Chapter 6- Government Influence on Exchange Rates

Question 1

Exchange rate systems can be classified according to the degree of government control and fall into the following categories:

Answer 1

Fixed
Freely floating
Managed float
Pegged

Question 2

Fixed Exchange Rate System

Answer 2

Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.

-In general, the central bank must offset any imbalance between demand and supply conditions for its currency to prevent its value from changing.

Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies. If a currency’s value is allowed to fluctuate in response to market conditions, we use the term depreciation

Central bank can also revalue or increase the value of its currency against other currencies. If a currency’s value is allowed to fluctuate in response to market conditions, we use the term appreciation

Question 3

Fixed Exchange Rate System (continued)

Answer 3

Bretton Woods Agreement 19 44 – 19 71 (Bretton Woods Era) — Most exchange rates were fixed according to the system planned at the Bretton Woods conference by representatives from many countries. Each currency was valued in terms of gold. (For example, 1 USD was valued as 1/35 ounce of gold.). Therefore, the currencies’ values with respect to each other were fixed. Governments intervened to ensure that exchange rates drifted no more than 1% above or below the initial rates.

However, during the Bretton Woods era, U.S. experienced balance-of-trade deficits – USD has been overvalued.

Smithsonian Agreement 19 71 – 19 73 — called for a devaluation of the U.S. dollar by about 8% against other currencies. But by March 1973, most governments no longer attempted to maintain their currency values within the boundaries established by this agreement.

Question 4

Advantages of fixed exchange rates

Answer 4

First, exporters and importers could engage in international trade without worrying about exchange rate movements of the currency to which their local currency is linked.

Second, firms could engage in direct foreign investment without worrying about exchange rate movements of that currency.They would convert their earnings denominated in foreign currencies into home currency.

Third, investors would be able to invest funds in foreign countries without worrying that the foreign currency denominating their investments might weaken over time.

Question 5

Disadvantages of fixed exchange rates

Answer 5

Risk that government will alter value of currency. Some central banks might need to constantly intervene to maintain their currency’s value, which could cause concerns that they do not have the resources or ability to consistently stabilize the currency’s value.

Institutional investors will invest funds in whatever country that has the highest interest rate.

Country and M N C may be more vulnerable to economic conditions in other countries.

Question 6

Freely Floating Exchange Rate System

Answer 6

Exchange rates are determined by market forces without government intervention. It’s the opposite extreme of the fixed exchange rate system. A freely floating exchange rate adjusts on a continual basis in response to the demand and supply conditions for that currency

Question 7

Advantages of a freely floating system

Answer 7

In a freely floating exchange rate system, the problems experienced in one country will not necessarily be contagious. Exchange rate adjustments serve as a form of protection against “exporting” economic problems to other countries.):
–> A country is more insulated from inflation of other countries.
–> A country is more insulated from unemployment of other countries.

Question 8

Disadvantages of a freely floating exchange rate system:

Answer 8

Can adversely affect the country that initially experiences high inflation.

Can adversely affect the country that initially experiences high unemployment.

Question 9

Managed Float Exchange Rate System:

Answer 9

The currency’s value floats on a daily basis.

Governments sometimes intervene to prevent their currencies from moving too far in a certain direction or to achieve other economic goals.

Countries with floating exchange rates: Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. (Exhibit 6.1)

Question 10

Criticisms of the managed float system:

Answer 10

Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others. This criticism could also apply to the fixed exchange rate system.

Question 11

Pegged Exchange Rate System:

Answer 11

Home currency value is pegged to one foreign currency or to an index of currencies.

A government may peg its currency to a stable currency, such as USD to stabilize its own currency in two ways (USD is more stable than most currencies):

-> First, this practice forces the pegged currency’s exchange rate with the dollar to be fixed.
-> Second, that currency will move against non-dollar currencies to the same extent as the dollar does.

Question 12

Limitations of pegged exchange rate:

Answer 12

Although a country with pegged exchange rate 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. For example, sudden recession

Question 13

Pegged Exchange Rate System (continued) Examples:

Answer 13

Europe’s Snake Arrangement 19 72 – 19 79: established by several European countries. The snake was difficult to maintain and market pressure caused some currencies to move outside their established limits.

European Monetary System (E M S) 19 79 – 19 92: In response to problems with the Snake arrangement. Central banks of these countries allowed their currencies to fluctuate by no more than 2.25% ( 6% for some currencies) from the initially established values. This method of linking European currency values with the ECU (a weighted average of exchange rates of the member countries) was known as the exchange rate mechanism (ERM). The EMS forced participating countries to have similar interest rates so that capital will not flow to high-interest countries. However, some of the member countries want to lower interest rate to stimulate economy.

Mexico’s Pegged System 19 94: In 1994, Mexico’s central bank used a special pegged exchange rate system that linked the peso to the USD but allowed it to fluctuate against the dollar within a certain range.

This crisis illustrates that central bank intervention may not be able to overcome market forces, which serves as an argument for letting a currency float freely.

Question 14

Pegged Exchange Rate System (continued) Examples pt.2:

Answer 14

Asian Pegged Exchange Rates in the Late 19 90s: many Asian countries such as Indonesia, Malaysia, and Thailand had their currencies pegged to USD. However, when the Asian economies showed signs of weakening, the institutional investors began to withdraw their funds, which substantially increased the supply of Asian currencies. Some Asian central banks raised their local interest rates to encourage new capital flows from U.S. investors. However, higher interest rates increased the cost of debt in Asia. Furthermore, this strategy was not successful in attracting more funds from the U.S. because U.S. investors feared that the pegged exchange rates could not be sustained. Consequently, the values of many Asian currencies declined by 20% or more in 1998.

China’s Pegged Exchange Rate 19 96 – 2005: many governments argue that the central bank of China purposely maintains a low value for the yuan, which ensures a strong foreign demand for China’s exports

Venezuela’s Pegged Exchange Rate 2010：pegged rates for essential imports and for nonessential imports. However, the government devalued Bolivar as economy weakened.

Question 15

Currency Boards Used to Peg Currency Values:

Answer 15

A system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed. A currency board is effective only if investors believe that it will last.

Question 16

Interest Rates of Pegged Currencies:

Answer 16

A country that uses a currency board does not have complete control over its local interest rates because its rates must be aligned with the interest rates of the currency to which it is tied.

Question 17

Exchange Rate Risk of a Pegged Currency:

Answer 17

A currency that is pegged to another currency cannot be pegged against all other currencies. If a currency is pegged to the dollar, then it will move in tandem with the dollar against all other currencies.

Exhibit 6.2 provides examples of countries/territories that have pegged the exchange rate of their currency to a specific currency. Currencies are commonly pegged to the U.S. dollar or to the euro.

Question 18

Dollarization

Answer 18

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. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars.

In an effort to stabilize trade and economic conditions, Ecuador replaced the sucre with the U.S. dollar as its currency in 2000.

Question 19

Black Markets for Currencies:

Answer 19

When a government sets a fixed exchange rate and imposes restrictions on residents that require them to exchange currency at that official rate, it may trigger the creation of a “black market” for foreign exchange.

The term black market refers to an underground (illegal) network that circumvents the legal (formal) network in the economy.

A black market for foreign exchange becomes especially active when local residents fear an impending currency crisis.

Question 20

A Single European Currency:

Answer 20

In January 1999, the euro replaced the national currencies of 11 European countries (with official implementation for all transactions in 2002)

The adoption of the euro subjects all participating countries to the same monetary policy (controls growth of the money supply)in the Eurozone

–> European Central Bank (ECB)— Based in Frankfurt and is responsible for setting monetary policy for all participating European countries
–> Objective is to control inflation in the participating countries and to stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

Question 21

Impact on Firms in the Eurozone

Answer 21

— Prices of products are now more comparable among European countries. Firms can engage in international trade within eurozone without foreign exchange costs. Also encourages more long-term international trade arrangements within eurozone.

Question 22

Impact on Financial Flows in the Eurozone

Answer 22

— Bond investors who reside in the eurozone can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros.

Question 23

Impact of a Eurozone Country Crisis on Other Eurozone Countries:

Answer 23

Financial problems of one bank can easily spread to other banks because banking industry in the eurozone is integrated.

Banks in Eurozone frequently engage in syndicated loans. If companies have trouble repaying, all banks may be affected.

News about concerns in one area of Eurozone can trigger actions in other areas.

Eurozone country governments do not have their own monetary policy and must rely on fiscal policy (for example, spending more and lowering taxes) when they experience serious financial problems which may lead to budget deficit.

Banks lend heavily to governments. Banks’ performance is related to whether that government can repay its debts.

Question 24

E C B Role in Resolving Economic Crises

Answer 24

In recent years the bank’s role has expanded to include providing credit for eurozone countries that are experiencing a financial crisis.

The E C B imposes restrictions (measures such as higher tax rates and reduced government spending) intended to help resolve the country’s budget deficit problems over time.

Question 25

Impact of a Country Abandoning the Euro

Answer 25

Would allow a country to set its own exchange rate to encourage purchasers of exports.

Would possibly be expelled from the European Union, which would almost certainly reduce its trade with other European Union countries.

Question 26

Impact of Abandoning the Euro on Eurozone Conditions

Answer 26

One country’s abandonment of the euro could lead to concerns that other countries might also abandon the euro. A fear of future declines in the value of euro-denominated assets could cause the euro to weaken.

An economic analysts contend that the mere threat to abandon the euro would create more problems for the eurozone than would an actual abandonment.

Question 27

Reasons for central banks’ Direct Intervention

Answer 27

1. Smoothing exchange rate movements
   If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time.
2. Establishing implicit exchange rate boundaries
   Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries.
3. Responding to temporary disturbances
   A central bank may intervene to insulate a currency’s value from a temporary disturbance (for example, sale of local currency due to economic or political problems).

Question 28

The Direct Intervention Process (Exhibit 6.3)

Answer 28

A country’s central bank can use direct intervention by engaging in foreign exchange transactions that affect the demand or supply market conditions for its currency. For example, the Fed may

use its USD to buy GBP (increase GBP value against USD) The outward shift in the demand of pounds in the left graph of Exhibit 6.3.

use GBP to buy USD (increase USD value against GBP) The outward shift in the supply of pounds in the right graph of Exhibit 6.3.

Question 29

Reliance on reserves:

Answer 29

The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.

Question 30

Coordinated Intervention:

Answer 30

Intervention more likely to be effective when it is coordinated by several central banks.

For example, ECB, the Fed and the Bank of England can use their Euro reserves to buy USD if they believe Euro value against USD is too high.

Question 31

Nonsterilized versus sterilized intervention

Answer 31

When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention. For example, if the Fed exchanges dollars for foreign currencies in the foreign exchange markets in an attempt to strengthen foreign currencies (weaken the dollar), the dollar money supply increases

In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets (for example, by selling/buying treasury securities to financial institutions, a certain amount of USD will decrease/increase in the banking system). As a result, the dollar money supply is unchanged.

Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring and the extent of the intervention in order to capitalize on the anticipated results of the intervention effort.

Question 32

Direct Intervention as a Policy Tool:

Answer 32

Influence of a Weak Home Currency:

–> The central bank implements a direct intervention to weaken its home currency in an effort to stimulate foreign demand for the country’s products. (See Exhibit 6.5)

Influence of a Strong Home Currency:

–>The central bank may also implement a direct intervention to strengthen its home currency, which can reduce the country’s inflation. (See Exhibit 6.6) A strong home currency increases the purchasing power of local consumers and corporations that buy goods from other countries. This situation intensifies foreign competition and forces domestic producers to refrain from increasing their prices. Therefore, the country’s overall inflation rate should be lower if its currency is stronger, other things being equal.

Question 33

Speculating on Direct Intervention:

Answer 33

Speculating on Intervention Intended to Strengthen a Currency: take a position of this currency then sell it

Speculating on Intervention Intended to Weaken a Currency: short that currency then reverse the transaction.

Central Banks’ Efforts to Disguise Their Strategy: It calls commercial banks and obtains both bid and ask quotes on currencies; that way, the banks will not know whether the Fed is considering purchases or sales of these currencies.

Question 34

Indirect Intervention

Answer 34

The Fed can affect the dollar’s value indirectly by influencing the factors that determine it.

e = f (ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP)

where
e = percentage change in the spot rate
ΔINF = change in the differential between U. S . inflation and the foreign country’s inflation
ΔINT = change in the differential between the U.S. interest rate and the foreign country’s interest rate
ΔINC = change in the differential between the U.S. income level and the foreign country’s income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates

Question 35

Indirect Intervention (continued):

Answer 35

Although the central bank can affect all of the variables, it is likely to focus on interest rates or government controls when using indirect intervention.

Government Control of Interest Rates by increasing or reducing interest rates.

Government Use of Foreign Exchange Controls such as restrictions on the exchange of the currency.

–>. Intervention Warnings intended to warn speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency.