CHAPTER 6
GOVERNMENT INFLUENCE
ON EXCHANGE RATE
Luong Thi Thu Hang. PhD
Chapter objective
Describe the exchange rate system used by various
governments
Explain how governments can use direct intervention to
influence exchange rates
Explain how government intervention in the foreign
exchange market can affect economic conditions
Exchange Rate Systems
Exchange rate systems can be classified
according to the degree of government control
and fall into the following categories:
Fixed
Freely floating
Managed float
Pegged
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Exchange Rate Systems
Fixed Exchange Rate System
Exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
Central bank can also revalue or increase the value of
its currency against other currencies.
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Exchange Rate Systems
Fixed Exchange Rate System (cont.)
Bretton Woods Agreement 1944 – 1971 - Each
currency was valued in terms of gold.
Smithsonian Agreement 1971 – 1973 - called for a
devaluation of the U.S. dollar by about 8 percent
against other currencies.
Advantages of fixed exchange rates
Insulate country from risk of currency appreciation.
Allow firms to engage in direct foreign investment without
currency risk.
Disadvantages of fixed exchange rates
Risk that government will alter value of currency.
Country and MNC may be more vulnerable to economic
conditions in other countries.
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Exchange Rate Systems
Freely Floating Exchange Rate System
Exchange rates are determined by market forces without
government intervention.
Advantages of a freely floating system:
Disadvantages of a freely floating exchange rate system:
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Exchange Rate Systems
Managed Float Exchange Rate System
Governments sometimes intervene to prevent their currencies
from moving too far in a certain direction.
Countries with floating exchange rates: Currencies of most
large developed countries are allowed to float, although they
may be periodically managed by their respective central
banks. (Exhibit 6.1)
Criticisms of the managed float system: Critics suggest that
managed float allows a government to manipulate exchange
rates to benefit its own country at the expense of others.
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Exhibit 6.1 Countries with Floating Exchange Rates and
Their Currencies
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Exchange Rate Systems
Pegged Exchange Rate System
Home currency value is pegged to one foreign currency
or to an index of currencies.
Limitations of pegged exchange rate
May attract foreign investment because exchange rate
is expected to remain stable.
Weak economic or political conditions can cause firms
and investors to question whether the peg will be
broken.
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Exchange Rate Systems
Pegged Exchange Rate System (cont.)
Examples:
Europe’s Snake Arrangement 1972 – 1979
European Monetary System (EMS) 1979 – 1992
Mexico’s Pegged System 1994
China’s Pegged Exchange Rate 1996 – 2005
Venezuela’s Pegged Exchange Rate 2010
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Exchange Rate Systems
Pegged Exchange Rate System (cont.)
Currency Boards Used to Peg Currency Values
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 has printed.
Interest Rates of Pegged Currencies
Interest rate will move in tandem with the interest rate of the
currency to which it is tied.
Exchange Rate Risk of a Pegged Currency
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 and the
Currencies to Which They Are Pegged
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Exchange Rate Systems
Dollarization
Replacement of a foreign currency with U.S. dollars.
This process is a step beyond a currency board because it forces
the local currency to be replaced by the U.S. dollar. Although
dollarization and a currency board both attempt to peg the local
currency’s value, the currency board does not replace the local
currency with dollars.
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Government Intervention
Direct Intervention (Exhibit 6.3)
To force the dollar to depreciate, the Fed can intervene
directly by exchanging dollars that it holds as reserves for
other foreign currencies in the foreign exchange market.
By “flooding the market with dollars” in this manner, the
Fed puts downward pressure on the dollar.
If the Fed desires to strengthen the dollar, it can exchange
foreign currencies for dollars in the foreign exchange
market, thereby putting upward pressure on the dollar.
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Exhibit 6.3 Effects of Direct Central Bank Intervention in the
Foreign Exchange Market
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Government Intervention
Direct Intervention (cont.)
Nonsterilized versus sterilized intervention (See Exhibit 6.4)
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.
In a sterilized intervention, the Fed intervenes in the foreign exchange
market and simultaneously engages in offsetting transactions in the
Treasury securities markets.
Speculating on direct intervention
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 the
Foreign Exchange Market
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Government Intervention
Indirect Intervention
The Fed can affect the dollar’s value indirectly by influencing the factors that
determine it.
e f ( INF , INT , INC , GC , EXP )
where
e percentage change in the spot rate
INF change in the differenti al between U. S. inflation
and the foreign country' s inflation
INT change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC change in government controls
EXP change in expectatio ns of future exchange rates
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Indirect Intervention
Indirect Intervention (cont.)
Government Control of Interest Rates by increasing or
reducing interest rates
Government Use of Foreign Exchange Controls such as
restrictions on the exchange of the currency
Intervention Warnings intended to warn speculators. The
announcements could discourage additional speculation and
might even encourage some speculators to unwind (liquidate)
their existing positions in the currency.
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Intervention as a Policy Tool
A weak home currency can stimulate foreign demand for
products. (See Exhibit 6.5)
A strong home currency can encourage consumers and
corporations of that country to buy goods from other
countries. (See Exhibit 6.6)
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Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S.
Economy
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Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation
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SUMMARY
Exchange rate systems can be classified as fixed rate, freely
floating, managed float, and pegged. In a fixed exchange rate
system, exchange rates are either held constant or allowed
to fluctuate only within very narrow boundaries. In a freely
floating exchange rate system, exchange rate values are
determined by market forces without intervention. In a
managed float system, exchange rates are not restricted by
boundaries but are subject to government intervention. In a
pegged exchange rate system, a currency’s 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 (Cont.)
Numerous European countries use the euro as their home
currency. The single currency allows international trade
among firms in the eurozone without foreign exchange
expenses and without concerns about future exchange rate
movements. However, countries that participate in the euro
do not have complete control of their monetary policy
because a single policy is applied to all countries in the
eurozone. In addition, being part of the eurozone may
render some countries more susceptible to a crisis occurring
in some other eurozone country.
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SUMMARY (Cont.)
• Governments can use direct intervention by purchasing or
selling currencies in the foreign exchange market, thereby
altering demand and supply conditions and hence the
currencies’ equilibrium values. When a government purchases
a currency in the foreign exchange market, it puts upward
pressure on that currency’s equilibrium value. When a
government sells a currency in the foreign exchange market, it
puts downward pressure on the currency’s equilibrium value.
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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SUMMARY (Cont.)
When the Fed intervenes to weaken the U.S. dollar, the
weaker dollar stimulates the U.S. economy by reducing U.S.
demand for imports and increasing foreign demand for U.S.
exports. Thus, the weak dollar tends to increase U.S.
employment but can also increase U.S. inflation. When
government intervention strengthens the U.S. dollar, the
stronger dollar increases the U.S. demand for imports and so
intensifies foreign competition. The strong dollar can reduce
U.S. inflation but may lead to higher levels of U.S.
unemployment.
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