Chapter 2

Question 1

3 reasons why central bank “manages” exchange rate

Answer 1

1) To SMOOTH exchange rate movements
2) To establish implicit exchange rate BOUNDARIES
3) In response to temporary DISTURBANCES

Question 2

Direct intervention

Answer 2

exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market

Question 3

Direct Intervention is most effective when

Answer 3

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

Question 4

Indirect intervention

Answer 4

influencing the factors that determine the value of a currency (interest rates, inflation, income level, government controls, expectations)

Question 5

Indirect intervention example

Answer 5

• 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)

Question 6

Fixed/Pegged System

Answer 6

• 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

Question 7

Benefits of Fixed/Pegged System

Answer 7

-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
-

Question 8

Disadvantages of Fixed/Pegged System

Answer 8

• 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.

Question 9

Freely Floating Exchange Rate Systems

Answer 9

• Rates are determined by market forces without government intervention
• Adjusts according to demand and supply conditions of the currency

Question 10

Benefits of Freely Floating Exchange Rate Systems

Answer 10

• 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

Question 11

Disadvantages of Freely Floating Exchange Rate Systems

Answer 11

-MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations

Question 12

Governments want

Answer 12

the CERTAINTY of fixed rates and the INDEPENDENCE of floating rates

Question 13

Managed Float

Answer 13

• 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

Question 14

Dollarization

Answer 14

• The replacement of a foreign currency with US dollars.

- Decision cannot be easily reversed, as the country no longer has a local currency

Question 15

Freely Floating

Answer 15

Australia, Brazil, Canada, Sweden, Euro Countries, Israel, Japan, Switzerland, Mexico, Norway, Poland, Taiwan, South Africa, Russia, United Kingdom

Question 16

Pegged

Answer 16

Bahamas, Bermuda, Hong Kong, China, Barbados, Saudi Arabia

Question 17

Managed Rate

Answer 17

Singapore, Indonesia, India, Thailand