Part II Exchange Rate Behavior

Existing spot
exchange rate
covered interest arbitrage

Existing forward
exchange rate

locational
arbitrage
triangular
arbitrage

Fisher
effect

covered interest arbitrage

Existing interest
rate differential

international
Fisher effect

Existing spot
exchange rates
at other locations
Existing cross
exchange rates
of currencies
Existing inflation
rate differential
purchasing power parity

Future exchange
rate movements

Chapter

6
Government Influence
On Exchange Rates

South-Western/Thomson Learning 2003

Chapter Objectives
To describe the exchange rate
systems used by various governments;

To explain how governments can use

direct and indirect intervention to
influence exchange rates; and

To explain how government intervention in

the foreign exchange market can affect
economic conditions.
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Exchange Rate Systems

Exchange rate systems can be classified
according to the degree to which the rates
are controlled by the government.

Exchange rate systems normally fall into one

of the following categories:
fixed
freely floating
managed float
pegged
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Fixed
Exchange Rate System
In a fixed exchange rate system, exchange
rates are either held constant or allowed to
fluctuate only within very narrow bands.

The Bretton Woods era (1944-1971) fixed each

currencys value in terms of gold.

The 1971 Smithsonian Agreement which

followed merely adjusted the exchange rates
and expanded the fluctuation boundaries. The
system was still fixed.
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Online Application
Find out more about the Bretton Woods
conference and the Smithsonian
Agreement at:

http://www.imfsite.org/origins/confer.html

http://www.mises.org/money.asp

C6 - 6

Fixed
Exchange Rate System
Pros: Work becomes easier for the MNCs.
Cons: Governments may revalue their
currencies. In fact, the dollar was
devalued more than once after the U.S.
experienced balance of trade deficits.

Cons: Each country may become more

vulnerable to the economic conditions in
other countries.
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Freely Floating
Exchange Rate System
In a freely floating exchange rate system,
exchange rates are determined solely by
market forces.

Pros: Each country may become more

insulated against the economic problems in
other countries.

Pros: Central bank interventions that may

affect the economy unfavorably are no longer
needed.
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Freely Floating
Exchange Rate System
Pros: Governments are not restricted by
exchange rate boundaries when setting
new policies.

Pros: Less capital flow restrictions are

needed, thus enhancing the efficiency of
the financial market.

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Freely Floating
Exchange Rate System
Cons: MNCs may need to devote
substantial resources to managing their
exposure to exchange rate fluctuations.

Cons: The country that initially

experienced economic problems (such as
high inflation, increasing unemployment
rate) may have its problems compounded.

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Managed Float
Exchange Rate System
In a managed (or dirty) float exchange rate
system, exchange rates are allowed to move
freely on a daily basis and no official
boundaries exist. However, governments
may intervene to prevent the rates from
moving too much in a certain direction.

Cons: A government may manipulate its

exchange rates such that its own country
benefits at the expense of others.
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Pegged
Exchange Rate System
In a pegged exchange rate system, the
home currencys value is pegged to a
foreign currency or to some unit of account,
and moves in line with that currency or unit
against other currencies.

The European Economic Communitys

snake arrangement (1972-1979) pegged the
currencies of member countries within
established limits of each other.
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Pegged
Exchange Rate System
The European Monetary System which
followed in 1979 held the exchange rates of
member countries together within specified
limits and also pegged them to a European
Currency Unit (ECU) through the exchange
rate mechanism (ERM).

The ERM experienced severe problems in

1992, as economic conditions and goals
varied among member countries.
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Pegged
Exchange Rate System
In 1994, Mexicos central bank pegged the
peso to the U.S. dollar, but allowed a band
within which the pesos value could
fluctuate against the dollar.

By the end of the year, there was substantial

downward pressure on the peso, and the
central bank allowed the peso to float freely.
The Mexican peso crisis had just began ...

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Online Application
For more information on the Mexican peso
crisis, visit:

http://www.cfr.org/public/pubs/mexican.html

http://www.frbatlanta.org/publica
/ECO-REV/REV_ABS/janfeb96.html

http://www.brook.edu/views/papers/lustig
/114.htm

C6 - 15

Currency Boards
A currency board is a system for
maintaining the value of the local currency
with respect to some other specified
currency.

For example, Hong Kong has tied the value

of the Hong Kong dollar to the U.S. dollar
(HK$7.8 = $1) since 1983, while Argentina
has tied the value of its peso to the U.S.
dollar (1 peso = $1) since 1991.
C6 - 16

Currency Boards
For a currency board to be successful, it
must have credibility in its promise to
maintain the exchange rate.

It has to intervene to defend its position

against the pressures exerted by economic
conditions, as well as by speculators who
are betting that the board will not be able to
support the specified exchange rate.

C6 - 17

Online Application
Find out more about Hong Kongs
currency board system (and see a chart
showing the resilience of the Hong Kong
dollar against external shocks) at
http://www.info.gov.hk/hkma/eng
/currency/link_ex/index.htm.

C6 - 18

Exposure of a Pegged Currency to

Interest Rate Movements
A country that uses a currency board does
not have complete control over its local
interest rates, as the rates must be aligned
with the interest rates of the currency to
which the local currency is tied.

Note that the two interest rates may not be

exactly the same because of different
risks.
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Exposure of a Pegged Currency to

Exchange Rate Movements
A currency that is pegged to another
currency will have to move in tandem with
that currency against all other currencies.

So, the value of a pegged currency does

not necessarily reflect the demand and
supply conditions in the foreign exchange
market, and may result in uneven trade or
capital flows.
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Dollarization
Dollarization refers to the replacement of a
local currency with U.S. dollars.

Dollarization goes beyond a currency

board, as the country no longer has a local
currency.

For example, Ecuador implemented

dollarization in 2000.

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Online Application
A table showing the currencies of the
world and their exchange rate
arrangements can be found at:

http://pacific.commerce.ubc.ca/xr
/currency_table.html

C6 - 22

A Single European Currency

In 1991, the Maastricht treaty called for a

single European currency. On Jan 1, 1999,
the euro was adopted by Austria, Belgium,
Finland, France, Germany, Ireland, Italy,
Luxembourg, Netherlands, Portugal, and
Spain. Greece joined the system in 2001.

By 2002, the national currencies of the 12

participating countries will be withdrawn
and completely replaced with the euro.
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A Single European Currency

Within the euro-zone, cross-border trade

and capital flows will occur without the
need to convert to another currency.

European monetary policy is also

consolidated because of the single money
supply. The Frankfurt-based European
Central Bank (ECB) is responsible for
setting the common monetary policy.
C6 - 24

A Single European Currency

The ECB aims to control inflation in the

participating countries and to stabilize the
euro within reasonable boundaries.

The common monetary policy may eventually

lead to more political harmony.

Note that each participating country may

have to rely on its own fiscal policy (tax and
government expenditure decisions) to help
solve local economic problems.
C6 - 25

A Single European Currency

As currency movements among the

European countries will be eliminated,
there should be an increase in all types of
business arrangements, more comparable
product pricing, and more trade flows.

It will also be easier to compare and

conduct valuations of firms across the
participating European countries.
C6 - 26

A Single European Currency

Stock and bond prices will also be more

comparable and there should be more
cross-border investing. However, nonEuropean investors may not achieve as
much diversification as in the past.

Exchange rate risk and foreign exchange

transaction costs within the euro-zone will
be eliminated, while interest rates will have
to be similar.
C6 - 27

A Single European Currency

Since its introduction in 1999, the euro has

declined against many currencies.

This weakness was partially attributed to

capital outflows from Europe, which was in
turn partially attributed to a lack of
confidence in the euro.

Some countries had ignored restraint in favor

of resolving domestic problems, resulting in
a lack of solidarity.
C6 - 28

 strengthens weakens

A Single European Currency

1.80
1.60

1.40
1.20
1.00

/$
/100

0.80
0.60
0.40
Jan-99

/SwF (Swiss Franc)

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01
C6 - 29

Online Application
For more information on the euro, visit:

http://www.euro.ecb.int/en.html

http://www.ecb.int/

http://pacific.commerce.ubc.ca/xr/euro/

C6 - 30

Government Intervention
Each country has a government agency
(called the central bank) that may
intervene in the foreign exchange market
to control the value of the countrys
currency.

In the United States, the Federal

Reserve System (Fed) is the
central bank.
C6 - 31

Online Application
To link to the websites of the central banks
around the world, visit http://www.bis.org/
cbanks.htm.

C6 - 32

Government Intervention
Central banks manage exchange rates

to smooth exchange rate movements,

to establish implicit exchange rate
boundaries, and/or
to respond to temporary disturbances.

Often, intervention is overwhelmed by

market forces. However, currency
movements may be even more volatile in the
absence of intervention.
C6 - 33

Government Intervention
Direct intervention refers to the exchange
of currencies that the central bank holds
as reserves for other currencies in the
foreign exchange market.

Direct intervention is usually most

effective when there is a coordinated
effort among central banks.

C6 - 34

Government Intervention
Fed exchanges $ for
to strengthen the
Value
of
V2
V1

S1

D2

D1

Quantity of

Fed exchanges for $

to weaken the
Value
of
V1
V2

S1

S2

D1
Quantity of

C6 - 35

Online
Application

http://www.federalreserve.gov
Treasury and Federal Reserve Foreign Exchange Operations
During the third quarter of 2000, the dollar appreciated 8.2 percent
against the euro and 2.0 percent against the yen. On a tradeweighted basis, the dollar ended the quarter 4.1 percent stronger
against the currencies of the United States' major trading partners.
On September 22, the U.S. monetary authorities intervened in the
foreign exchange markets, purchasing 1.5 billion euros against the
dollar. The operation, which was divided evenly between the U.S.
Treasury Department's Exchange Stabilization Fund and the
Federal Reserve System, was coordinated with the European
Central Bank and the monetary authorities of Japan, Canada, and
the United Kingdom.
C6 - 36

Government Intervention
When a central bank intervenes in the
foreign exchange market without
adjusting for the change in money supply,
it is said to engaged in nonsterilized
intervention.

In a sterilized intervention, Treasury

securities are purchased or sold at the
same time to maintain the money supply.
C6 - 37

Nonsterilized Intervention
Federal Reserve
To
Strengthen
the C$:

C$

Banks participating
in the foreign
exchange market
Federal Reserve

To Weaken
the C$:

C$

Banks participating
in the foreign
exchange market
C6 - 38

Sterilized Intervention
T- securities

Federal Reserve
To
Strengthen
the C$:

C$

Banks participating
in the foreign
exchange market
$

Federal Reserve
To Weaken
the C$:

C$

Financial
institutions
that invest
in Treasury
securities

T- securities

Banks participating
in the foreign
exchange market

Financial
institutions
that invest
in Treasury
securities
C6 - 39

Government Intervention
Some speculators attempt to determine
when the central bank is intervening, and
the extent of the intervention, in order to
capitalize on the anticipated results of the
intervention effort.

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Government Intervention
Central banks can also engage in indirect
intervention by influencing the factors that
determine the value of a currency.

For example, the Fed may attempt to

increase interest rates (and hence boost the
dollars value) by reducing the U.S. money
supply.
Note that high interest rates adversely
affects local borrowers.
C6 - 41

Government Intervention
Governments may also use foreign
exchange controls (such as restrictions
on currency exchange) as a form of
indirect intervention.

C6 - 42

Online Application
The Feds objective for
open market operations
has gradually shifted
toward attaining a
specified level of the
federal funds rate. Find
out more at http://www.
federalreserve.gov/fomc/
fundsrate.htm.
C6 - 43

Online Application
During the 1997-98 Asian financial crisis,
some governments intervened in an
attempt to control their exchange rates.
Find out more about the crisis (and the
consequences of the intervention efforts)
at http://www.stern.nyu.edu/globalmacro/.

C6 - 44

Exchange Rate Target Zones

Many economists have criticized the
present exchange rate system because of
the wide swings in the exchange rates of
major currencies.

Some have suggested that target zones be

used, whereby an initial exchange rate will
be established with specific boundaries
(that are wider than the bands used in fixed
exchange rate systems).
C6 - 45

Exchange Rate Target Zones

The ideal target zone should allow rates to
adjust to economic factors without
causing wide swings in international trade
and fear in the financial markets.

However, the actual result may be a

system no different from what exists
today.

C6 - 46

Intervention as a Policy Tool

Like tax laws and money supply, the
exchange rate is a tool which a
government can use to achieve its desired
economic objectives.

A weak home currency can stimulate

foreign demand for products, and hence
local jobs. However, it may also lead to
higher inflation.
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Intervention as a Policy Tool

A strong currency may cure high inflation,
since the intensified foreign competition
should cause domestic producers to
refrain from increasing prices. However, it
may also lead to higher unemployment.

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Impact of Government Actions on Exchange Rates

Government Monetary
and Fiscal Policies

Relative Interest
Rates

Relative Inflation
Rates

Relative National
Income Levels

International
Capital Flows

Exchange Rates

International
Trade

Government
Purchases & Sales
of Currencies
Tax Laws,
etc.

Government Intervention in
Foreign Exchange Market

Quotas,
Tariffs, etc.

C6 - 49

Impact of Central Bank Intervention

on an MNCs Value
Direct Intervention
Indirect Intervention

E CF E ER

Value =
t =1

j 1

j, t

1 k

j, t

E (CFj,t )
=
expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t )
=
expected exchange rate at
which currency j can be converted to dollars at

C6 - 50

Chapter Review
Exchange Rate Systems

Fixed Exchange Rate System

Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
Currency Boards
Exposure of a Pegged Currency to Interest
Rate and Exchange Rate Movements
Dollarization
C6 - 51

Chapter Review
A Single European Currency

Membership
Euro Transactions
Impact on European Monetary Policy
Impact on Business Within Europe
Impact on the Valuation of Businesses in
Europe
Impact on Financial Flows
Impact on Exchange Rate Risk
Status Report on the Euro
C6 - 52

Chapter Review
Government Intervention

Reasons for Government Intervention

Direct Intervention
Indirect Intervention

Exchange Rate Target Zones

C6 - 53

Chapter Review
Intervention as a Policy Tool

Influence of a Weak Home Currency on the

Economy
Influence of a Strong Home Currency on
the Economy

How Central Bank Intervention Can Affect

an MNCs Value

C6 - 54