Exam 7: The Foreign Exchange Market and the International Monetary System

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Fisher Effect
The Fisher Effect focuses on capital flow. It argues that real interest rates should be equal across countries. Real interest rates are defined as nominal interests adjusted for inflation rates. If a country's inflation rate is higher than another country's, its nominal interest rate is also higher so that real interest rates in both counties should be the same. It predicts that higher nominal interest rates will be offset by higher inflation rates. The future spot exchange rate should change in an equal proportion but in the opposite direction to the difference in nominal interest rates between two countries.
International Fisher Effect
The International Fisher Effect is a combination of the relative PPP theory and the Fisher effect. It derives from the relationship between interest differentials and changes in the spot exchange rate. The theory contends that the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Furthermore, it is based on an analysis of interest rates associated with present and future investments and is used to help predict currency movements. Finally, it arises from the concept that real interest rates are independent of other monetary variables and provides for the assumption that countries with lower interest rates will likely also experience lower levels of inflation, resulting in increases in the real value of associated currency in comparison to other nations.

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IMF
The IMF is one of the major international financial institutions that comprise the international monetary system. It was created by the Bretton Woods agreement that adopted a fixed exchange rate system. Under this system, all countries agreed to link their currencies to the U.S dollar, the only currency that is convertible to gold. The organization was created to help member countries escape financial crises by extending short-term loans and credits. Its primary functions are to monitor the exchange rate policies of the member countries to preempt potential international financial crises. It also provides short-term financial assistance (including credits and loans) to its member countries who are experiencing financial difficulties. Finally, it offers technical assistance for afflicted countries by providing them with expertise and strategic consulting in devising fiscal and monetary policy. Countries can become members by paying a "quota" or membership due. The quota amount is determined by the size of a country's economy.
Criticism
To help countries eliminate the root causes of financial crises, the IMF adopts harsh austerity measures such as currency devaluation, interest rate increase, and substantial reduction in government spending due to its belief that financial crises stem from hyperinflation, massive fiscal deficit, widening trade deficit, and overvalued currency. Critics question the effectiveness of these approaches and whether these approaches improve the affected country's economic and financial stability.
The first criticism the IMF has faced is its "one size fits all approach." The IMF follows a rigid formula when dealing with countries in financial distress. The organization applies the same approach to helping a country overcome financial suffering even though the cause of the crises differ from country to country. The criticism holds that recipient countries are being forced to adopt the same policy reforms centered on austerity measures without considering differences in economic status, business environment, and cultural norms.
The second criticism refers to the moral hazard issue. A moral hazard is a term used to describe reckless behavior that people display when they know beforehand that such behavior will be forgiven. It refers to the imprudent lending practices of international banks that assume their loans are risk free since these institutions believe the IMF will intervene when necessary to avoid a large-scale global financial crisis.
The third criticism is that the IMF lacks accountability. Critics have pointed out that the organization's austerity measures tend to exacerbate a country's economic and financial situation. There is no way to demand responsibility from the IMF when a bailout program or proposal does not work.
Prescription Improvement
Foremost, the IMF should have open communication amongst its members and increase transparency relating to prescriptions to increase buy in and identify the areas in which the organization can improve. Greater input and involvement by the parties affected by the IMF's decisions should produce better performance by the organization. Additionally, structural and political reforms are necessary to give policy advice and to finance countries when necessary. Its governance needs to be modernized to reflect the increased role of emerging economies. It must revise its principles and expand its global vision to meet the world's needs and provide equitable growth.