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Chapter 6

This chapter discusses how governments can influence exchange rates through direct and indirect intervention. It describes different exchange rate systems such as fixed rates, where a currency's value is kept constant; floating rates, where the market determines value; and pegged rates, where a currency is tied to another. The chapter explains how governments directly intervene by buying or selling their own currency to influence supply and demand. Indirect intervention methods like adjusting interest rates can also impact exchange rates. Government intervention aims to stabilize rates, respond to economic changes, and influence trade balances.

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Feriel El Ilmi
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76 views

Chapter 6

This chapter discusses how governments can influence exchange rates through direct and indirect intervention. It describes different exchange rate systems such as fixed rates, where a currency's value is kept constant; floating rates, where the market determines value; and pegged rates, where a currency is tied to another. The chapter explains how governments directly intervene by buying or selling their own currency to influence supply and demand. Indirect intervention methods like adjusting interest rates can also impact exchange rates. Government intervention aims to stabilize rates, respond to economic changes, and influence trade balances.

Uploaded by

Feriel El Ilmi
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Exchange Rate Behavior

Chapter 6
Government Influence on Exchange
Rates
 Chapter Objectives
This chapter will:

A. Describe the exchange rate system used by various


governments
B. Explain how governments can use direct intervention to
influence exchange rates
C. Explain how governments can use indirect intervention to
influence exchange rates
D. Explain how government intervention in the foreign
exchange market can affect economic conditions
Exchange Rate Systems
1. Fixed
2. Freely floating
3. Managed float
4. Pegged
Fixed Exchange Rate System
1. Exchange rates are either held constant or allowed
to fluctuate only within very narrow boundaries
2. Central bank can reset a fixed exchange rate by
devaluing (devaluation) or reducing the value of
the currency against other currencies.
3. Central bank can also revalue (revaluation) or
increase the value of its currency against other
currencies
4. What is the difference between devaluation and
depreciation? (fixed vs. floating; central bank vs.
market)
Fixed Exchange Rate System
1. Examples:
a. Bretton Woods Agreement 1944 – 1971
b. Smithsonian Agreement 1971 – 1973
2. Advantages of fixed exchange rate system
a. Insulate country from risk of currency appreciation
b. Allow firms to engage in direct foreign investment
without currency risk
3. Disadvantages of fixed exchange rate system
a. Risk that government will alter value of currency
b. Country and MNC may be more vulnerable to economic
conditions in other countries. Refer to Example p. 172
Freely Floating Exchange Rate System
1. Exchange rates are determined by market forces
without government intervention
2. Advantages of freely floating system:
a. Country is more insulated from inflation of other countries
b. Country is more insulated from unemployment of other
countries
c. Does not require central bank to maintain exchange rates
within specified boundaries
Refer to Examples p. 173
3. Disadvantages of freely floating system:
a. Can adversely affect a country that has high unemployment
b. Can adversely affect a country with high inflation
Managed Float Exchange Rate System
1. Governments sometimes intervene to
prevent their currencies from moving too
far in a certain direction
2. Critics suggest that managed float allows a
government to manipulate exchange rates
to benefit its own country at the expense
of others
Pegged Exchange Rate System
1. Home currency value is pegged to one
foreign currency or to an index of
currencies
2. May attract foreign investment because
exchange rate is expected to remain stable
3. Weak economic or political conditions can
cause firms and investors to question
whether the peg will be broken
Pegged Exchange Rate Systems
1. Examples:
a. Europe’s Snake Arrangement 1972 – 1979
b. European Monetary System (EMS) 1979 – 1992
c. Mexico’s Pegged System 1994
d. China’s Pegged Exchange Rate 1996 - 2005
2. Currency Boards Used to Peg Currency Values
3. Interest Rates of Pegged Currencies
4. Exchange Rate Risk of a Pegged Currency
Dollarization
 Replacement of a foreign currency with U.S.
dollars
Exhibit 6.1 Exchange Rate
Arrangements
A Single European Currency
1. Impact on European Monetary Policy
a. European Central Bank
b. Implications of a European Monetary Policy
2. Impact on the Valuation of Business in Europe
3. Impact on Financial Flows
4. Impact on Exchange Rate Risk
Reasons for Government Intervention
1. To smooth exchange rate movements
2. To establish implicit exchange rate
boundaries
3. To respond to temporary disturbances
Direct Intervention
1. Reliance on reserves
2. Nonsterilized versus sterilized intervention
3. Speculating on direct intervention
Exhibit 6.2 Effects of Direct Central Bank
Intervention in the Foreign Exchange Market
Exhibit 6.3 Forms of Central Bank Intervention
in the Foreign Exchange Market
Indirect Intervention
e  f (INF , INT , INC , GC , EXP )

where
e  percentage change in the spot rate
INF  change in the differential between U.S. inflation
and the foreign country's inflation
INT  change in the differential between the U.S. interest rate
and the foreign country's interest rate
INC  change in the differential between the U.S. income level
and the foreign country's income level
GC  change in government controls
EXP  change in expectations of future exchange rates
Intervention as a Policy Tool
1. A weak home currency can stimulate
foreign demand for products
2. A strong home currency can encourage
consumers and corporations of that
country to buy goods from other countries
Exhibit 6.4 How Central Bank
Intervention Can Stimulate the U.S.
Economy
Exhibit 6.5 How Central Bank
Intervention Can Reduce Inflation

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