Chapter 6 Flashcards
Types of exchange rates
Fixed
Freely floating
Managed float
Pegged
Fixed rate systems
an exchange rate system in which exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.
some central bank intervention
Smithsonian Agreement
called for a devaluation of the U.S. dollar by about 8% against other currencies
US had balance of trade deficits - dollar may have been overvalued
Disadvantages of Fixed system
Disadvantages:
Risk gov will alter currency
Country and MNC may be more vulnerable to economic conditions
Central banks may need to constantly intervene to maintain value
Advantages of Fixed system
Export/importers can internationally trade w/out worry of exchange rate movements to which their currency is linked
Allow firms to engage in direct foreign investment without currency risk.
Investors can invest funds in foreign countries w out worry foreign will weaken
Freely Floating rate system
exchange rate system in which exchange rates between currencies are allowed to fluctuate in response to market forces.
US and Eurozone use - most common?
Advantages Freely Floating rate system
Country is more insulated from inflation of other countries.
Country is more insulated from unemployment of other countries.
Does not require central bank to maintain exchange rates within specified boundaries. (only occasionally intervene)
Disadvantages Freely Floating rate system
Can adversely affect a country that has high unemployment.
Can adversely affect a country with high inflation.
Managed Float Exchange Rate System
Governments sometimes intervene to prevent their currencies from moving too far in a certain direction.
Criticism: may manipulate for own benefit
Pegged Exchange Rate System
exchange rate whose value is pegged to another currency’s value or to a unit of account (index).
Rates move w rate of currency its tied with
Peg against stable currency to help stabilize own
Pegged Exchange Rate System Limitation
May attract foreign investment because exchange rate is expected to remain stable.
Weak economic or political conditions can cause firms and investors to question whether the peg will be broken.
What are currency boards?
A system for pegging the value of the local currency to some other specified currency. The board must (backed by) maintain currency reserves for all the currency that it has printed.
only effective if investors believe it will last
What is dollarization?
replacement of a foreign currency with U.S. dollars.
This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar.
What is the black market for currencies?
an underground (illegal) network that circumvents the legal (formal) network in the economy.
Active when residents fear a currency crisis
When a government sets a fixed exchange rate and imposes restrictions on residents that require them to exchange currency at that official rate, it can trigger creation
Monetary Policy in the Eurozone
European central bank responsible for setting monetary policy in all countries
Objective: control inflation + stabilize value of euro
