Managing the Exchange Rate Flashcards
The three aspects of the trilemma
- Exchange Rate stability
- Financial Integration
- Monetary Policy Autonomy
Definition monetary autonomy policy
the independence of a country’s central bank to affect its own money supply and conditions in its domestic economy
Monetary policy definition
Consists of the management of money supply (central banks)
Fiscal policy
refers to the use of government spending and tax policies to influence economic conditions
Financial integration
The interconnectedness between countries, businesses and economies
How is the EMU positioned at the trilemma?
EMU has a stable exchange rate, and financial integration. So:
Stable exchange rate: ^S = 0
Financial integration: i = i*
No autonomy to set i independent from i*
How is a free float positioned at the trilemma?
Free float has financial integration, and monetary autonomy policy. So:
Financial integration: i = i*
Monetary autonomy policy: i =/ i*
No Exchange rate stability
How is Bretton Woods positioned at the trilemma?
Monetary policy autonomy and exchange rate stability. So:
^S = 0
i =/ i*
Meaning that there is no capital mobility
The different exchange rate systems.
- Fee float -> no intervention
- Managed float -> some intervention
- Wide target zones
- Crawling peg
- Unilateral fixed exchange rates
- Fixed rates by agreement (EMS)
- Currency board
- Currency union (EMU)
What is a crawling peg?
Crawling peg is a system where a fixed exchange rate where it is allowed to make adjustments in a certain band width. The par state is also adjusted frequently due to inflation.
What is a soft peg?
The exchange rate regime applied to a currency to keep its value stable against a reserve currency or a basket of currencies
Dollarization
These countries have given up their own monetary policy and adopted other countries currencies such as the dollar
Which methods can be used to defend a currency?
- Intervention 2. Interest rates
Intervention
buying your own currency when its weak from the spot and forward market
Interest rates
Increasing the short-term interest rate in such way that you are more attractive for investors than other countries
Which retrospective risk is their for businesses?
Translation risk
Define translation risk
A firm has accounting exposure when it transforms the foreign financial statements into the home currency. Translation risk relates to the effect of currency fluctuations on this conversion.
Which prospective risks are their for businesses?
- Transaction risk
2. Economic risk
Transaction risk
Is currency risk focused on future cash flows on one easily identifiable transaction. Easy to measure.
Economic risk
Is currency risk focused on all future cash flow necessary to determine firm value. Difficult to measure.
How to manage transaction risk?
Forward contracts, future contracts, hedging with swaps and options
How to manage economic risk?
On the supply side: plant location and input mix
On demand side: product and pricing strategy
