1. EXCHANGE RATE BEHAVIOUR
ISFENTI SADALIA

2. Government Influence On Exchange Rate
Exchange Rate Systems Classification
Fixed
Freely Floating
Managed Float
Pegged

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Intervention as a policy tool
Influence of a Weak Home Currency

10. 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

11. 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

12. 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

13. International Arbitrage
Triangular arbitrage is possible when a cross exchange rate quote differs from the
rate calculated from spot rates

14. 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

16. 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)

17. Derivation of IRP

18. Graphic Analysis of Interest Rate Parity

19. 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

20. Derivation of PPP

21. 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

22. Derivation of the IFE

23. Graphic Analysis of the International Fisher Effect

24. Comparison of IRP, PPP, and IFE Theories