Alternative FOREX regimes - Topic E

Question 1

What are the 3 types of ER regimes?

Answer 1

Fixed (value pegged to value of another currency - anchor currency)

Floating (value free to fluctuate against all other currencies)

Managed (dirty) float (influence ERs by buying + selling currencies)

Question 2

Give an example of ER regimes in practise

Answer 2

From 1979-90, the EU operated under a fixed ER system

ER mechanism: rate between any pair of participating currencies were not supposed to fluctuate outside limits (snake), but in practise all currencies were pegged to the German mark

Question 3

What steps should the CB take if domestic currency is (over)valued? (too high for state of economy)

Answer 3

Purchase domestic currency to keep the ER fixed and conduct a devaluation, vice versa for an undervalue (revaluation rather)

Question 4

Illustrate intervention in the case of an overvalued ER, labelling the axes and demonstrating the movements, describing why

Answer 4

Y = ER (foreign/domestic currency), X = Q of domestic assets

Supply is perfectly inelastic and there are 2 downward sloping demand curves, D1 shifting rightwards onto D2, E1 moving up to Epar, vice versa for undervalued ER

Question 5

What are the downsides to fixed ER systems?

Answer 5

Speculative attacks, e.g. Sept 1992 crisis rocked the EMS > GBP overvalued, speculators expected devaluation thus sold large amounts of GBP > despite attempts to influence IR and stabilise ER, UK was unsuccessful > withdrew from ERM, adopting a floating ER system instead, leading to sharp depreciation of the currency

Question 6

What is the policy trilemma?

Answer 6

Countries (or monetary unions like the Eurozone) can’t pursue 3 policies at the same time: 1) free capital mobility, 2) a fixed (stable) ER and 3) an independent monetary policy

Question 7

Implication of K outflows and inflows?

Answer 7

Outflows: may increase capital flight, financial instability

Inflows: may lead to excessive risk-taking by financial intermediaries

Question 8

Give the advantages and disadvantages of exchange-rate targeting

Answer 8

Advantages: keeps inflation under control, provides clarity to the public

Disadvantages: open to speculative attacks on currency, no longer able to use independent monetary policy if they are under a system of capital mobility also