Lecture Objectives

• Describe the exchange rate system used by various governments.

• Describe the development and implications of a single European currency.
• Explain how governments can use direct intervention to influence exchange
rates.
• Explain how governments can use indirect intervention to influence
Lecture 6 exchange rates.

Government Influence on
Exchange Rates

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Exchange Rate Systems (1 of 10) Exchange Rate Systems (2 of 10)

Exchange rate systems can be classified according to the degree of Fixed Exchange Rate System
government control and fall into the following categories: • Exchange rates are either held constant or allowed to fluctuate only within
• Fixed very narrow boundaries.
• Freely floating • Central bank can reset a fixed exchange rate by devaluing or reducing the
• Managed float value of the currency against other currencies.
• Pegged • Central bank can also revalue or increase the value of its currency against
other currencies.

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Exchange Rate Systems (3 of 10) Exchange Rate Systems (4 of 10)
Fixed Exchange Rate System (continued) Freely Floating Exchange Rate System
• Bretton Woods Agreement 1944 – 1971 — Each currency was valued in terms of • Exchange rates are determined by market forces without government
gold. intervention.
• Smithsonian Agreement 1971 – 1973 — called for a devaluation of the U.S. dollar • Advantages of a freely floating system:
by about 8% against other currencies.
o Country is more insulated from inflation of other countries.
• Advantages of fixed exchange rates
o Country is more insulated from unemployment of other countries.
o Insulate country from risk of currency appreciation.
o Does not require central bank to maintain exchange rates within specified
o Allow firms to engage in direct foreign investment without currency risk.
boundaries.
• Disadvantages of fixed exchange rates
• Disadvantages of a freely floating exchange rate system:
o Risk that government will alter value of currency.
o Can adversely affect a country that has high unemployment.
o Country and MNC may be more vulnerable to economic conditions in other countries.
o Can adversely affect a country with high inflation.
o Central banks might need to constantly intervene to maintain their currency’s value

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Exchange Rate Systems (5 of 10) Exhibit 6.1 Countries with Floating Exchange
Rates and Their Currencies (1 of 2)
Managed Float Exchange Rate System COUNTRY CURRENCY
• Governments sometimes intervene to prevent their currencies from moving Afghanistan New afghani
too far in a certain direction. Argentina Peso
Australia Dollar
• Countries with floating exchange rates: Currencies of most large
Brazil Real
developed countries are allowed to float, although they may be periodically
Canada Dollar
managed by their respective central banks. (Exhibit 6.1)
Chile Peso
• Criticisms of the managed float system: Critics suggest that managed Euro participants Euro
float allows a government to manipulate exchange rates to benefit its own Hungary Forint
country at the expense of others. India Rupee
Indonesia Rupiah
Israel New shekel
Jamaica Dollar
Japan Yen

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Exhibit 6.1 Countries with Floating Exchange Exchange Rate Systems (6 of 10)
Rates and Their Currencies (2 of 2)
COUNTRY CURRENCY Pegged Exchange Rate System
Mexico Peso • Home currency value is pegged to one foreign currency or to an index of
Norway Bone currencies.
Paraguay Guarani
• Limitations of pegged exchange rate
Poland Zloty
Romania Leu o May attract foreign investment because exchange rate is expected to remain
Russia Ruble stable.
Singapore Dollar o Weak economic or political conditions can cause firms and investors to question
South Africa Rand whether the peg will be broken.
South Korea Won
Sweden Krona
Switzerland Franc
Taiwan New dollar
Thailand Baht
United Kingdom Pound
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Exchange Rate Systems (7 of 10) Exchange Rate Systems (8 of 10)

Pegged Exchange Rate System (continued) Pegged Exchange Rate System (continued)
Examples: • Currency Boards Used to Peg Currency Values
• Europe’s Snake Arrangement 1972 – 1979 o 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
• European Monetary System (EMS) 1979 – 1992 has printed.
• Mexico’s Pegged System 1994 • Interest Rates of Pegged Currencies
• Asian Pegged Exchange Rates in the Late 1990s o Interest rate will move in tandem with the interest rate of the currency to which it
• China’s Pegged Exchange Rate 1996 - 2005 is tied.
• Venezuela’s Pegged Exchange Rate 2010 • Exchange Rate Risk of a Pegged Currency
o Provides examples of countries 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.
• Classification of Pegged Exchange Rates (Exhibit 6.2)
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Exhibit 6.2 Countries with Pegged Exchange Rates Exchange Rate Systems (9 of 10)
and the Currencies to Which They Are Pegged
Dollarization
COUNTRY NAME OF LOCAL CURRENCY PEGGED TO
Bahamas Dollar U.S. dollar
• Replacement of a foreign currency with U.S. dollars.
Barbados Dollar U.S. dollar • This process is a step beyond a currency board because it forces the local
Bermuda Dollar U.S. dollar currency to be replaced by the U.S. dollar. Although dollarization and a
Brunei Dollar Singapore dollar
currency board both attempt to peg the local currency’s value, the currency
board does not replace the local currency with dollars.
Bulgaria Lev Euro
Denmark Krone Euro
Hong Kong Dollar U.S. dollar
Saudi Arabia Riyal U.S. dollar
United Arab Emirates Dirham U.S. dollar
Venezuela Bolivar U.S. dollar

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Exchange Rate Systems (10 of 10) A Single European Currency (1 of 4)

Black Markets for Currencies: Monetary Policy in the Eurozone
• When a government sets a fixed exchange rate and imposes restrictions on • European Central Bank — Based in Frankfurt and is responsible for setting
residents that require them to exchange currency at that official rate, it may monetary policy for all participating European countries
trigger the creation of a “black market” for foreign exchange. • Objective is to control inflation in the participating countries and to stabilize
• The term black market refers to an underground (illegal) network that (within reasonable boundaries) the value of the euro with respect to other
circumvents the legal (formal) network in the economy. major currencies.
• A black market for foreign exchange becomes especially active when local Impact on Firms in the Eurozone — Prices of products are now more
residents fear an impending currency crisis. comparable among European countries.
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.

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A Single European Currency (2 of 4) A Single European Currency (3 of 4)
Impact of a Eurozone Country Crisis on Other Eurozone Countries • ECB Role in Resolving Economic Crises
• Financial problems of one bank can easily spread to other banks. o In recent years the bank’s role has expanded to include providing credit for
eurozone countries that are experiencing a financial crisis.
• Banks in Eurozone frequently engage in loan participations. If companies
have trouble repaying, all banks may be affected. o The ECB imposes restrictions intended to help resolve the country’s budget
deficit problems over time.
• News about concerns in one area of Eurozone can trigger actions in other
areas.
• Eurozone country governments must rely on fiscal policy when they
experience serious financial problems.
• Banks lend heavily to governments. Performance is related to whether that
government can repay its debts.

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A Single European Currency (4 of 4) Direct Intervention (1 of 6)

Impact of a Country Abandoning the Euro Reasons for Direct Intervention
• Would allow a country to set its own exchange rate to encourage purchasers • Smoothing exchange rate movements
of exports. o If a central bank is concerned that its economy will be affected by abrupt
• Would possibly be expelled from the European Union, which would almost movements in its home currency’s value, it may attempt to smooth the currency
certainly reduce its trade with other European Union countries. movements over time.
• Establishing implicit exchange rate boundaries
Impact of Abandoning the Euro on Eurozone Conditions
o Some central banks attempt to maintain their home currency rates within some
• A fear of future declines in the value of euro-denominated assets could unofficial, or implicit, boundaries.
cause the euro to weaken.
• Responding to temporary disturbances
• An economic analysts contend that the mere threat to abandon the euro
would create more problems for the eurozone than would an actual o A central bank may intervene to insulate a currency’s value from a temporary
disturbance.
abandonment.

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Direct Intervention (2 of 6) Exhibit 6.3 Effects of Direct Central Bank
Intervention in the Foreign Exchange Market
The Direct Intervention Process (Exhibit 6.3)
• A country’s central bank can use direct intervention by engaging in foreign
exchange transactions that affect the demand or supply market conditions for
its currency.
• The outward shift in the demand of pounds in the left graph of Exhibit 6.3.
• The outward shift in the supply of pounds in the right graph of Exhibit 6.3.

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Direct Intervention (3 of 6) Direct Intervention (4 of 6)

• Reliance on reserves • Nonsterilized versus sterilized intervention (See Exhibit 6.4)
o The potential effectiveness of a central bank’s direct intervention is the amount of
reserves it can use. o When the Fed intervenes in the foreign exchange market without adjusting for the
change in the money supply, it is engaging in a nonsterilized intervention.
• Coordinated Intervention
o Intervention more likely to be effective when it is coordinated by several central o In a sterilized intervention, the Fed intervenes in the foreign exchange market
banks. and simultaneously engages in offsetting transactions in the Treasury securities
markets.
o Some traders in the foreign exchange market attempt to determine when Federal
Reserve intervention is occurring and the extent of the intervention in order to
capitalize on the anticipated results of the intervention effort.

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Exhibit 6.4 Forms of Central Bank Intervention in Direct Intervention (5 of 6)
the Foreign Exchange Market
Direct Intervention as a Policy Tool
• Influence of a Weak Home Currency
o The central bank implements a direct intervention to weaken its home currency in
an effort to stimulate foreign demand for the country’s products. (See Exhibit 6.5)
• Influence of a Strong Home Currency
o The central bank may also implement a direct intervention to strengthen its home
currency, which can reduce the country’s inflation. (See Exhibit 6.6)

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Exhibit 6.5 How Central Bank Intervention Can Exhibit 6.6 How Central Bank Intervention Can
Stimulate the U.S. Economy Reduce Inflation

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Direct Intervention (6 of 6) Indirect Intervention (1 of 2)
Speculating on Direct Intervention Indirect Intervention
• Speculating on Intervention Intended to Strengthen a Currency The Fed can affect the dollar’s value indirectly by influencing the factors that
• Speculating on Intervention Intended to Weaken a Currency determine it.
• Central Banks’ Efforts to Disguise Their Strategy e = f (ΔINF, ΔINT, ΔINC, ΔGC, ΔEXP)
where
e = percentage change in the spot rate
ΔINF = change in the differential between U. S . inflation and the foreign country's inflation
ΔINT = change in the differential between the U.S. interest rate and the foreign country's
interest rate
ΔINC = change in the differential between the U.S. income level and the foreign country's
income level
ΔGC = change in government controls
ΔEXP = change in expectations of future exchange rates
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Indirect Intervention (2 of 2) Summary (1 of 4)

Indirect Intervention (continued) • Exchange rate systems can be classified as fixed rate, freely floating,
• Government Control of Interest Rates by increasing or reducing interest managed float, and pegged. In a fixed exchange rate system, exchange
rates. rates are either held constant or allowed to fluctuate only within very narrow
• Government Use of Foreign Exchange Controls such as restrictions on boundaries. In a freely floating exchange rate system, exchange rate values
the exchange of the currency. are determined by market forces without intervention. In a managed float

o Intervention Warnings intended to warn speculators. The announcements could

system, exchange rates are not restricted by boundaries but are subject to
discourage additional speculation and might even encourage some speculators government intervention. In a pegged exchange rate system, a currency’s
to unwind (liquidate) their existing positions in the currency. value is pegged to a foreign currency or a unit of account and moves in line
with that currency (or unit of account) against other currencies.

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Summary (2 of 4) Summary (3 of 4)

• Numerous European countries use the euro as their home currency. The • Governments can use direct intervention by purchasing or selling currencies
single currency allows international trade among firms in the eurozone in the foreign exchange market, thereby altering demand and supply
without foreign exchange expenses and without concerns about future conditions and hence the currencies’ equilibrium values. When a government
exchange rate movements. However, countries that participate in the euro do purchases a currency in the foreign exchange market, it puts upward
not have complete control of their monetary policy because a single policy is pressure on that currency’s equilibrium value. When a government sells a
applied to all countries in the eurozone. In addition, being part of the currency in the foreign exchange market, it puts downward pressure on the
eurozone may render some countries more susceptible to a crisis occurring currency’s equilibrium value.
in some other eurozone country.

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Summary (4 of 4)

• Governments can use indirect intervention by influencing the economic

factors that affect equilibrium exchange rates. A common form of indirect
intervention is to increase interest rates in order to attract more international
capital flows, which may cause the local currency to appreciate. However,
indirect intervention is not always effective.

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