CHAPTER – 6
GOVERNMENT INFLUENCE ON EXCHANGE RATES
Exchange Rate Systems
• Exchange rate systems can be classified according to the
degree to which the rates are controlled by the government:
– Fixed
– Freely Floating
– Managed Float
– Pegged
Fixed Exchange Rate System
• A fixed exchange rate is a country's exchange rate regime
under which the government or central bank fixed the
exchange rate of foreign currency to home currency.
• Rates are held constant or allowed to fluctuate within very
narrow bands only.
– Devaluation refers to a downward adjustment of the
exchange rate by the central bank.
– Revaluation refers to an upward adjustment of the
exchange rate by the central bank.
Benefits 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.
• Firms could engage in direct foreign investment, without
concern about exchange rate movements of that currency.
• Investors would be able to invest funds in foreign countries,
without concern about exchange rate movements of that
currency.
Disadvantages of Fixed Exchange Rate System
• There is still risk that the government will alter the value of
a specific 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.
– Inflationary Problem
– Unemployment Problem
Freely Floating Exchange Rate System
• Rates are determined by market forces without
governmental intervention.
• Freely floating exchange rate system allows complete
flexibility for exchange rate movements.
• A freely floating exchange rate system adjusts on a continual
basis in response to demand and supply conditions for that
currency.
Benefits of Freely Floating Exchange Rate System
• Each country is more insulated from the economic problems of
other countries.
• Central bank is not required to constantly maintain exchange
rates within specified boundaries.
• Governments can implement policies without concern as to
whether the policies will maintain the exchange rates within
specified boundaries.
• Finally, if exchange rates are allowed to float, Less capital flow
restrictions are needed, thus enhancing market efficiency.
Disadvantages of Freely Floating Exchange
Rate System
• Higher volatility
• Adversely affect a country that initially experienced
the economic problem like inflation.
• Adversely affect a country with high unemployment.
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.
Pegged Exchange Rate System
• The currency’s value is pegged to a foreign currency or to some
unit of account, and thus moves in line with that currency or unit
against other currencies.
• Some governments peg their currency’s value to that of a stable
currency, such as the dollar, because that forces the value of their
currency to be stable.
Overview of Bangladesh
• Historically, Bangladesh had been maintaining various
pegged exchange rate regimes, such as:
– Pegged to pound sterling (£):1972-1979;
– Pegged to a basket of major trading partners' currencies
(£ as the intervening currency) 1980-1982;
– Pegged to a basket of major trading partners' currencies
(US$ as the intervening currency): 1983-1999;
– Crawling band: 2000-2003;
– Floating exchange rate: May 30, 2003- Present.
Government Intervention
• Each country has a central bank that may intervene in
the foreign exchange market to control its currency’s
value.
• A central bank may also attempt to control the money
supply growth in its country.
Government Intervention
• Central banks manage exchange rates
– to smooth exchange rate movements,
– to establish implicit exchange rate boundaries, and
– to respond to temporary disturbances.