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EXCHANGE RATE BEHAVIOUR
ISFENTI SADALIA
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Government Influence On Exchange Rate
Exchange Rate Systems Classification Fixed Freely Floating Managed Float Pegged
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Fixed Exchange Rate System
Exchange rates are either held constant or allowed to fluctuate only within very narrow bands. Devaluation Revaluation The Bretton Woods era ( ) fixed each currency’s 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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Benefits and Disadvantages of Fixed Exchange Rate System
Exporters and importers could engage in international trade without concern about exchange rate movements of the currency to which their local currency is linked There is still risk that the government will alter the value of a specific currency Firms could engage in direct foreign investment, without concern about exchange rate movements of that currency From a macro viewpoint, a fixed exchange rate system may make each country and its MNCs more vulnerable to economic conditions in other countries like Inflationary Problem Unemployment Problem Investors would be able to invest funds in foreign countries, without concern about exchange rate movements of that currency
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Freely Floating Exchange Rate System
Exchange rates are determined solely by market forces Benefits and Disadvantages of Fixed Exchange Rate System Benefits Disadvantages Each country is more insulated from the economic problems of other countries Higher volatility Central bank is not required to constantly maintain exchange rates within specified boundaries Adversely affect a country that initially experienced the economic problem like inflation Governments can implement policies without concern as to whether the policies will maintain the Adversely affect a country with high unemployment Finally, if exchange rates are allowed to float, Less capital flow restrictions are needed, thus enhancing market efficiency
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Managed 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 This type of system is also known as “dirty” float 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
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 The European Economic Community’s snake arrangement ( ) pegged the currencies of member countries within established limits of each other 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) In 1994, Mexico’s central bank pegged the peso to the U.S. dollar, but allowed a band within which the peso’s value could fluctuate against the dollar By the end of the year, there was substantial downward pressure on the peso, and the central bank all owed the peso to float freely. The Mexican peso crisis had just began
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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 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 dollar’s value) by reducing the U.S. money supply* Governments may also use foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention Intervention warning *Note that high interest rates adversely affects local borrowers
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Intervention as a policy tool
Influence of a Weak Home Currency
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Impact of Government Actions on Exchange Rates
Government Intervention in Foreign Exchange Market Government Monetary and Fiscal Policies Relative Interest Rates Relative Inflation Relative National Income Levels International Capital Flows Exchange Rates Trade Tax Laws, etc. Quotas, Tariffs, etc. Government Purchases & Sales of Currencies
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International Arbitrage & Interest Rate Parity
Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices. Often, the funds invested are not tied up and no risk is involved In response to the imbalance in demand and supply resulting from arbitrage activity, prices will realign very quickly, such that no further risk-free profits can be made
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International Arbitrage
Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency
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International Arbitrage
Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rates
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International Arbitrage
Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries, while covering for exchange rate risk Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials
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Interest Rate Parity Market forces cause the forward rate to differ from the spot rate by an amount that is sufficient to offset the interest rate differential between the two currencies Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP)
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Derivation of IRP
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Graphic Analysis of Interest Rate Parity
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Relationships between Inflation, Interest Rates, and Exchange Rates
Purchasing Power Parity (PPP) Purchasing Power Parity (PPP) attempts to quantify this inflation - exchange rate relationship When one country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the country’s currency Absolute form of PPP Relative form of PPP The “law of one price,” suggests that similar products in different countries should be equally priced when measured in the same currency accounts for market imperfections like transportation costs, tariffs, and quotas. It states that the rate of price changes should be similar
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Derivation of PPP
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International Fisher Effect (IFE)
According to the Fisher effect, nominal risk-free interest rates contain a real rate of return and an anticipated inflation If the same real return is required, differentials in interest rates may be due to differentials in expected inflation According to PPP, exchange rate movements are caused by inflation rate differentials The international Fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation
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Derivation of the IFE
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Graphic Analysis of the International Fisher Effect
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Comparison of IRP, PPP, and IFE Theories
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