Basket of currency and the economy Term Paper Example | Topics and Well Written Essays - 1750 words

Basket of currency and the economy - Term Paper Example Every country has its own accepted currency. They have unique ways of identifying the currencies; for example, the American Dollar ($) and the Swiss Franc and so on. Basket of currency can be defined as the weighted average of a group of currencies that can be used as a measure of its value. What makes up the basket of currency and the weighting is highly depends on the purpose intended. It serves as a way to tell the movements of regional currency. As Investopedia asserts, countries sign contracts to avoid the fluctuations of currencies. The best examples are the Asian and European currency unit but, the Euro replaced the European Currency Unit. The basket of currency helps countries' currencies not to collapse. In 1997, Asia experienced a currency crisis and this has led to the discussion on how the Asian countries can have a desirable exchange rate. The crisis major cause was the adoption and use of the dollar peg system. It is said that the dollar peg system led to huge capital inflow in to the Asian countries thus led to the crisis (Ogawa & Sasaki, 2002). Huge capital inflows are dangerous to the economy as it can lead to a reverse of the capital flow direction. This led to the Asian economies adopting the currency basket system which included a more flexible exchange rate. The main currencies which show a strong economic relationship are included in the currency basket. The strong relationships are in terms of international finance and trade and foreign direct investment. The main currencies are: the Japanese Yen, the Euro and the US dollar. An analysis of the Asian countries interest and exchange rates, foreign reserves and monetary base was done and it revealed that the Asian currenc ies and the US dollar exhibited a strong link and the exchange rates were not floating freely as expected (Calvo& Reinhart, 2002). The Asian countries saw that by acquiring the intermediate exchange rate, it would lead to overvaluation or undervaluation of their currencies. Undervaluation would yield import inflation while overvaluation would make goods for trade to be less competitive. Therefore, currency of basket was the only significant way for Asian countries to avoid the crisis but they must have been export-oriented. Currency swap A currency swap occurs when two parties agree to exchange a specific amount of different types of currencies. At the initial stage of the exchange there are interest payments that are done. The deal can be either of the parties to pay floating exchange or fixed interest rate. Agreements can be made to ensure that both parties use both at the same time. The principal amounts are always exchanged back as the currency swap matures. It must be noted that in a currency swap, both the principal and the interest are exchanged in full amounts. After the Asian countries currency crisis, the monetary authorities have come up with a new initiative, Chiang Mai Initiative, which is a regional monetary cooperation. The initiative comprises of many currency swaps to help manage the currency crisis. More so it acts as a tool of surveillance and helps in the preventing currency crisis. It helps the Deputy finance Ministers to mainly observe the macroeconomic domestic variables, inflation rates and GD P, at any policy making meetings and economic