Chapter 6

Question 1

fixed Exchange rate system

Answer 1

held constant

or allowed to fluctuate only within a very narrow boundaries

Question 2

freely floating Exchange Rate

Answer 2

ER values are determined by market forces without intervention

Question 3

managed float systm

Answer 3

ER are not restricted by boundaries but are subject to government intervention

Question 4

pegged exchange rate system

Answer 4

currency´s value is pegged to a foreign currency o unit of account
moves in line with that currency (or unit of account) against other currencies

Question 5

Direct Intervention

Central Bank

Answer 5

use their currency reserves to buy up a spec. currency in FX Market so as to place upward pressure on that currency (demand > supply)
attempt to force currency depreciation by flooding the market with that spec. currency (sell that currency in exchange for others)
E.g. depreciation of EUR can cause demand for euro imports and thus stimulate eco. growth

Question 6

Indirect Intervention

Central Bank

Answer 6

increase value of HC by increasing IR - thus attracting foreign demand for home currency to buy high-yield securities
decrease value - lower IR

Question 7

weak home currency effect

Answer 7

increase country´s export & decrease imports
lowering unemployment
cause higher Infl. ate since reduction in foreign competitions (currency is worth less in foreign countries)
local producer can more easily increase prices without concern about pricing themselves of the market

Question 8

strong home currency effect

Answer 8

keep inflation low (encourages consumer to buy abroad)
local producers must maintain low prices to remain competitive
foreign supply can be obtain cheaply helping inflation remain low
BUT increase unemploym. due to imports > exports

Question 9

Indirect Intervention vs Market Forces

Answer 9

Asian Bank rises IR to prevent their currency weakening
but high IR didn´t offset outflows of funds, as investors had no confidence that currencies would stabilise & unwilling to invest in Asia

Question 10

Reasons for using Pegged system

Answer 10

attempt to reduce speculative flows that occur because of ER volatility
it tries to comfort investors by making them believe that currency will be more stable

Question 11

typical forces that break peg if country is not able to maintain it

Answer 11

foreign inv. become concerned that peg breaks –> currency may decline by more than 20% against home
adverse effect return on investment thus they try to liquidate their investment and move their fund out of that currency
places downward pressure as S>D
CB may attempt to offset these forces by buying the currency in FX Market (but has only limited currency reserves thus becomes overwhelmed)

Question 12

Fixed ER

Benefits

Answer 12

ex/importers could engage in IT without concern of ER movement (linked to currency)
invest in foreign country knowing ER to which convert CF back –> makes MNC easier
any firm needing to obtain f.c in the future would be insulated from risk of c. appreciating
any firm needing to accept f.c payment would be insulated from risk of c. depreciating
investors would be able to invest in funds without concern f.c might weaken
country with stable ER attracts more funds (stabilise country &support eco. growth)

Question 13

Fixed ER

criticism

Answer 13

remains risk that government can alter the currency value
obviously not continual movement but risk of de/revaluation
macro approach fixed rat makes a country & firms more vulnerable to eco. conditions in other countries
–> “exporting” inflation &unemployment
speculation if Er is set artificial level (too high/low)
–> Smithsonian & Bretton Woods still cause trade imbalances

Question 14

Free floating Rate

Benefits

Answer 14

country is more insulated from problems of other countries
(e.g. inflation/unemployment)
freedom of CB in their intervention policies (they aren´t required to constantly maintain Er within spec. boundaries)
not required to implement intervention policy that may have unfav. effect on economy just to control ER
government can implement policies without concern if policy will maintain ER within spec. boundaries
ER adjustments serve as protection against “exporting” eco. problems to other countries
more freedom of capital flow and hence more efficiency within the financial market

Question 15

floating

Disadvantage

Answer 15

benefit from country who is isolated from this “exporting problem” risk is a disadvantage fro country initially experienced eco problem
government will have in/direct intervention when adversely affects eco. condition of country (or CB)
but sometimes this won´t help as marker forces are too strong!!!

Question 16

managed “dirty” float ER

system

Answer 16

a) freely = ER fluctuates on daily basis (no official boundaries)
b) like fixed - government can intervene to prevent their currencies from moving too far in certain direction

Question 17

“dirty” float ER

Critcism

Answer 17

allows government to manipulate ER in a manner that benefit its own country at expense of others
(not clear what type of policies they use!!)

Question 18

Pegged Exchange Rate System

Answer 18

home currency is pegged to foreign (more stable one)
will move according with that currency against the others
due to pegged makes own currency more stable

Question 19

Pegged ER System

Disadvantages

Answer 19

may attract FI as it looks stable
but weak economic/ political conditions can question peg stability
–> speculation due to fear of pegged break can place downward pressure on currency (as it will be exposed to MF)
–> e.g. peso
a) limitation of depreciation of peso so as to reduce infl. pressure cause weak HC
b) speculators recognised that peso was maintain art. high (speculate on potential decline)
c) investment outflow due to fear (add. downward pressure)