exchange rate behaviour

8/7/2019 EXCHANGE RATE BEHAVIOUR

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EXCHANGE RATE SYSTEM


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EXCHANGE RATE

y THE RATE AT WHICH ONE CURRENCY CAN

BE EXCHANGED FOR ANOTHER.y THE VALUE PER UNIT OF ONE CURRENCY

IN TERMS OF ANOTHER CURRENCY.


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Exchange Rate System

Exchange rate systems can be classified according to the degree by which

exchange rates are continuously followed by the government.

Exchange rate system normally fall into one of the

following categories: -

y Fixed

y Freely floating

y

Managed floaty Pegged

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Fixed Exchange Rate System

y

In a fixed exchange rate system, exchange rates are either held constant orallowed to fluctuate only within very narrow boundaries. A fixed exchange ratewould be beneficial to a country for the following reasons: -

1. Exporters or importers could engage in international trade without concernabout exchange rate movements of the currency to which their local currency

is linked.2. Any firms that accept the foreign currency as payment would be insulted

from the risk that the currency could depreciate over time; in addition anyfirms that need to obtain that foreign currency in the future would beinsulated from the risk of the currency appreciating over time.

3. Another benefit is that firms could engage in direct foreign investment,without concern about exchange rate movements of that currency, theywould be able to convert their foreign currency earning into their homecurrency without concern that the foreign currency denominating theirearning might weaken over time. Thus the management of an MNC would bemuch easier.

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General points

If an exchange rate begins to move too much, government intervenes to maintain

it within the boundaries. In some situation, a government will devalue or reduce the

value of its currency against other currencies. In other situation, it will revalue or

increase the value of its currency against other currencies.

A central banks action to devalue a currency in a fixed exchange rate system is

referred to as devaluation.. Devaluation refers to a downward adjustment of the

exchange rate by the central bank. Conversely revaluation refers to an upward

adjustment of the exchange rate by the central bank.

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Advantages ofFixed Exchange Rates to MNCs

1. In a fixed exchange rate environment, MNCs may be able

to engage in international trade, direct foreign investment,

and international finance without worrying about thefuture exchange rate.

Consequently, the managerial duties of an MNC are

less difficult.

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Disadvantages ofFixed Exchange Rates to MNCs

1. One disadvantages of a fixed exchange rate system is that there is still

risk that the government will alter the value of a specific currency.

Although an MNC is not exposed to continual movements in an

exchange rate, it does face the possibility that its government will

devalue or revalue its currency.

2. A second disadvantage is that from a macro / worldwide point of view,

a fixed exchange rate system may make each country and its MNCs

more vulnerable / weak / helpless .condition in other countries.

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FREELYFLOTING EXCHANGE RATE SYSTEM

y

In a freely floating exchange rate system, exchange rate values aredetermined by market forces without intervention by government.

Whereas a fixed exchange rate system allows no flexibility for

exchange rate movements, a freely floating exchange rate system allows

complete flexibility.

y A freely floating exchange rate adjusts on a continual basis in response todemand and supply conditions for that currency.

y Advantages: -

One advantages of a freely floating exchange rate system is that a country

is more insulated from the inflation of other countries.

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Example

y Continue with the previous example in which there are only two

countries, but now assume a freely floating exchange rate system. If the USexperienced high rate inflation, the increased US demand for British goods

will place upward pressure on the value of the British pound. As second

consequences of the high US inflation, the reduced British demand for US

goods will result in a reduced supply of pounds for sale (exchanged for

dollar

y The pound will appreciate due to these market forces (it was not allowed

to appreciate under the fixed rate system). This appreciation will make

British goods more expensive for US consumers even through British

produced did not raise their prices. The higher prices will simply be due tothe pounds appreciation; (that is, a greater number of US dollars are required to

buy the same number of pounds as before)

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Other Advantages

y Another advantage of freely floating exchange rates is that a country is more insulated

from unemployment problems in other countries.

y Example: -

Under a floating rate system, the decline in US purchase of British goods will reflect a

reduced US demand for British pounds. Such a shift in demand can cause the pound todepreciate against the dollar (under the fixed rate system, the pound would not be allowed

to depreciate).

The depreciation of the pound will make British goods look cheap to US

consumers, offsetting the possible reduction in demand for these goods resulting from a

lower level of US income.

As was true with, a sudden change in unemployment will have less influence on a

foreign country under a floating rate system than under a fixed rate system.

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PEGGED EXCHANGE RATE SYSTEM

ySome countries use a pegged exchange rate arrangement, in which theirhome currencys value is pegged / attached to a foreign currency. While

the home currencys value is fixed in terms of the foreign currency to

which it is pegged, it moves in line with that currency against other

currencies.

y Some government peg their currencys value to that of a stable

currency, such as the dollar, because the value of their currency to be

stable.

y First, this force their currencys exchange rate with the dollar be fixed,

second, their currency will move against non dollar currencies by thesame degree as the dollar. Since the dollar is more stable than most

currencies, it will make their currency more stable than most

currencies.

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Limitations ofPegged Exchange Rate

y While countries with a pegged exchange rate may attract foreign investment because the

exchange rate is expected to remain stable, but weak economic or political conditions

can cause firms and investors to question whether the peg will hold.

y For example: -

If the country suddenly experiences a recession, it may experience capitaloutflows as some firms and investors withdraw funds because they believe there are

better investment opportunities in other countries.

These transaction result in an exchange of the local currency for dollars and other

currencies,which places downward pressure on the local currency value.

The central bank would need to offset this by intervening in the foreign exchangemarket, so they might be not able to maintain that peg.

If the peg is broken than the exchange rate will dictated by the market forces,

than local currencies value would decline immediately.

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y If foreign investors fear that a peg may be broken, they quickly sell their

investment in that country and convert the proceeds into their home

currency. This trancation place more downward pressure on the localcurrency of that country.

y For the reasons explained here, countries have difficulty maintaining a peg

exchange rate when they are experiencing major political or economicproblems.

y While a country with a stable exchange rate can attract foreign

investments, the investors will move their funds to another country if

there are concerns that the peg will break.

y Thus a pegged exchange rate system could ultimately create instability in a

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Examples of Critics

y Creation of Europes snake arrangement: - one of the best known

pegged exchange rate arrangement was establishment by several

European countries in April 1972.

y Their goal was to maintain their currencies within established

limits of each other.This arrangement became known as snake.

y The snake was difficult to maintain, however and maker pressurecaused some currencies to move outside their established limits

consequently, some members withdrew from the snake

arrangement, and some currencies were realigned.

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Creation of the European monetary system (EMS)

y Due to continued problems with the snake arrangement, the European monetary

system was pushed into operation in March 1979. The EMS concept was similar to the

snake,but the specific characteristics differed.

y Under the EMS exchange rates of members countries were held together within

specified limits and were also tied to the European currency units. Its value was

weighted average of exchange rates of the member countries each weight was

determined by a member; relative gross national product and activity in intra-European

trade.

y The currencies of these countries were allowed to fluctuate by more than 2.25% and

6% for some currencies from the initially established values.

y The method of linking European currency values with ECU was known as the exchange

rate, mechanism, (ERM). The participating governments intervened in the foreign

exchange markets to maintain the exchange rates within boundaries by the ERM.

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Demises of the European Monetary system

y In the fall of 1992, however, the exchange rate mechanism experienced severeproblems, as economic conditions and goals began to vary among Europeans centuries.

y The German government was mostly concerned about inflation because its economy

was relatively strong. It increased local interest rates to present excessive spending and

inflation other European governments, however were most concerned about stimulatingtheir economies to lower their high unemployment levels, so they wanted to reduce

interest rates.

y In Oct 1992 the British and Italian government suspended their participation in the

ERM because they could not achieve their own goals for a stronger economy while theirinterest rates were so highly influenced by the German interest rates.

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The break in chinas pegged exchange rate

y

y From 1996 to until 2005, chinas Yuan was pegged to be worth about $ 12(8.28 Yuan perUS dollar). During this period the Yuans value would change against non dollar

currencies on a daily basis to the same degree as the dollar.

y Because of the peg, the Yuans value remained at that level even though the US was

experiencing a trade deficit of more than $100 billion per year with China. US politiciansargued that the Yuan was being held at a superficially low level by the Chinese

government, and if it was allowed to float, its value would raise 10 to 20%.

y The politicians were pressured by US firms that lost business to Chinese exports. In 2005

some politicians argued that an explicit tax of about 30% should be imposed on allproducts imported from China. In response to growing critics China revalued its Yuan by

2.1% in July 2005. It also agreed to allow Yuan to float subject to a .3% limit every day

from previous days closing, but it did not have a major impact on the trade imbalance

between China and US. In May 2007 china widened its band so that Yuans value could

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y Even through the Yuan is not allowed to float, (within the limit), the

huge balance of trade deficit was not automatically force appreciation

of Yuan. Large net capital flows from china to the US (purchase of US

securities) could offset the trade flows.

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exchange rate behaviour

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