1. Part II Exchange Rate Behavior
Existing spot
exchange rates
at other locations
locational
arbitrage
Existing spot
exchange rate
Existing cross
exchange rates
of currencies
triangular
arbitrage
covered interest arbitrage
Existing forward exchange rate
Existing inflation
rate differential
Fisher
effect
covered interest arbitrage
purchasing power parity
Existing interest rate differential
Future exchange
rate movements
international Fisher effect

2. Government Influence on Exchange Rates
CHAPTER 6
Government Influence on Exchange Rates
© 2000 South-Western College Publishing 1

3. Chapter Objectives
To describe the exchange rate systems used by various governments;
To explain how governments can use direct intervention to influence exchange rates;
To explain how governments can use indirect intervention to influence exchange rates; and
To explain how government intervention in the foreign exchange market can affect economic conditions.

4. Exchange Rate Systems
Exchange rate systems can be classified according to the degree to which exchange rates are controlled by the government.
Exchange rate systems normally fall into one of the following categories:
fixed
freely floating
managed float
pegged

5. Fixed Exchange Rate Systems
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.
Examples: Bretton Woods era ( )
Smithsonian Agreement (1971)
Pros: Work becomes easier for the MNCs. Cons: The government may alter the value of
a specific currency.
In fact, the dollar was devalued more than once after the United States experienced balance of trade deficits.

6. Freely Floating Exchange Rate Systems
In a freely floating exchange rate system, exchange rates are determined by market forces without intervention by governments.
Pros:
¤ World stability is enhanced as problems
experienced by one country may not easily spread to other countries.
¤ No intervention policies are needed and
governments are not restricted by exchange rate boundaries when setting new policies.
¤ Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.

7. Freely Floating Exchange Rate Systems
Cons:
¤ The MNCs will need to devote substantial
resources to managing exposure to exchange rate fluctuations.
¤ The country that initially experienced economic
problems (such as high inflation, increasing unemployment rate) may have its problems compounded.

8. US dollar - excessive fluctuations ?

9. Managed Float Exchange Rate Systems
A managed float or “dirty” float exchange rate system resembles the freely floating system in that rates are allowed to fluctuate freely on a daily basis. Yet, it is like the fixed system in that governments may intervene to prevent the rates from moving too much in one direction.
It has been pointed out that a government can manipulate exchange rates such that its own country benefits at the expense of others.
Examples: Korea (1997), Russia (1997)

10. Pegged Exchange Rate Systems
In a pegged exchange rate system, the home currency’s 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.
Examples:
Malaysia and Thailand before the Asian crisis
The European Economic Community’s snake arrangement ( )
The European Monetary System’s exchange rate mechanism (ERM) ( )

11. Current systems

12. The Euro is born

13. The Euro
On January 1, 1999, the euro was introduced. At January , the national currencies of the participating countries were withdrawn from the financial system and replaced with the euro.
The Frankfurt-based European Central Bank is responsible for setting a common monetary policy. It aims to control inflation and to stabilize the value of the euro.
As currency movements among the European countries will be eliminated, more long-term business arrangements between firms of European countries will be encouraged.

14. Euro banknotes

15. The Euro
Non-European firms can also compare European products and European firms more easily, as their values are denominated in the same currency.
Cross-border investing may increase due to the elimination of exchange rate risk. However, non-European investors may not achieve as much diversification as in the past.

16. Euro - a bumpy ride ?

17. Government Intervention
Each country has a government agency (called the central bank) that may intervene in the foreign exchange markets to control the value of the country’s currency.
In Euroland, the European Central Bank (ECB) is the central bank.
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.

19. 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.
Example: To strengthen the dollar, the Fed will exchange foreign currencies for dollars.
Direct intervention is usually most effective when there is a coordinated effort among central banks.

20. Effects of Direct Central Bank Intervention in the Foreign Exchange Market
Value of £
Quantity of £ V2 V1 S D2 D1
Value of £
Quantity of £ V1 V2 S2 D S1

21. Government Intervention
When the change in money supply is not adjusted for, the intervention is said to be nonsterilized. A sterilized intervention occurs when Treasury securities are bought or sold simultaneously to maintain the money supply.
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.

22. Government Intervention
The central bank can also intervene indirectly by influencing the factors that determine a currency’s value, such as interest rates.
Note that high interest rates adversely affects local borrowers, and may weaken the economy.
Some governments also use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention.

23. Exchange Rate Target Zones
Many economists have criticized the present system because of the wide swings in the exchange rates of major currencies.
It has been suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries.
The ideal target zone should allow rates to adjust to economic factors without causing wide swings in international trade and fear in financial markets. However, the actual result may be a system no different from what exists today.

24. Intervention as a Policy Tool
The exchange rate is a tool, like tax laws and money supply, with which the government can use to achieve its desired economic objectives.
A weak home currency can stimulate foreign demand for products (and hence local jobs), but may lead to higher inflation.
A strong currency is a possible cure for high inflation, but may cause higher unemployment.

25. Impact of Government Actions on Exchange Rates
Government Intervention in
Foreign Exchange Market
Government Monetary
and Fiscal Policies
Relative National
Income Levels
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies

26. Impact of Central Bank Intervention
on an MNC’s Value
Direct intervention
Indirect intervention
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 the end of period t
k = the weighted average cost of capital of the U.S. parent

27. Chapter Review Exchange Rate Systems Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
Europe’s Exchange Rate Mechanism
Currency Boards
Impact of Exchange Rates on Countries with Pegged Currencies

28. Chapter Review A Single European Currency
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
Government Intervention
Reasons for Government Intervention
Direct Intervention
Indirect Intervention

29. Chapter Review Exchange Rate Target Zones
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 MNC’s Value