Chapter 6- Government Influence on Exchange Rates Flashcards
Exchange rate systems can be classified according to the degree of government control and fall into the following categories:
Fixed
Freely floating
Managed float
Pegged
Fixed Exchange Rate System
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
Fixed Exchange Rate System (continued)
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.
Advantages of fixed exchange rates
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.
Disadvantages of fixed exchange rates
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.
Freely Floating Exchange Rate System
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
Advantages of a freely floating system
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.
Disadvantages of a freely floating exchange rate system:
Can adversely affect the country that initially experiences high inflation.
Can adversely affect the country that initially experiences high unemployment.
Managed Float Exchange Rate System:
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)
Criticisms of the managed float system:
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.
Pegged Exchange Rate System:
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.
Limitations of pegged exchange rate:
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
Pegged Exchange Rate System (continued) Examples:
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.
Pegged Exchange Rate System (continued) Examples pt.2:
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.
Currency Boards Used to Peg Currency Values:
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.
Interest Rates of Pegged Currencies:
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.
Exchange Rate Risk of a Pegged Currency:
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.
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. 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.
Black Markets for Currencies:
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.
A Single European Currency:
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.
Impact on Firms in the Eurozone
— 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.
Impact on Financial Flows in the Eurozone
— 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.
Impact of a Eurozone Country Crisis on Other Eurozone Countries:
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.
E C B Role in Resolving Economic Crises
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.
