Government influence on exchange rates

Question 1

How are exchange rate systems classified and examples

Answer 1

Classed according to the degree of government control used:
Fixed
Freely floating
Managed float
Pegged

Question 2

Define a fixed exchange system with example

Answer 2

Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. Not used much.
Central banks can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies - the terms appreciate or depreciate are only used when rates change with market forces.
Ex: Smithsonian Agreement 1971 – 1973

Question 3

Advantages of fixed exchange rates and disadvantages

Answer 3

Advantages: Insulate the country from risk of currency appreciation.
Allow firms to engage in direct foreign investment without currency risk.

Disadvantages: Risk that the government will alter the value of currency.- particularly likely in periods of stress and economic downturn. Countries and MNC may be more vulnerable to economic conditions in other countries.

Question 4

Assuming a fixed exchange rate system and US inflation > UK inflation what is the effect on US and UK market

Answer 4

US production will be reduced and the US unemployment rate will rise. The excessive demand for British goods can cause higher inflation in the UK – US “exports’’ its inflation to the UK. Prices are lifted by an exchange rate effect, there was no problem in the UK but it was passed on from the US. UK unemployment also rises as US unemployment is “exported” as reduced US income leads to reduced UK purchases. There is nothing the UK can do as the currency is fixed.

Question 5

Why would high inflation countries currency weaken

Answer 5

As it takes more of currency to buy the same amount of goods - money loses power. Purchasing power is reduced.

Question 6

Define the freely floating exchange rate system

Answer 6

Exchange rates are determined by market forces without government intervention.

Question 7

Describe the advantages and disadvantages of a freely floating exchange rate system

Answer 7

Advantages: Country is more insulated from inflation and unemployment of other countries. Does not require the central bank to maintain exchange rates within specified boundaries.

Disadvantages: Can adversely affect a country that has high unemployment.
Can adversely affect a country with high inflation

Question 8

Assume a freely floating exchange rate describe what advantages would happen for the UK if the US experience a higher rate of inflation?

Answer 8

US high inflation, means increased U.S. demand for U.K. goods will place upward pressure on the pound. Reduced U.K. demand for U.S. goods will result in a reduced supply of British pounds for sale (exchanged for dollars), placing upward pressure on the pound’s value. The pound will appreciate in response to these market forces (recall that appreciation is not allowed under the fixed rate system).

Question 9

Assume a freely floating exchange rate what effect would a decline in US purchases of UK goods have?

Answer 9

Will lead to reduced U.S. demand for British pounds. The pound would depreciate against the dollar (under the fixed rate system, the pound would not be allowed to depreciate). This will make British goods cheaper for U.S. consumers than before, offsetting the reduced demand for these goods that may follow a reduction in U.S. income.

Question 10

Assuming a freely floating exchange rate system what disadvantages would occur for the home country if US experiences high inflation

Answer 10

US high inflation means the dollar may weaken, thereby insulating the UK from the inflation. As U.S. producers foreign competition has been reduced by the weak dollar, they can more easily raise their prices without losing customers to foreign competition. If the U.S. unemployment rate is rising then U.S. demand for imports will decrease, putting upward pressure on the dollar’s value. A stronger dollar will then cause U.S. consumers to purchase foreign rather than U.S. products because the foreign products can be purchased cheaply. This can be detrimental to the United States during periods of high unemployment.

Question 11

how does central bank influence interest rates with high inflation

Answer 11

If currency weakens against other currencies then investors will ask for a higher rate of the return to be compensated for weakening of the currency.

Question 12

What is stagflation

Answer 12

When you have high rates of both employment and inflation

Question 13

Define the managed float exchange rate system

Answer 13

Hybrid - combines elements from both fixed and free float systems. Governments sometimes intervene to prevent their currencies from moving too far in a certain direction. Currencies of most large developed countries are allowed to float.
Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others

Question 14

Define with an example the pegged exchange rate system

Answer 14

Home currency value is pegged to one foreign currency or to an index of currencies
Ex: Montenegro has pegged its national currency to the euro.
May attract foreign investment as the 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.

Question 15

What is the ECB

Answer 15

European Central Bank - based in Frankfurt and is responsible for setting monetary policy for all participating European countries. It’s objective is to control inflation in the participating countries and to stabilise the value of the euro to major currencies

Question 16

What is the impact of a single european currency in the monetary policy eurozone

Answer 16

Impact of a single european country: Prices of products are now more comparable among European countries
Important to note, the inception of the euro hasn’t made credit risk the same across all European countries. Any given monetary policy used in the eurozone during a particular period may enhance conditions in some countries and adversely affect others. Hence using the euro countries so not have control of their monetary policy.

Question 17

How do crisis work within the eurozone as a result of being a single currency zone?

Answer 17

Crisis may affect the economic conditions of the other participating countries
Financial problems of one bank can easily spread to other banks
Banks in the Eurozone frequently engage in loan participations. If companies have trouble repaying, all banks may be affected
Eurozone country governments must rely on fiscal policy, not monetary policy

Question 18

How does the ECB work to prevent crisis int he eurozone. Give an example of what they did after financial crisis.

Answer 18

Their role includes providing credit for countries that are experiencing a financial crisis.
The ECB imposes restrictions intended to help resolve the country’s budget deficit problems over time
ECB accepted collateral in its liquidity operations with lower credit ratings than it did before the financial crisis after the fact.

Question 19

Define a sovereign credit rating

Answer 19

A sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity

Question 20

What affect does sovereign downgrades have on the eurozone banks

Answer 20

Sovereign downgrades may spill over to banks, affecting both their access to funding and its cost, while reducing the funding benefits they derive from implicit and explicit government guarantees

Question 21

What impact is there on a country that abandons the euro

Answer 21

Allows a country to set its own exchange rate to encourage purchasers of exports, possibly be expelled from the European Union which would almost certainly reduce its trade with EU countries.

Question 22

What is the impact of abandoning the euro on eurozone conditions

Answer 22

Investors may fear other countries abandoning the euro and reduce investments in the eurozone.Often threat of abandonment creates more problems than actual abandonment.

Question 23

Why do governments intervene in exchange rate systems

Answer 23

Smoothing exchange rate movements- If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s , it may attempt to smooth currency movements over time
Establishing implicit exchange rate boundaries- Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries
Responding to a temporary disturbance

Question 24

How does the FEB directly intervene forcing the dollar to depreciate/appreciate

Answer 24

To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign -“flooding the market with dollars” the Fed puts downward pressure on the dollar.
If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.

Question 25

What limits the effectiveness of direct intervention?

Answer 25

Reliance on reserves - The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.
Intervention more likely to be effective when it is coordinated by several central banks.

Question 26

What are the two classifications of direct intervention

Answer 26

Nonsterilised and sterilised

Question 27

Explain sterilized intervention

Answer 27

Intervention in foreign exchange market while simultaneously engaging in offsetting transactions in treasury security markets. To strengthen foreign currencies (weaken the dollar) without affecting the dollar money supply, thenFED (1) exchanges dollars for foreign currencies and (2) sells some of its holdings of Treasury securities for dollars.

Question 28

Explain non sterilized direct intervention

Answer 28

Not adjusting for the change in the real economy (may be a time lag). Mean without adjusting for change in the money supply.

Question 29

What does indirect intervention mean?

Answer 29

Occurs when the FED affect the dollar value by influencing the factors that determine it. These are: The difference in inflation, interest rate, income level between the US and foreign country. And also the change in government controls and expectations.

Question 30

How can governments indirectly intervene in foreign exchange markets?

Answer 30

Governments can indirectly intervene by controlling interest rates, foreign exchange controls or intervention warnings to warn speculators. This might encourage some speculators to liquidate their existing positions in the currency.

Question 31

What effect does weak/strong home currency on demand for home/foreign currency

Answer 31

A weak home currency can stimulate foreign demand for products.
A strong home currency can encourage consumers and corporations of that country to buy goods from other countries

Question 32

What is the impossible trinity of government policy choice

Answer 32

States that it is impossible to have all three of the following at the same time:
✓ A fixed foreign exchange rate
✓ Free capital movement (absence of capital controls)
✓ An independent monetary policy

Question 33

Describe the three options the central bank would have to choose from as a consequence of the impossible trinity

Answer 33

A stable exchange rate and free capital flows (but not an independent monetary policy because setting a domestic interest rate that is different from the world interest rate would undermine a stable exchange rate due to appreciation or depreciation pressure on the domestic currency)
Independent monetary policy and free capital flows (but not a stable exchange rate)
A stable exchange rate and independent monetary policy (but no free capital flows, which would require the use of capital controls)