Chapter 2 Flashcards
3 reasons why central bank “manages” exchange rate
1) To SMOOTH exchange rate movements
2) To establish implicit exchange rate BOUNDARIES
3) In response to temporary DISTURBANCES
Direct intervention
exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market
Direct Intervention is most effective when
there is a coordinated effort among central banks and when the central banks have high levels of reserves that they can use in the event of needs
Indirect intervention
influencing the factors that determine the value of a currency (interest rates, inflation, income level, government controls, expectations)
Indirect intervention example
- Increase interest rates > discourage excessive outflow of funds > limit downward pressure on the value of their currency
- Foreign exchange controls i.e restrictions on currency exchange. (require govt permission before exchanging domestic currency for foreign currency)
Fixed/Pegged System
- Exchange rates held constant or allowed to fluctuate within very narrow bands only
- Pegged to a foreign country’s currency/basket of currencies so moves in line with the fluctuations of that
- Implemented through a currency board
Benefits of Fixed/Pegged System
-MNCs can engage in international trade with greater certainty. It provides stability in international prices and hence lessen risks (e.g exchange rate risk)
-No exchange rate risk -> more cross border trade
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Disadvantages of Fixed/Pegged System
- Central banks need to maintain large quantities of reserves for use in the occasional defence of the fixed rates. (e.g to revalue or devalue their currencies) Only central bank can intervene.
- Makes the country vulnerable to economic conditions of other countries. Interdependency.
Freely Floating Exchange Rate Systems
- Rates are determined by market forces without government intervention
- Adjusts according to demand and supply conditions of the currency
Benefits of Freely Floating Exchange Rate Systems
- Each currency is more insulated from the economic problems of other countries
- Governments are not constrained by the need to maintain exchange rates when setting new policies
- Less capital flow restrictions are needed thus enhancing market efficiency
Disadvantages of Freely Floating Exchange Rate Systems
-MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations
Governments want
the CERTAINTY of fixed rates and the INDEPENDENCE of floating rates
Managed Float
- Exchange rates are allowed to move freely on a daily basis and no official boundaries exist
- However, governments may intervene to prevent the rates from moving too much in a certain direction
Dollarization
- The replacement of a foreign currency with US dollars.
- Decision cannot be easily reversed, as the country no longer has a local currency
Freely Floating
Australia, Brazil, Canada, Sweden, Euro Countries, Israel, Japan, Switzerland, Mexico, Norway, Poland, Taiwan, South Africa, Russia, United Kingdom
Pegged
Bahamas, Bermuda, Hong Kong, China, Barbados, Saudi Arabia
Managed Rate
Singapore, Indonesia, India, Thailand
