lecture 2(1)_chapter 6

7/31/2019 Lecture 2(1)_Chapter 6

1/5

Exchange rate systems can be classified according to degree of governmentcontrol:FixedRates: held constant or allowed to fluctuate within narrow boundaries.Central bank can reset through de/re-valuate (down/up) the value of the currencyagainst others.

Advantages: Insulate country from risk of currency appreciation.-Allow firms to engage in direct foreign investment without currency risk.- Allow knowing the future exchange rates.

Disadvantages: Risk that government will alter value of currency.-Country and MNC may be more vulnerable to economic conditions in other

countries.E.g.Bretton Woods Agreement (1944 1971) Each currency was valued in

terms of gold.-Smithsonian Agreement (1971 1973) A devaluation of U.S. currency by

8% against others.

Freely floating rates: are determined by market forces without governmentintervention.

Advantages: -Less capital flow restrictions are needed, thus enhancingmarket efficiency.

-Insulation from inflation or economic problems(unemployment) of othercountries.

-Central bank interventions to control exchange rates within boundaries arenot needed.

-Governments arent constrained to maintain exchange rates when settingnew policies.

Disadvantages: Can adversely affect a country that has high unemploymentor inflation.

-MNCs may devote substantial resources to cope exposure to exchange ratefluctuations.

Managed float rates: move freely on a daily basis and no official boundariesexist

-Governments sometimes intervene to manipulate their currencies frommoving too far in a certain direction to benefit its own country at theexpense of others.-Currencies of most large developed countries are allowed to float, althoughthey may be periodically managed by their respective central banks.

Pegged: Home currency value is pegged to a foreign currency or an index ofcurrencies

-May attract foreign investment because exchange rate is expected toremain stable.

-Weak economic or political conditions can cause questions whether the pegwill be broken.Examples:Europes SnakeArrangement 1972 1979European Monetary System(EMS) 1979 1992

Mexicos Pegged System tothe U.S. dollar 1994


2/5

Chinas Pegged Exchange Rate 1996 2005Venezuelas Pegged Exchange Rate 2010

Currency Boards: a system for pegging the value of the local currency to someother specified currency must maintain its currency reserves for all currencies thatit has printed.

Advantages: A board can stabilize a currencys value

Disadvantages: Local interest rates must align with interest rates to whichthe local currency is tied (which may include a risk premium). It is effectiveonly if investors believe it lasts.

Dollarization: the replacement of a foreign currency with U.S. dollars. It goesbeyond a currency board, as a country no longer has a local currency. Eg Ecuadorimplemented dollarization in 2000.

1A Single European Currency:The 1991 Maastricht treaty called for a single

currency. By June 2002, currencies of 12 countries* had been withdrawn andreplaced with the euro. *Austria, Belgium, Finland, France, Germany, Greece,

Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain.

European Central Bank: in Frankfurt and is responsible for setting

monetary policy for all participating countries. This is to control inflation and

stabilize (within reasonable boundaries) the euro value with respect to other

major currencies.

Impact on Firms Prices of products are easier to compare amongst

countries, and encourages more cross-border trade, investments and capital

flows. Yet, non-European investors may not achieve as much diversification,

in compare to the past.

Impact on Financial Bond investors can invest in bonds issued by

governments and corporations without concern about exchange rate risk or

foreign exchange transaction cost.

Exposure of Countries A single European monetary policy prevents any

individual country from solving local economic problems with its own unique

monetary policy. Any monetary policy may enhance conditions and

adversely affect other countries.

Impact of Crises may affect the economic conditions of the other

participating countries because they all rely on the same currency and

same monetary policy.

Reasons for Government Intervention1. If a central bank is concerned that its economy will be affected by abruptmovements in its home currencys value, it may attempt to smooth the currencymovements over time.2. To maintain their home currency rates within some unofficial, implicit, exchangerate boundaries.3. A central bank may intervene to insulate its currencys value from a temporarydisturbance.4. A central bank may attempt to control the money supply growth in its country.

5. Often overwhelmed by market forces, currency movements are even morevolatile without it.


3/5

Direct Intervention refers to theexchange of currencies the centralbank holds as reserves for othercurrencies in the foreign exchange

market. It is most effective whenthere is a coordinated effort amongcentral banks, and has high levels ofreserves.

To force the dollar to depreciate, theFed intervenes directly byexchanging dollars that it holds asreserves for other foreigncurrencies. By flooding the market with dollars, the Fed puts downward pressureon the dollar. If the Fed desires to strengthen the dollar, it can exchange foreigncurrencies for dollars, thereby putting upward pressure on the dollar. The Fed may

attempt to increase interest rates (and hence boost the dollars value) by reducingthe money supply. Some traders speculate in attempt to determine when FederalReserve direct intervention is occurring, and the extent of the intervention, inorder to capitalize on the anticipated results of the intervention effort.

When the Fed intervenes in the foreign exchange market without adjusting for thechange in the money supply, it is engaging in a nonsterilized intervention.In a sterilized intervention, the Fed intervenes in the foreign exchange marketand simultaneously engages in offsetting transactions in the Treasury securitiesmarkets to maintain the money supply.Indirect Intervention: affecting

the dollars value by influencing the

factors that determine it.

- Government Control by increasing

or reducing interest rates

-Foreign Exchange Controls with

restrictions on the exchange of the

currency

-Intervention Warnings could

discourage additional speculation

and might even encourage some

speculators to unwind (liquidate)

their existing positions in the

currency.


4/5

Intervention as a Policy Tool

1. A weak home currency stimulates foreign demand for products, reduces

unemployment, and causes a higher inflation at home.

2. A strong home currency can encourage consumers and corporations of that

country to buy goods from other countries. It may lower inflation, since itintensifies foreign competition and forces domestic producers to refrain from

increasing prices. It may also lead to higher unemployment.

3. Like tax laws and money supply, the exchange rate is a tool that a government

use to achieve its desired economic objectives.

Exchange Rate Target Zones have been suggested for reducing exchange rate

volatility. An initial exchange rate will be established with specific boundaries.

Ideally, the rates will be able to adjust to economic factors without causing fear in

financial markets and wide swings in international trade.


5/5

Impact of Government Actions on Exchange Rates

lecture 2(1)_chapter 6

Documents