supply and thus loses control of the domestic interest rates.

Let us now look at the relative merits of fixed and flexible exchange rates and see when it is better to have a flexible rate regime. What is the case for and against flexible exchange rates? Basically, a flexible exchange rate regime, the case for which was always quite popular among many economists and became attractive to policymakers of many countries in the wake of currency crises in the late 1960s in Western countries, is a system where the central bank does not intervene in the foreign exchange markets to fix rates, is supposed to automatically ensure exchange rate flexibility. Moreover, this system is supposed to confer other benefits as well. Let us look at these putative benefits now.

First, under flexible rates, there is monetary policy autonomy. If central banks were no longer required and obliged to intervene in currency markets to fix exchange rates, governments would be able to use monetary policy to reach internal and external balance. No country would be able, moreover, to export inflation or unemployment to other nations. Secondly, under a system of flexible exchange rates, the underlying asymmetries of power prevalent under fixed exchange rate system, like that of the US under the Bretton Woods arrangement, would vanish, and powerful countries like the US will not be able to set world monetary conditions all by themselves. Finally, and this is related to the first point above, under a flexible exchange rate regime, the exchange rates would act as automatic stabilisers. Even in the absence of an active monetary policy, the quick adjustment of market determined exchange rates would help countries maintain internal and external balance in the presence of fluctuating aggregate demand.

What is the case against floating exchange rates? The experience with floating exchange rates has not been uniformly nice, so that some scepticism about floating exchange rates have arisen. The following points are put forward as reasons for lack of faith in flexible exchange rates. First, since central banks are freed from the obligation to fix exchange rates, it is feared that some indiscipline may creep in, and they may embark on an inflationary policy. The discipline imposed on them would be lost.

Secondly, flexible exchange rates allow speculators to step in, and speculation on changes in exchange rates, it is feared, could lead to instability in foreign exchange markets, and this instability, in turn, might have negative effects on countries’ external and internal balance. Moreover, floating exchange rates could cause more disruptions to a country’s home money markets than fixed exchange rates. Third, floating exchange markets can make relative international prices more predictable and hence damage international trade and investment.

A floating exchange rate regime indicates that coordination on adjustment is less than under fixed exchange rate regime, which had an architecture like the Bretton Woods system. Under flexible exchange rates, countries might follow a policy without thinking of possible beggar-thy-neighbour effects. The poor countries might be hurt by competitive currency practices. This is the fourth point against floating exchange rates. Finally, proponents of flexible exchange rates claim that a flexible exchange rate regime provides greater autonomy to policymaking by countries. Sceptics of floating exchange rate regimes claim that such autonomy is largely illusory. Fluctuations in exchange rates would have such large and wide-ranging macroeconomic effects that central banks would be forced to intervene in foreign exchange markets, even though they may not have a formal commitment to peg. Floating exchange rates would thus increase the uncertainty without giving macroeconomic policy greater liberty.

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