Introduction to foreign exchange

Question 1

Types (3)

Answer 1

• Freely convertible
• Externally convertible
• Non convertible

Question 2

Why limit convertibility? Preserve foreign exchange reserves to: (3)

Answer 2

• payback international debt
• make international purchases on behalf of the government
• prevent capital flight
• make imports more difficult to make

Question 3

Exchange rate regimes about peg (2)

Answer 3

• Fixed/hard peg
  Eliminate the foreign exchange rate risk
  (Does not work in long term)

Make trade more “fair”

Easier for consumer and businesses to compare prices

• Crawling/Adjustable peg
  The rate is revalued/devalued at regular intervals to align with fundamentals

Question 4

Gold standards 1870-1914 :

Answer 4

When countries to agree to buy or sell gold for an established number of currency units (fixed value of exchange)

Also a government could not create money not backed by gold

Question 5

Why did Gold standards break down? (2)

Answer 5

• Failed resumption after WW1

- Great Depression

Question 6

General consensus of Bretton Woods (3)

Answer 6

• Stable exchange rate were desirable
• Floating or fluctuating exchange rate had proved unsatisfactory
• The government controls of trade, exchange and production that developed through WW2 were wasteful and discriminatory

Question 7

The original role of IMF

Answer 7

• historically worked to help countries to maintain fixed echang rate
• now lending money, technical assistance and surveillance consultations
• loans come with conditions

Question 8

Some currencies have fixed exchange rates. What are the benefits of having a fixed exchange rate?

Answer 8

• Remove foreign exchange risk

- Make trade more fair

Question 9

Draw a chart over time for one of the following exchange rate regimes.

• fixed/pegged exchange rate
• crawling peg
• managed/dirty float
• floating

Answer 9

Fucking look it up youself.

Question 10

Who or what determines the exchange rate?
Fixed/Pegged Exchange Rates: 
Crawling Peg: 
Managed/Dirty Float: 
Floating:

Answer 10

Fixed/Pegged Exchange Rates: The issuing government sets the exchange rate

Crawling Peg: The issuing government sets the exchange rate

Managed/Dirty Float: The government + supply & demand in the forex market

Floating: supply & demand in the forex market

Question 11

What role does the government play in this exchange rate regime? (You may need to consider the role of the government in a broader context.)

Answer 11

Fixed/Pegged Exchange Rate:
The government plays the primary role. It sets the exchange rate, and manages the economy in an effort to “support” the rate.

Crawling Peg Exchange Rate:
The government plays the primary role. It sets the exchange rate, and makes adjustments at intervals of time that it determines.

Managed/Dirty Float Exchange Rate:
The government intervenes (buy & sells), as needed in the currency markets when a destabilizing event occurs. Governments typically justify their interventions in terms of “smoothing market irregularities” or “assuring orderly markets”.

Free Floating/Floating Exchange Rate:
The government focuses on management of the economy rather than directly intervening in the market or setting exchange rates. (For some currencies given the volume and value of the currency traded in the forex market it might be impossible for the government to really intervene even if it wanted to.)

Question 12

Why is law of one price not very accurate?

Answer 12

• one product approach is flawed, there may be special/valid reasons why a certain product is cheaper in one country vis a vis the other
• cultural differences
• government interventions

Question 13

Why is the IMF lender of last resort?

Answer 13

• Loans of the IMF come with conditions which have consequences for the flexibility and decision making of loan taking country

Question 14

Controversies of the IMF

Answer 14

• crises keep happening
• moral hazard: stop acting as the lender of the last resort
• lack of accountability: executive board is not responsible and does not face that many checks; too less consultation with taking countries
• Power divide/ voting power allocation: need 85 % to vote for some major actions; US has more than 15 %, nothing can be passed without US

Question 15

Causes of asian financial crisis

Answer 15

• capital flight “contagion” origination in Thailand fanned the crisis to adjacent markets
• market lost faith in fixed exchange rate as it was artificially high
• loans taken in foreign currency to fuel growth
• –>weak financial institutions to regulate lending practices
• Thailand lacked sufficient reserves to pay back foreign dept